Naked Economics (34 page)

This lack of control over the money supply and exchange rate ultimately took a steep toll. Beginning in the late 1990s, the Argentine economy slipped into a deep recession; authorities did not have the usual tools to fight it. To make matters worse, the U.S. dollar was strong because of America’s economic boom, making the Argentine peso strong. That punished Argentine exporters and did further harm to the economy. In contrast, Brazil’s currency, the real, fell more than 50 percent between 1999 and the end of 2001. To the rest of the world, Brazil had thrown a giant half-price sale and Argentina could do nothing but stand by and watch. As the Argentine economy limped along, economists debated the wisdom of the currency board. The proponents argued that it was an important source of macroeconomic stability; the skeptics said that it would cause more harm than good. In 1995, Maurice Obstfeld and Kenneth Rogoff, economists at UC Berkeley and Princeton, respectively, had published a paper warning that most attempts to maintain a fixed exchange rate, such as the Argentine currency board, were likely to end in failure.
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Time proved the skeptics right. In December 2001, the long-suffering Argentine economy unraveled completely. Street protests turned violent, the president resigned, and the government announced that it could no longer pay its debts, creating the largest sovereign default in history. (Ironically, Ken Rogoff had by then made his way from Princeton University to the International Monetary Fund, where, as chief economist, he had to deal with the economic wreckage that he had warned against years earlier.) The Argentine government scrapped its currency board and ended the guaranteed one-for-one exchange between the peso and the dollar. The peso immediately plunged some 30 percent in value relative to the dollar.

Funny money.
Some currencies have no international value at all. In 1986, I crossed through the Berlin Wall into East Berlin, behind the Iron Curtain. When we crossed into East Germany at “Checkpoint Charlie,” we were required to change a certain amount of “hard currency” (dollars or West German marks) for a certain amount of East German currency. How was that exchange rate determined? Make believe. The East German mark was a “soft” currency, meaning that it did not trade anywhere outside of the communist world and therefore had no purchasing power anywhere else. The exchange rate was more or less arbitrary, though I’m fairly certain that the purchasing power of what we got was worth less than the purchasing power of what we gave up. In fact, we weren’t even allowed to take our East German money out of the country when we left. Instead, the East German border guards took what we had left and “put it on account” (that’s really what they said) for our next visit. Somewhere in the now unified Germany, there is an account with my name on it that contains a small amount of worthless East German currency. So I’ve got that going for me.

Soft currencies were a more serious problem for the few U.S. companies doing business in communist countries with soft currencies. In 1974, Pepsi struck a deal to sell its products in the Soviet Union. Communists drink cola, too. But what the heck was Pepsi going to do with millions of rubles? Instead, Pepsi and the Soviet government opted for old-fashioned barter. Pepsi swapped its soft-drink syrup to the Soviet government in exchange for Stolichnaya vodka, which did have real value in the West.
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That all sounds so orderly, except for the riots in the streets in Argentina. In fact, the Argentina-type currency meltdown is surprisingly frequent. Let’s revisit a line from a few pages ago: “Investors take their capital somewhere else, selling the local currency on their way out.” Only now, let’s dress that statement up to more closely approximate reality: “Investors panic, weeping and screaming as they sell assets and ditch the local currency—as much as possible, for whatever price is possible—in hopes of getting out the door before the market completely collapses!”

Argentina, Mexico, Russia, Turkey, South Korea, Thailand, and the country for which we’ve named the chapter, Iceland. What do they have in common? Not geography. Not culture. Certainly not climate. They are all countries that have suffered currency crises. No two crises are exactly the same. They do have a pattern, usually a play in three acts: (1) A country attracts significant foreign capital. (2) Something bad happens: a government borrows too heavily and stands at risk of default; a property bubble bursts; a country with a pegged exchange rate faces devaluation; a banking system is exposed as rife with bad loans—or some combination of all of these things. (3) Foreign investors try to move their capital somewhere else—preferably before everyone else does. Asset prices fall (as foreigners sell) and the currency plunges. Both of these things make the underlying economic problems worse, which causes asset prices and the currency to plunge further. The country pleads with the rest of the world to help stop the downward economic spiral.

To get a sense of how this all plays out, let’s look at the most recent victim: Iceland. Iceland is not a poor, developing country. In fact, Iceland was at the top of the UN Human Development Index rankings in 2008. Here are Iceland’s three acts, as best I can figure them out:

Act I.
In the first decade of the twenty-first century, Iceland’s currency, the Icelandic krona, was extremely strong, and real interest rates were high by global standards. Iceland’s relatively unregulated banks were attracting capital from all over the world as investors sought high real returns. At the peak, Iceland’s banks had assets 10 times the size of the country’s entire GDP. The banks were using this huge pool of capital to make the kinds of investments that seemed very smart in 2006. Meanwhile, the high domestic interest rates induced Icelanders to borrow in other currencies, even for relatively small purchases. An economist at the University of Iceland told CNN Money, “When you bought a car, you’d be asked, ‘How do you want the financing? Half in yen and half in euros?’”
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Act II.
The global financial crisis was bad for the world and disastrous for Iceland. Iceland’s banks suffered huge losses from bad investments and nonperforming loans. By the fall of 2008, the country’s three major banks were defunct; the central bank, which had taken control of the largest private banks, was technically in default as well. The
New York Times
reported a story in November 2008 that began, “People go bankrupt all the time. Companies do, too. But countries?”

As the krona plummeted, the cost of all those consumer loans in foreign currencies skyrocketed. Think about it: If you borrow in euros, and the krona loses half its value relative to the euro, the monthly payment in krona on your loan
doubles.
Of course, many of the assets that Icelanders had purchased with those loans, such as homes and property, were simultaneously plummeting in value.

