Naked Economics

by Wheelan, Charles

  Nonetheless, Prime Minister John Major declared emphatically that his “over-riding objective” was to defend the pound’s targeted value in the ERM, even as that task seemed ever more difficult. Soros called the government’s bluff. He bet that the Brits would eventually give up trying to defend the pound, at which point its value would fall sharply. The mechanics of his billion-dollar day are complex,* but the essence is straightforward: Soros bet heavily that the value of the pound would fall, and he was right.2 On September 16, 2002—“Black Wednesday”—Britain withdrew from the ERM and the pound immediately lost more than 10 percent of its value. The pound’s loss was Soros’s gain—big time.

  International economics shouldn’t be any different than economics within countries. National borders are political demarcations, not economic ones. Transactions across national borders must still make all parties better off, or else we wouldn’t do them. You buy a Toyota because you think it is a good car at a good price; Toyota sells it to you because they can make a profit. Capital flows across international borders for the same reason it flows anywhere else: Investors are seeking the highest possible return (for any given level of risk). Individuals, firms, and governments borrow funds from abroad because it is the cheapest way to “rent” capital that is necessary to make important investments or to pay the bills.

  Everything I’ve just described could be Illinois and Indiana, rather than China and the United States. However, international transactions have an added layer of complexity. Different countries have different currencies; they also have different institutions for creating and managing those currencies. The Fed can create American dollars; it can’t do much with Mexican pesos. You buy your Toyota in dollars. Toyota must pay its Japanese workers and executives in yen. And that is where things begin to get interesting.

  The American dollar is just a piece of paper. It is not backed by gold, or rice, or tennis balls, or anything else with intrinsic value. The Japanese yen is exactly the same. So are the euro, the peso, the rupee, and every other modern currency. When individuals and firms begin trading across national borders, currencies must be exchanged at some rate. If the American dollar is just a piece of paper, and the Japanese yen is just a piece of paper, then how much American paper should we swap for Japanese paper?

  The rate at which one currency can be exchanged for another is the exchange rate. We have a logical starting point for evaluating the relative value of different currencies. A Japanese yen has value because it can be used to purchase things; a dollar has value for the same reason. So, in theory, we ought to be willing to exchange $1 for however many yen or pesos or rubles would purchase roughly the same amount of stuff in the relevant country. If a bundle of everyday goods costs $25 in the United States, and a comparable bundle of goods costs 750 rubles in Russia, then we would expect $25 to be worth roughly 750 rubles (and $1 should be worth roughly 30 rubles). This is the theory of purchasing power parity, or PPP.

  By the same logic, if the value of the ruble is losing 10 percent of its purchasing power within Russia every year while the U.S. dollar is holding its value, we would expect the ruble to lose value relative to the U.S. dollar (or depreciate) at the same rate. This isn’t advanced math; if one currency buys less stuff than it used to, then anyone trading for that currency is going to demand more of it to compensate for the diminished purchasing power.*

  I learned this lesson once—the hard way. I arrived in Guangzhou, China, in the spring of 1989 by train from Hong Kong. At the time, the Chinese government demanded that tourists exchange dollars for renminbi at ridiculous “official” rates that had no connection to the relative purchasing powers of the two currencies. For a better deal, backpackers typically exchanged money on the black market. I had studied my guide book, so when I arrived at the station in Guangzhou I knew roughly what the black market rate for dollars ought to be, subject to the usual bargaining. I found a currency trader right away and made an opening hardball offer—which the trader accepted immediately. He didn’t even quibble, let alone bargain.

  It turned out that my guide book was old; the Chinese currency had been steadily losing value ever since publication. I had swapped my $100 for the Chinese equivalent of about $13.50.

  Purchasing power parity is a helpful concept. It is the tool used by official agencies to make comparisons across countries. For example, when the CIA or the United Nations gathers data on per capita income in other countries and converts that figure into dollars, they often use PPP, as it presents the most accurate snapshot of a nation’s standard of living. If someone earns 10,000 Jordanian dinars a year, how many dollars would a person need in the United States to achieve a comparable standard of living?

