Should we save the RON?

In my last post I was arguing mostly from a theoretical point of view that Inflation Targeting has failed in Romania. To be fair it was never been given a fair chance. Two years into implementing the regime the NBR decided not target inflation but the exchange rate .  One perverse result from this in an economy with historically high inflation and no growth is dominance of local currency by ones from countries with economic growth and low inflation. In other words the central bank has implicitly subsidized the dominance of EUR by undermining RON.
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This dominance can easily be seen in the preferred currency for domestic transactions. In fact if the Romanian government will allow taxes to be paid in other currencies than RON will cease to exist.

As I showed here NBR responds more to the exchange rate than does to the inflation rate. It does so by intervening in the FX market by buying RON and selling EUR. When the NBR buys RON it lowers the M1  measure of money. The graph below show the almost perfect correlation of M1 and the exchange rate EURRON. A fall in M1 is correlated to a fall in the exchange rate which means RON appreciation.

There are real negative implications for the economy in the short term which I covered before from such a policy especially if interventions are not sterilized. But today how the economy has responded to this new regime. You will see that it has led to a substitution of RON with EUR in almost all transactions. The only function left for RON is that of a legal tender, i.e. we use it to pay taxes.

The first question marks show up when we look at a measure of money multiplier (m3/m1) compared to private sector credit(it includes credit in EUR and RON). As money multiplier falls private sector credit increases. Pretty odd I would say.

The mystery is half solved if we look at what the corporate sector prefers as the borrowing currency. As you can see until 2008 the corporate sector was keeping the balance between RON and EUR borrowing. However, after the NBR made it clear that it targets the exchange rate, October 2008, the corporate sector has moved to borrowing almost exclusively in EUR. We see some signs of life for the RON credit market in 2011 but I suspect is very much connected to short term borrowing for working capital.

However, the demise of RON is nowhere more obvious than when we look at the credit market for households. We observe a similar pattern as in the corporate sector until 2008. Afterwards the effect is more dramatic. Once the population has learned that the central bank will not allow the currency to depreciate , it borrowed exclusively  EUR. The decrease in the RON stock for credit might mean that some debts in RON were payback, unlikely, or that some switched their RON credit to EUR. There is no sign of reversal like in the corporate sector which means that for the population RON is just a currency they are forced to carry but in which they do not have any faith.

What are the implications from all of this?

It is always hard to guess what is in the mind of a central bank – objective function. Does it care about inflation or growth? Does it care about both and if yes does it care about them equally? Does it care about the political cycle?

The central banks all over the world have understood that it is inefficient to let the population guess their intentions. They came up with rules, like the Inflation Targeting one.  Of course no one believed them that they will only care about inflation and credibility had to be gained. The easiest way was by thwarting inflation.

As Romania is a country with a history of rampage inflation it made perfect sense that in 2005 it adopted de jure Inflation Targeting as a policy regime. To make it work NBR had to gain the trust of the markets and the only way was to be tough on inflation. It was not to be.  Starting with 2008  the evidence shows that the central bank cared about inflation at best a secondary objective and that the main one has become a stable exchange rate.

It took the markets some time to learn this but not to the private sector. Both households and corporates have understood that NBR has a “sweet tooth” for a stable RON and is almost indifferent to inflation volatility. Both categories acted on it as per the info in those graphs.

Going forward it will be even harder for the NBR to switch back to an IT regime. But it remains an option although only if the flexible exchange rate regime is brought back.  I do not see a chance of this happening. Rather I expect the NBR to keep the RON stable via direct interventions in the FX market. In the same time when there is no risk of liquidity dry up globally the central bank will sterilize those interventions at least partially in order to support the Ministry of Finance to borrow at a lower price. Of course the NBR will only sterilize those interventions at very short maturities.

Macroeconomic policies implemented so far have undermined the existence of RON. Trying to save it means free float and the risk, at least in 2012, of a negative shock to growth. I am afraid that the election year will not allow for this to happen, unless the NBR is independent de jure and de facto. It is obvious to me that the NBR and the Government have lost interest in RON.  Thus, in this game of musical chairs make sure you are not the one left standing.

27 thoughts on “Should we save the RON?

  1. No comments? Let’s add one:

    The economy of a country or of an individual are complex systems. They are multi-facet systems. They are not linear.

    So, to use a linear method, in this case “targeting inflation”, is almost bound to fail. That’s because you will influence positively certain aspects but you will influence negatively or perturb other aspects.