Act III.
The Icelandic krona lost half its value. The stock market fell by 90 percent; GDP fell 10 percent; unemployment hit a forty-year high. People were angry—just like in Argentina. One woman told
The Economist,
“If I met a banker, I’d kick his ass so hard my shoes would be stuck inside.” And she was a preschool teacher.
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Even the Big Mac Index had a sad postscript in Iceland. In October 2009, Iceland’s three McDonald’s restaurants closed after becoming victims of the financial crisis. McDonald’s required that its Iceland franchises buy their food inputs and packaging from Germany. Because the krona had plummeted in value relative to the euro and because the government had imposed high import tariffs, the cost of these inputs from Germany roughly doubled. The owner of the Iceland franchises said that to make a “decent profit,” a Big Mac would have had to sell for the equivalent of more than six dollars—higher than anywhere else in the world and an untenable price for a country in the midst of a deep recession. McDonald’s closed its doors in Iceland instead.
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The economic wreckage that results time after time as investors flee a country suggests an obvious fix: Maybe it should be harder to flee. Some countries have experimented with capital controls, which place various kinds of limits on the free flow of capital. Like many obvious fixes, this one has less obvious problems. If foreign investors can’t leave a country with their capital, they are less likely to show up in the first place. It’s a bit like trying to improve revenues at a department store by banning all returns. A group of economists studied fifty-two poor countries between 1980 and 2001 to examine the relationship between financial liberalization (making it easier to move capital in and out of the country) and economic performance. There is a tradeoff: Countries that impose some kind of capital controls also grow more slowly.
The Economist
summarized the study’s findings: “An occasional crisis may be a price worth paying for faster growth.”
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Okay, what if we all had the same currency? Wouldn’t that help avoid currency-related headaches? After all, Iowa has never had a financial meltdown because Illinois investors took their capital back across the Mississippi River. There are benefits to broadening a currency zone; this was the logic of the euro, which replaced most of the individual currencies in Europe. A single currency across Europe (and in the fifty U.S. states) reduces transaction costs and promotes price transparency (meaning that it’s easier to spot and exploit price discrepancies when goods are all priced in the same currency). But here, too, there is a trade-off. Remember, monetary policy is the primary tool that any government possesses to control the “speed” of its economy. A central bank raises or lowers interest rates by making its currency more or less scarce. Countries that share a currency with other nations, such as the European countries that adopted the euro, must give up control over their own monetary policy. The European Central Bank now controls monetary policy for the whole euro zone. (Obviously Louisiana and California do not have their own monetary policy either.) This can be a problem if one part of the currency zone is in an economic slump and would benefit from lower interest rates while another region at the same time is growing quickly and must raise rates to ward off inflation.

We don’t really care about currencies per se; what we really care about is the underlying flow of goods and services. These trades across international borders are what make us better off; currencies are merely a tool for facilitating mutually beneficial transactions. In the long run, we would expect the value of the goods and services that we send to other countries to be more or less equal to the value of what they send to us. If not, someone is getting a really bad deal. Even little kids trading snacks in the lunchroom recognize that what you give up should be worth what you get back.

Except for the United States. We’re the guys in the lunchroom giving up liverwurst sandwiches and getting a turkey sandwich, plus chips, cookies, juice, and a peanut-free snack. The United States has been running large and persistent current account deficits with the rest of the world, meaning that year after year we are getting more goods and services from the rest of the world than we sell to them. (The current account measures income earned abroad from trade in goods and services, plus some other sources of foreign income, such as dividends and interest on overseas investments as well as remittances sent home by Americans working abroad.) How are we getting away with that? Might it be a problem in the long run? The answer to the second question is yes. The first question is more complicated.

As noted in Chapter 9, there is nothing inherently bad about a current account deficit, nor anything inherently good about a current account surplus; countries like Algeria and Equatorial Guinea were running current account surpluses in 2007, but that does not make them economic powerhouses. Still, there is an unavoidable economic reality lurking here: A country running a current account deficit is earning less income from the rest of the world than it is paying out. Consider a simple example: If we buy $100 million in cars from Japan and sell them $50 million in planes, then we’ve got a $50 million current account deficit. The Japanese are not sending us an extra $50 million in merchandise because we’re friendly and good looking; they expect us to make up the difference. To do that, we have only a couple of options. One option is to sell our Japanese trading partners assets instead—stocks, bonds, real estate, and so on.

For example, we might sell Japanese firms $25 million in Manhattan real estate and $25 million of equity in American firms (stocks). Now the ledger makes sense. Americans get $100 million of goods and services from Japan; in exchange, we send over $50 million in goods (the planes), and another $50 million in assets. That’s an even deal. It comes with a price, however; the assets that we’re giving up (real estate and stocks) would have generated income for us in the future (rents and dividends). Now that income will go to our trading partner instead. We’re buying cars now by giving up future income.

That’s not our only choice. We can buy our merchandise on credit. We can ask some willing party in the global financial community to loan us $50 million. In that case, we “pay for” our $100 million in Japanese cars with $50 million in planes and $50 million in borrowed capital. That, too, has obvious future costs. We have to pay back the loans, with interest. Again, we are paying for current consumption by borrowing against the future—literally in this case.

Why is the United States running chronic current account deficits? It has virtually nothing to do with the quality of our goods and services or the competitiveness of our labor force, as conventional wisdom would have it. (To my earlier point, do you think Algeria and Equatorial Guinea are running current account surpluses because they are producing better stuff with more productive workers?) The United States is running chronic current account deficits because year after year we are consuming more than we produce. In other words, we are doing the opposite of saving (in which you produce more than you consume and set the extra aside). As a nation, we are literally doing what economists call “dissaving.”