  In the long run, basic economic logic suggests that exchange rates should roughly align with purchasing power parity. If $100 can be exchanged for enough pesos to buy significantly more stuff in Mexico, who would want the $100? Many of us would trade our dollars for pesos so that we could buy extra goods and services in Mexico and live better. (Or, more likely, clever entrepreneurs would take advantage of the exchange rate to buy cheap goods in Mexico and import them to the United States at a profit.) In either case, the demand for pesos would increase relative to dollars and so would their “price”—which is the exchange rate. (The prices of Mexican goods might rise, too.) In theory, rational people would continue to sell dollars for pesos until there was no longer any economic advantage in doing so; at that point, $100 in the United States would buy roughly the same goods and services as $100 worth of pesos in Mexico—which is also the point at which the exchange rate would reach purchasing power parity.

  Here is the strange thing: Official exchange rates—the rate at which you can actually trade one currency for another—deviate widely and for long stretches from what PPP would predict. If purchasing power parity makes economic sense, why is it often a poor predictor of exchange rates in practice? The answer lies in the crucial distinction between goods and services that are tradable, meaning that they can be traded internationally, and those that are not tradable, which are (logically enough) called nontradable. Televisions and cars are tradable goods; haircuts and child care are not.

  In that light, let’s revisit our dollar-peso example. Suppose that at the official peso-dollar exchange rate, a Sony television costs half as much in Tijuana as it does in San Diego. A clever entrepreneur can swap dollars for pesos, buy cheap Sony televisions in Mexico, and then sell them for a profit back in the United States. If he did this on a big enough scale, the value of the peso would climb (and probably the price of televisions in Mexico), moving the official exchange rate in the direction that PPP predicts. Our clever entrepreneur would have a hard time doing the same thing with haircuts. Or trash removal. Or babysitting. Or rental housing. In a modern economy, more than three-quarters of goods and services are nontradable.

  A typical basket of goods—the source of comparison for purchasing power parity—contains both tradable and nontradable goods. If the official exchange rate makes a nontradable good or service particularly cheap in some country (e.g., you can buy a meal in Mumbai for $5 that would cost $50 in Manhattan), there is nothing an entrepreneur can do to exploit this price difference—so it will persist.

  Using the same Mumbai meal example, you should recognize why PPP is the most accurate mechanism for comparing incomes across countries. At official exchange rates, a Mumbai salary may look very low when converted to dollars, but because many nontradable goods and services are much less expensive in Mumbai than in the United States, a seemingly low salary may buy a much higher standard of living than the official exchange rate would suggest.

  Currencies that buy more than PPP would predict are said to be “overvalued” currencies that buy less are “undervalued.” The Economist created a tongue-in-cheek tool called the Big Mac Index for evaluating official exchange rates relative to what PPP would predict. The McDonald’s Big Mac is sold around the world. It contains some tradable components (beef and the condiments) an
d lots of nontradables (local labor, rent, taxes, etc.). The Economist explains, “In the long run, countries’ exchange rates should move towards rates that would equalize the prices of an identical basket of goods and services. Our basket is a McDonald’s Big Mac, produced in 120 countries. The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in America as elsewhere. Comparing these with actual rates signals if a currency is under-or overvalued.”3

  In July 2009, a Big Mac cost an average of $3.57 in the United States and 12.5 renminbi in China, suggesting that $3.57 should be worth roughly 12.5 renminbi (and $1 worth 3.5 renminbi). But that was not even close to the official exchange rate. At the bank, $1 bought 6.83 renminbi—making the renminbi massively undervalued relative to what “burgernomics” would predict. (Conversely, the dollar is overvalued by the same measure.) This is not a freak occurrence; the Chinese government has promoted economic policies that rely heavily on a “cheap” currency. Of late, the value of the renminbi relative to the dollar has been a significant source of tension between the United States and China—a topic we’ll come back to later in this chapter.

  Exchange rates can deviate quite sharply from what PPP would predict. That invites two additional questions: Why? And so what?