    Unless you understand perfectly how the entire economy works: the public + the private sector, and you can measure it and predict it precisely, then you can use a linear method sometimes, and surely not all the time. That’s because you know how these complex systems will react.

    You are right to ask the following questions:
    “Does it care about inflation or growth? Does it care about both and if yes does it care about them equally? Does it care about the political cycle?”

    That’s what happens when they are trying to apply a linear solution to a complex problem. It’s like trying to solve second degree equations by applying 1st degree solutions.

    1st degree equations: http://www.mathsteacher.com.au/year10/ch02_linear_equations/01_one_operation/solve.htm#m4
    2nd degree or quadratic equations: http://en.wikipedia.org/wiki/Quadratic_equation

    *****
    What’s the solution then?
    We have to divide all of these extremely complex systems into easy chunks that are linear, imperfect and easy to accomplish. The free market does it for us. It breaks down really complex systems into very simple transactions which can be:
    1. exchanging products indirectly through the monetary system
    2. exchanging products directly through barter

    In order for an exchange to happen, there’s a need for different parties. So everyone has to have his own area of control. Otherwise, there’s no exchange, there’s just movement without purpose. There’s no point in exchanging something that belongs to all of us. We could just share everything together. And we usually end up consuming it because that’s what our ancient brain wiring tells us to do.

    What the state can do about it?
    In order for an economy to grow, as many transactions as possible have to affect positively all the parties involved. The state by definition does harm before doing good. The more good the state wants to do, the more harm has to do ahead of time. What’s the harm? Coercing individuals into giving up their resources.

    For a state to work economically and increase prosperity for the country, it has to create more good for its citizens than the harm previously created through coercion. So it has to be even more efficient than the private sector. That’s because it has to make up for the first transaction that he got through coercion.

    Experience has shown that in most if not all economic domains the state does a poorer job even when it comes to the second part, to the doing of something good.

    State’s economic influence = coercion + good things + stealing = harm + a few good things
    Private sector influence = more good things than what the state can provide

    So basically the state is only more efficient than the private sector in doing harm.

    1. Btw, in the eastern spiritual tradition there’s a spiritual philosophy & tradition called non-duality.
      http://en.wikipedia.org/wiki/Nondualism

      It’s basically a way to break down really complex systems, in this case the entire reality, into simple linear equations. Non-duality means to break down everything into their opposites and then you let go of them while realizing that they do not actually exist.

      Let’s take “short” and “long”. They are opposites. A stick can be “short” compared to a tree. And “long” compared with a dot. So, the stick is basically neither “short” nor “long”. This is how you realize that the idea of “short” and “long” exists just inside your mind. It doesn’t really exist in reality.

      You can apply the same above formula to absolutely everything. And this is how you can solve any emotional problem. You realize that it exists just in your mind, it was made up.

      And by applying the same formula, you realize that everything you are seeing is actually made up by your mind. It doesn’t really exist the way you see it.

      The world you think you are seeing was created by your mind alone. So the only way left is to act based on something that doesn’t depend on a specific mind, something that is the same regardless of your emotions and regardless of which mind sees it. That’s the objective reality that can be measured and acted upon.

      If you have 10 trees in your garden, it doesn’t matter who counts them, they are still 10 trees, not 9, not 17.

      1. @Adrian
        I do not think anyone in the right mind disputes the fact that economies are complex systems. If you look through my early posts I think I wrote something about it.
        However, that does not mean that we can approximate the reality around us. All models are a liner approximation of our realities but through the lens of a particular individual.
        The main problem is not that the economy is complex, other systems are too, but the fact that we perceive it differently. Some believe that there are no rigidities out there and a productivity shock is transferred to the rest of the economy immediately while others believe that legal and social contracts slow this process down.
        Or some believe that the world would be better off without bankers while others see value in the banking business. You get my point.
        However, this does not mean that we cannot attempt to improve the our way of understanding how the economy works. Also, throughout history some policies proved to be better than others. My big problem is that economic research focuses mostly on US and other developed economies.
        My hypothesis is that while our agents and factors of production respond the same way to incentives they act in a different framework where their preferences are altered.
        For example I believe that the presence of the state is so big in Romania that agents might display puzzling reactions. I point here to the immediate reaction of most Romanians when you tell them about lower taxes: what about the budget deficit? their concern is for the welfare of the state not for themselves.
        I digress.
        Back to monetary policy in Romania. Yes there are a multitude of problems starting with the fact that we use forecasts and survey data etc. But there are some simple and clear relationships. Take a lot of money from the economy by surprise and you have a recession. The key element here is “by surprise”. If the people and firms would know about it they would adjust to the new reality hopefully. There are no clear solutions but there solutions.
        Due to complexity of the economy rules based policies, transparency and credibility from the policy makers help agents navigate these murky waters.

