Scapegoats and exchange rates

OKONOMOS

Outside of the physical sciences, it is impossible to assign a one-to-one reason for why something happens. That is an important reason why statisticians developed the technique of weighing for use in social sciences. The idea was to arrange, in some sort of order, the relative importance of a set of probable reasons for why something happens.

Mostly, this method works. But sometimes it fails. Perhaps more importantly, the bigger the problem or the issue, the more spectacular is the failure. A recent paper* by Philippe Bacchetta and Eric van Wincoop tells us why exchange rate fluctuations provide an excellent example of this.

Ever since Kenneth Rogoff (the former IMF chief economist) and Richard Meese showed, in 1983, that macroeconomic variables do not influence exchange rates in the short or medium run, the tendency amongst macro economists has been to look into the far distance for explanations. It is little wonder that they have been unable to come up with anything very useful.

But even as economics has ruled out macro factors as influencing short- or medium-term exchange rates, market participants always blame macro variables for the fluctuations. This suggests that, as usual, no one really knows what's what and as the authors put it, "there is confusion in the market about the true source of exchange rate fluctuations."

Bacchetta and van Wincoop thus point to the time when the Euro was introduced in January 1999. It immediately slipped against the dollar. The strong US growth relative to the much slower European growth was blamed for its rapid descent.

Now the boot is on the other foot with the dollar slipping against the Euro, and it is the large US current account deficit that is being blamed. The truth, in all likelihood, is different.

"The varying weight that traders give to different macro indicators may explain why formal models of exchange rates have found so little explanatory power of macro variables" says the authors.

"In contrast to existing models, the relationship between macro variables and the exchange rate appears to be highly unstable... found that some models, with certain macro variables, do well in some periods, but not in others."

The reason why this happens, say Bacchetta and van Wincoop, is that a particular variable is given "excessive" weight during some period. They call this the scapegoat phenomenon, that is, "the exchange rate may change for reasons that have nothing to do with observed macro fundamentals, for example, due to unobserved liquidity trades."

What happens then holds the key. The market begins to look around for "rational" explanations for the changes and lights upon one or the other macro indicator. "This macro indicator then becomes a natural scapegoat and influences trading strategies. Over time, different observed variables can be taken as scapegoats so that the weights attributed to macro variables change."

The next step is well known. The wrong identification of causality results in a cascade effect. "When a macro variable becomes a scapegoat, it has a much larger impact on the exchange rate than otherwise due to confusion with liquidity trade."

So what is the lesson? It is that when the impact of the scapegoat effect is large, the impact of liquidity trade is also magnified. Thus, speculation that cannot be observed is responsible for an exchange rate depreciation, an unusually high money supply can easily be made the scapegoat and the central bank can take the wrong policy road of monetary tightening.

Something akin to this happened in India in September 1995. Its consequences began to be felt from mid-1996 onwards in the form of a massive industrial slowdown as interest rates shot up.

The difference was that it was the RBI that had read the tea leaves wrong, not the market. But then, on the other hand, it was a major market participant, not to mention judge, jury and hangman all combined.

*A Scapegoat Model of Exchange Rate Fluctuations,
NBER Working Paper No. 10245,
January 2004