  Let’s deal with the second question first. Imagine checking into your favorite hotel in Paris, only to discover that the rooms are nearly twice as expensive as they were when you last visited. When you protest to the manager, he replies that the room rates have not changed in several years. And he’s telling the truth. What has changed is the exchange rate between the euro and the dollar. The dollar has “weakened” or “depreciated” against the euro, meaning that each of your dollars buys fewer euros than it did the last time you were in France. (The euro, on the other hand, has “appreciated.”) To you, that makes the hotel more expensive. To someone visiting Paris from elsewhere in France, the hotel is the same price as it has always been. A change in the exchange rate makes foreign goods cheaper or more expensive, depending on the direction of the change.

  That is the crucial point here. If the U.S. dollar is weak, meaning that it can be exchanged for fewer yen or euros than normal, then foreign goods become more expensive. What is true for the Paris hotel is also true for Gucci handbags and Toyota trucks. The price in euros or yen hasn’t changed, but that price costs Americans more dollars, which is what they care about.

  At the same time, a weak dollar makes American goods less expensive for the rest of the world. Suppose Ford decides to price the Taurus at $25,000 in the United States and at the local currency equivalent (at official exchange rates) in foreign markets. If the euro has grown stronger relative to the dollar, meaning that every euro buys more dollars than it used to, then the Taurus becomes cheaper for Parisian car buyers—but Ford still brings home $25,000. It’s the best of all worlds for American exporters: cheaper prices but not lower profits!

  The good news for Ford does not end there. A weak dollar makes imports more expensive for Americans. A car priced at 25,000 euros used to cost $25,000 in the United States; now it costs $31,000—not because the price of the car has gone up, but because the value of the dollar has fallen. In Toledo, the sticker price jumps on every Toyota and Mercedes, making Fords cheaper by comparison. Or Toyota and Mercedes can hold their prices steady in dollars (avoiding the hassle of restickering every car on the lot) but take fewer yen and euros back to Japan and Germany. Either way, Ford gets a competitive boost.

  In general, a weak currency is good for exporters and punishing for importers. In 1992, when the U.S. dollar was relatively weak, a New York Times story began, “The declining dollar has turned the world’s wealthiest economy into the Filene’s basement of industrial countries.”4 A strong dollar has the opposite effect. In 2001, when the dollar was strong by historical standards, a Wall Street Journal headline proclaimed, “G.M. Official Says Dollar Is Too Strong for U.S. Companies.” When the Japanese yen appreciates against the dollar by a single yen, a seemingly tiny amount given that the current exchange rate is one dollar to 90 yen, Toyota’s annual operating earnings fall by $450 million.5

  There is nothing inherently good or bad about a “strong” or “weak” currency relative to what PPP would predict. An undervalued currency promotes exports (and therefore the industries that produce them). At the same time, a cheap currency raises the costs of imports, which is bad for consumers. (Ironically, a weak currency can also harm exporters by making any imported inputs more expensive.) A government that deliberately keeps its currency undervalued is essentially taxing consumers of imports and subsidizing producers of exports. An overvalued currency does the opposite—making imports artificially cheap and exports less competitive with the rest of the world. Currency manipulation is like any other kind of government intervention: It may serve some constructive economic purpose—or it may divert an economy’s resources from their most efficient use. Would you support a tax that collected a significant fee on every imported good you bought and used the revenue to mail checks to firms that produce exports?

  How do governments affect the strength of their currencies? At bottom, currency markets are like any other market: The exchange rate is the function of the demand for some currency relative to the supply. The most important factors affecting the relative demand for currencies are global economic forces. A country with a booming economy will often have a currency that is appreciating. Strong growth presents investment opportunities that attract capital from the rest of the world. To make these local investments (e.g., to build a manufacturing plant in Costa Rica or buy Russian stocks), foreign investors must buy the local currency first. The opposite happens when an economy is flagging. Investors take their capital somewhere else, selling the local currency on their way out.

