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Jackson Hole Preview: Draghi's Plan Should Net Positive for Markets


Draghi has done the math, knows the formula, and understands the channels through which a devaluation needs to work. He knows it's not just about trade, it's about real wealth and income and effects on capital investment.


Two other economists that appear to know a thing or two about equilibrium are Paul Samuelson and Robert Solow who both taught economics at MIT. I don't want to dwell on the details of all their work but I do want to point out the connection between equilibrium theory being taught at MIT and one of its students not named Ben Bernanke.

If Europe has a balance of payments crisis that requires an internal devaluation to fix the imbalance the question is whether their authorities are qualified to address this immense challenge in a way that does not collapse the monetary union. In November 1976 Mario Draghi submitted his thesis for his PhD from MIT in what he titled Essays on Economic Theory and Applications. In Chapter 2 with some eerie foresight Draghi asks the question: Under what circumstances will a devaluation improve the balance of payments of the devaluing country?

I was expecting to read a very dovish conclusion that would imply Draghi was heading towards an eventual devaluation of the euro currency. What I found was a well delivered rather hawkish analysis to why the classical approaches to devaluation were insufficient.

Inside Draghi's Reasoning

Draghi's reasoning is based on the interplay between the wealth effect, asset markets, and the demand for money based on equilibrium presumably due to the influences of Samuelson and Solow. In fact Solow with the Franco Modigliani (who wrote a couple of textbooks on financial markets with Frank Fabozzi) supervised Draghi's dissertation. He also credits Bernanke's mentor Stanley Fisher in the writing of Chapter 2.

I'm no economist so it took me five times to read (and I'm still trying to figure out what he's talking about) but you get the impression he respects the market clearing mechanism and he truly believes there is a difference between nominal and real income and wealth. Throughout the thesis he analyzes the cost benefit of the devaluation process by addressing concepts of equilibrium, real income, the demand for money, and the clearing price for goods and assets.

He first addresses the classical models to break down the respective theorems and highlight the flaws. His main criticism of the classical economist models seems to be that they focused on the balance of payments as a whole or simply in terms of trade flows but neglected the presence of assets markets and investment flows.

Draghi offers six propositions for analyzing a devaluation that seem to support his conclusion. Throughout the thesis he explores concepts of the negative wealth effect reducing the demand for money, market equilibrium and ability for markets to clear. He addresses the short term benefit of an improved balance of payments vs. the long term cost of a reduction in the demand for money. Then when he gets to Proposition 6 he gets to the crux of his argument:

A devaluation lowers the relative price of the traded good in the devaluing country and it raises it in the other country. Furthermore it raises the domestic price level less than proportionately to the amount of the devaluation and it increases the world interest rate.

Then if we exclude interest receipts a devaluation would unambiguously decrease the trade deficit. However, a devaluation creates positive excess demand for money in the world market, that, everything else constant, can be cleared only at a higher interest rate. This creates a positive income effect that may worsen the trade balance.

He concedes that the income affect improves the capital account because of the subsequent reduction in domestic demand for foreign bonds and increased foreign demand for domestic bonds. However due to the wealth elasticities of demand for bonds there will be less real domestic demand for foreign bonds and that because foreign demand for domestic bonds would require a much lower clearing price (higher interest) there would be a negative flow affect as you would be paying out more interest than you are earning. I think.

A devaluation affects the capital account through three channels: a wealth effect, an interest rate, or substitution effect and income effect. It unambiguously improves the capital account through the last channel: the decrease in real income in the devaluing country and the increase in real income in the other country respectively reduce the domestic flow for foreign bonds and increase the foreign flow demand for domestic bonds.


The interpretation descends from the definition of capital flows. They arise from the existing gap between desired demand and available stock of domestic bonds. Desired demand is among other things a function of real wealth. Following a devaluation, wealth and the available stock of domestic bonds in real terms, decrease in the same proportion as the increase in the price of traded goods in the devaluing country and conversely in the other country.

So I think Draghi is saying that in a devaluation, in real terms the demand for foreign bonds has been reduced by the increase in domestic prices and resulting decrease in purchasing power plus due to the exchange rate the supply of domestic debt available to foreigners in real terms falls because it takes much fewer units to invest in the same stock. Therefore, in real terms, less domestic money is flowing into foreign bonds and less foreign money flowing into domestic bonds. I think.

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