        There is no way you can measure the output of the economy as you count the trees in a garden. In the same time an economy is more vibrant and surprising than a garden.

      2. @Florin
        “However, that does not mean that we can approximate the reality around us.”
        No, we can approximate the economic system or the reality around us. We just have to measure it. In the case of the economic system, we just have to register somewhere all transactions that take place. What we can’t predict and measure in advance is the future.

        “All models are a liner approximation of our realities but through the lens of a particular individual.”
        Yes, that’s the limitation built in. The conscious mind can perceive just a few bits of information at once. So it deals only with linear models.

        “Or some believe that the world would be better off without bankers while others see value in the banking business. You get my point.”
        Yes, but the 3D world we live in is clearly measurable. Example: A few weeks back, I talked with a family member. He has a mortgage for the next 20 years, he already paid rates for the past 5 years.

        He told me all the facts and after 20 minutes he explained to him all the implications of the facts. He didn’t consider all the implications of the facts. And he was really pumped up to get rid of his mortgage and rent a place in the mean time.

        I’ll not get into details, but the idea: he had the exact same data as I did. He told me all the data but he didn’t look at what meant for the data.

        Everyone agrees that the deficit is 3.5%, for example. We all agree that the objective reality is true. The problem is the reality, the perception, that’s made up inside our minds.

        And I described you above a method to differentiate between what’s inside your mind and what’s in reality. There are certain things you don’t know for sure about the economy and you shouldn’t believe it’s one way or another.

        Let’s take for example the idea of voluntary exchanging REAL products and services. Both people are happy to trade money for products and services and the reverse. Otherwise, they won’t do it.

        And if they make a mistake, the next time they know better. So the people that take part in the market become better over time. And the ones that contribute in the best way, are rewarded more than the others.

        If you scale up a good model that works locally, between 2 people, it will work between 7 billion people as well. So it’s a model that works. There’s no point in looking for better models while we are in a recession when we have a model that already works.

        “However, this does not mean that we cannot attempt to improve the our way of understanding how the economy works.”
        The goal shouldn’t be to understand too well how the economy works. The goal should be to find a model that works, we already have one, and stick with it. Don’t pollute it with other models that might work. The market works pretty well already.

        “For example I believe that the presence of the state is so big in Romania that agents might display puzzling reactions. I point here to the immediate reaction of most Romanians when you tell them about lower taxes: what about the budget deficit? their concern is for the welfare of the state not for themselves.”
        This problem doesn’t have to do with the economy. It’s psychological. You tell them about lower taxes. They don’t really understand what that means. You should tell them about how the state steals from them and doesn’t give much back.(That’s not fair. People respond to fairness.) Tell them about how much time they work for the state alone each day. How the politicians believe the masses to be stupid. How the state is actually the enemy and they are presenting themselves as the God’s son on earth.

        “Take a lot of money from the economy by surprise and you have a recession. The key element here is “by surprise”.”
        Yes, but that can’t really happen in a free market. It can happen because there’s someone who can actually take a lot of money by surprise. In a free market, people could print their currencies. No problem if a bunch of money is no longer present. In a free market, in order to get a lot money to yourself you actually have to sell a lot of REAL products.

        “Due to complexity of the economy rules based policies, transparency and credibility from the policy makers help agents navigate these murky waters.”
        The murky waters are created by these policies. The policy is the problem, not the economy. The problem is not with the person who builds a valuable product for others. It’s with the policy maker who believes that he knows something. He doesn’t have a clue because his conscious murky mind is not adapted for such a complex task.

        “There is no way you can measure the output of the economy as you count the trees in a garden.”
        Yes, you can. You measured in dollars or RON etc. You just can’t measure it in advance.

    2. So if the state is bad at managing things … why should it manage the money supply ?

      I don’t know if you’re aware of this, but you just argued in favour of “free banking” (the very thing you were arguing against yesterday) …

      1. @Daniel
        I’m for free banking as long as free banking doesn’t mean “print money out of this air”. Banks should give loans to everyone they see fit. And they should charge any interest they wish.