  All else equal, great demand for a country’s exports will cause its currency to appreciate. When global oil prices spike, for example, the Middle East oil producers accumulate huge quantities of dollars. (International oil sales are denominated in dollars.) When these profits are repatriated to local currency, say back to Saudi Arabia, they cause the Saudi riyal to appreciate relative to the dollar.

  Higher interest rates, which can be affected in the short run by the Federal Reserve in the United States or the equivalent central bank in other countries, make a currency more valuable. All else equal, higher interest rates provide investors with a greater return on capital, which draws funds into a country. Suppose a British pound can be exchanged for a $1.50 and the real return on government bonds in both the United Kingdom and the United States is 3 percent. If the British government uses monetary policy to raise their short-term interest rates to 4 percent, American investors would be enticed to sell U.S. treasury bonds and buy British bonds. To do so, of course, they have to use the foreign exchange market to sell dollars and buy pounds. If nothing else changes in the global economy (an unlikely scenario), the increased demand for British pounds would cause the pound to appreciate relative to the dollar.

  Of course, “all else equal” is a phrase that never actually applies to the global economy. Economists have an extremely poor record of predicting movements in exchange rates, in part because so many complex global phenomena are affecting the foreign exchange markets at once. For example, the U.S. economy was ground zero for the global recession that began in 2007. With the U.S. economy in such a poor state, one would have expected the dollar to depreciate relative to other major global currencies. In fact, U.S. treasury bonds are a safe place to park capital during economic turmoil. So as the financial crisis unfolded, investors from around the world “fled to safety” in U.S. treasuries, causing the U.S. dollar to appreciate despite the floundering American economy.

  Countries can also enter the foreign exchange market directly, buying or selling their currencies in an effort to change their relative value, as the British government tried to do while fighting off the 1992 devaluation. Given the enormous size of the foreign exchange market—with literally trillions of doll
ars in currencies changing hands every day—most governments don’t have deep enough pockets to make much of a difference. As the British government and many others have learned, a currency intervention can feel like trying to warm up a cold bathtub with one spoonful of hot water at a time, particularly while speculators are doing the opposite. As the British government was buying pounds, Soros and others were selling them—effectively dumping cold water in the same tub.

  We still haven’t really answered the basic question at the beginning of the chapter: How many yen should a dollar be worth? Or rubles? Or krona? There are a lot of possible answers to that question, depending in large part on the exchange rate mechanism that a particular country adopts. An array of mechanisms can be used to value currencies against one another:

  The gold standard. The simplest system to get your mind around is the gold standard. No modern industrialized country uses gold any longer (other than for overpriced commemorative coins), but in the decades following World War II the gold standard provided a straightforward mechanism for coordinating exchange rates. Countries pegged their currencies to a fixed quantity of gold and therefore, implicitly, to each other. It’s like one of those grade-school math problems: If an ounce of gold is worth $35 in America and 350 francs in France, what is the exchange rate between the dollar and the franc?

  One advantage of the gold standard is that it provides predictable exchange ranges. It also protects against inflation; a government cannot print new money unless it has sufficient gold reserves to back the new currency. Under this system, the paper in your wallet does have intrinsic value; you can take your $35 and demand an ounce of gold instead. The “gold standard” has a nice ring to it; however, the system made for catastrophic monetary policy during the Great Depression and can seriously impair monetary policy even during normal circumstances. When a currency backed by gold comes under pressure (e.g., because of a weakening economy), foreigners start to demand gold instead of paper. In order to defend the nation’s gold reserves, the central bank must raise interest rates—even though a weakening economy needs the opposite. Economist Paul Krugman, who earned a Nobel Prize in 2008 for his work on international trade, explained recently, “In the early 1930s this mentality led governments to raise interest rates and slash spending, despite mass unemployment, in an attempt to defend their gold reserves. And even when countries went off gold, the prevailing mentality made them reluctant to cut rates and create jobs.”6 If the United States had been on the gold standard in 2007, the Fed would have been largely powerless to ward off the crisis. Under the gold standard, a central bank can always devalue the currency (e.g., declare that an ounce of gold buys more dollars than it used to), but that essentially defeats the purpose of having a gold standard in the first place.