        But they should also support the consequences if the loans are bad. If people can’t really return what they borrowed the banks will suffer a loss. They wouldn’t receive bailouts in these type of situations.

        The money supply should be backed by something real or simply be a limited quantity of it that doesn’t just increase whenever the central bank wants.

  2. Have you ever tried reading about “free banking” ? You should do so.

    “The money supply should be backed by something real or simply be a limited quantity of it”

    Dude. You have the basic equation of exchange M * V = P * Y.
    If you believe that prices are sticky … then it follows that sudden shocks to M * V should be avoided.

    So if V drops … M should rise (and vice-versa).

    “whenever the central bank wants”

    If you’re arguing in favour of a rules-based, forward-looking monetary policy – I’m 100% in agreement.

    If you think that looseness or tightness of monetary policy can be judged by looking only at the monetary base … you are very mistaken.
    And I really hope you won’t start arguing in favour of commodity-based money … because that’s truly a “barbarous relic”.

    1. @Daniel
      I’m not talking about your definition of “free banking”. I don’t see any necessary difference between a bank and a company. They shouldn’t have special rules.

      The loaning of the money is no different than renting an apartment. The interest on the loan is the equivalent of the rent on the apartment. The problem is when the money loaned is just printed and it’s not limited by anything.

      “If you’re arguing in favour of a rules-based, forward-looking monetary policy – I’m 100% in agreement.”
      I’m not in favor of any of those.

      “And I really hope you won’t start arguing in favour of commodity-based money … because that’s truly a “barbarous relic”.”
      If you can limit the quantity of money in any other way, let me know. Over time, people didn’t prove to be able to resist printing them when they had the opportunity.

      Saying that something is a “barbarous relic” doesn’t actually invalidate it. Do you sleep at night? That habit is a “barbarous relic” too. Do you eat? That habit is a “barbarous relic” too. They are all billions millions years old. Try going without sleep or food for a long period of time, see what happens. They are still with you because they still serve a purpose. They still work.

      “You have the basic equation of exchange M * V = P * Y.”
      That’s not the basic equation of exchange. It’s called like that, but it’s not really. The basic equation of exchange is: V >= P where V = the value of the product or service perceived by the buyer and P = the price that the buyer is actually paying for the product or service. And the actual exchange happens when the product or service is exchanged with the money.

      Your equation is dealing with a lot of exchanges not with an exchange.

      1. I’ll be nicer when he’ll be able to give a good reason why we should freeze the monetary base – and thus make the economy vulnerable to fluctuations in the demand for money.

      2. @Daniel
        You do not have to be nice just use arguments not personal attacks.
        On a different topic, have you looked at the FED statement?I am writing something about it for tomorrow.

      3. “Sorry to have to say this, but you bring absolutely nothing to the conversation.”
        Any input comes with some meaning attached to it. If you are not seeing it, it’s your problem. Get out of perceiving it.

        “I’ll be nicer when he’ll be able to give a good reason why we should freeze the monetary base – and thus make the economy vulnerable to fluctuations in the demand for money.”
        You are not freezing the monetary base. You are linking the monetary base to hard assets. Gold is one example.

        I’m against printing money backed by nothing. That’s the problem.

        People believe that money is what matters. They actually want to buy products and services, houses etc. These products and services don’t appear from nowhere.

        “@Florin Citu
        http://en.wikipedia.org/wiki/The_Art_of_Being_Right
        I don’t care about being right in a debate. I want to be accurate. I don’t want to find the very best solution that works theoretically. I want to find something that works most of the time practically.

      4. Adrian,

        You do know that the Great Depression of the 1930 was caused precisely by the gold standard, right ?

        To be more accurate, by the Bank of France’s decision to increase its gold reserves … which caused gold to increase in value, and pushing everyone on the gold standard into deflation.

        So to ask you again – why should we link the currency to a commodity (or even a basket of commodities) ?
        Why should we leave macro-economic stability vulnerable to one (or more) commodity’s fluctuation in value ?

        This is why Keynes referred to the gold standard as a “barbarous relic” (and rightly so).

        And WHY (God, why) are we still having this conversation ? Are we truly unable to learn from past mistakes ?

        The gold standard was not some macro-economic paradise of nominal stability. It was riddled with episodes of inflation and deflation.

        And even when it worked, it worked only because large gold reserves were discovered, which allowed for low inflation …

      5. “@Adrian
        How does the money supply in a gold standard accommodate a productivity shock that pushes the economy on a higher production frontier?”
        By productivity, I suppose you refer to someone producing something and then selling it. Otherwise, it doesn’t really matter because the product is unsold and stays in some deposit.

        So, if the product is actually sold then it simply goes from one person to another, faster. So M1 can stay the same and the volatility simply increases.

        Imo, the advantage of the gold standard is lower risk. Less power in a few hands. Less manipulation of the prices. A system that doesn’t pick winners and losers based banker’s decisions. It’s a system less dependent on banks.

        If the product is not sold through a voluntary exchange, then it doesn’t really matter if you produce it because it doesn’t count to the real economy. You are the only person/company benefiting from it.

        By the way, how can you take a population and make it more productive overnight? A productivity shock has to be preceded by a productivity shock at the individual level. It sounds to be as an unrealistic scenario. People don’t just become more productive really quickly unless you give them credit which creates only the impression that they are x times more productive.
        @Daniel
        “Why should we leave macro-economic stability vulnerable to one (or more) commodity’s fluctuation in value ?”
        Why does the macro-economic stability matter at all for everyone but bankers, traders and politicians? Let’s say that you have 10.000 companies doing business. They produce what is selling and they allocate more resources to what is selling.

        They don’t need any credit or they need little credit to try things to a smaller scale and see if their ideas work in the marketplace. Once they start making sales, their customers fund their business.

        “And WHY (God, why) are we still having this conversation ? Are we truly unable to learn from past mistakes ?”
        What caused this 2008 economic crisis? It obviously wasn’t caused by the gold standard. What caused it? Don’t you see that the system we have right now is screwed up? It comes with a system to filter the work of almost everyone to a few people.

        “The gold standard was not some macro-economic paradise of nominal stability. It was riddled with episodes of inflation and deflation.”
        It’s nothing wrong with prices falling. The gold standard is just better than the debt standard we have right now. People confuse debt with productivity and making something real happen. Just because money move around in the economy

        The problem is that with our monetary system everything is perceived through the lens of debt. Debt = negative Wealth for the debtor. The higher levels of debt you have, the less likely you are to be financially free or wealthy.

      6. “Wow man, thank you SO MUCH for writing that.
        Now I know I should just ignore you.”

        Which part I wrote made such an impact on you?😀

      7. “The one in which you made zero sense – that is, all of it.”
        hhhh. Btw, did you take any IQ tests in the past? What was the average result? I’m not trying to be mean, I’m just curios.

      8. Ok Florin, you tell me how to discuss “theories and models” with someone who says “Why does the macro-economic stability matter at all for everyone but bankers, traders and politicians?”

        Because, in full honesty … I don’t know how.

  3. I think the large government debt exposure in EUR has forced the NBR to abandon IT. Add to that the fact that a lot of households have loans in EUR and a volatile exchange rate would imply a lot more defaulted loans (households do not have the posibility to hedge).
    Anything else?…Ooh, yes, a ~5% interest rate in Romania vs a ~1% interest rate in the EU on deposits and a stable exchange rate (keeping capital in Romania is an IMF requirement).

    If this is a good move or not, only time will tell.

      1. Offtopic: this is one of your best & most concise posts so far.

        Ontopic: I agree with you, NBR is targeting the exchange rate and this is no secret (some economists were saying this since late 09 – early 10).

        To me the question is, how much of this behaviour is related to constraints (like those I’ve mentioned) and what part is discretionary policy?

      2. @DDR
        thank you
        Ontopic.: you mention three constraints; government debt, household debt and high real interest rates.

        As you can see from the graphs there is no real preference until 2008. The agents in the economy were trying to keep a balance between borrowing EUR vs. RON. At that time the perception was that the central bank is an inflation targeter. But in 2008 the NBR revealed a different reaction function implying a different objective function. At that point, although the RON last some value in the first part of 2008 the message was clear that the stability of RON is paramount.

        It is true however that at the moment of the NBR intervention in 2008 the economy was already highly euroized due to high domestic real rates. A central bank that cares a lot about GDP volatility would intervene. However, in the case of Romania the mistake was made when the interventions were not sterilized and this froze the money markets.

        But this is history now. What should the central bank do going forward? They talk about de-euroization but keep the exchange rate fixed. It will not work. They have to either admit a peg or a flexible exchange rate.

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