Naked Economics (32 page)

Monetary policy alone may not be able to break a deflationary spiral. In Japan, the central bank cut nominal interest rates to near zero a long time ago, which means that they can’t go any lower. (Nominal interest rates can’t be negative. Any bank that loaned out $100 and asked for only $98 back would be better off just keeping the $100 in the first place.)
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Yet even with nominal rates near zero, the rental rate on capital—the real interest rate—might actually be quite high. Here is why. If prices are falling, then borrowing $100 today and paying back $100 next year is not costless. The $100 you pay back has
more
purchasing power than the $100 you borrowed, perhaps much more. The faster prices are falling, the higher your real cost of borrowing. If the nominal interest rate is zero, but prices are falling 5 percent a year, then the real interest rate is 5 percent—a cost of borrowing that is too steep when the economy is stagnant. Economists have long been convinced that what Japan needs is a stiff dose of inflation to fix all this. One very prominent economist went so far as to encourage the Bank of Japan to do “anything short of dropping bank notes out of helicopters.”
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To hark back to the politics of organized interests covered in Chapter 8, one theory for why Japanese officials have not done more to fight falling prices is that Japan’s aging population, many of whom live on fixed incomes or savings, see deflation as a good thing despite its dire consequences for the economy as a whole.

The United States has had its own encounters with deflation. There is a consensus among economists that botched monetary policy was at the heart of the Great Depression. From 1929 to 1933, America’s money supply fell by 28 percent.
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The Fed did not deliberately turn off the credit tap; rather, it stood idly by as the money supply fell of its own volition. The process by which money is circulated throughout the economy had become unhitched. Because of widespread bank failures in 1930, both banks and individuals began to hoard cash. Money that was stuffed under a mattress or locked in a bank vault could not be loaned back into the economy. The Fed did nothing while America’s credit dried up (and actually raised interest rates sharply in 1931 to defend the gold standard). Fed officials should have been doing just the opposite: pumping money into the system.

In September 2009, the one-year anniversary of the collapse of Lehman Brothers, the chair of the Council of Economic Advisers, Christina Romer, gave a talk ominously entitled “Back from the Brink,” which laid much of the credit for our escape from economic disaster at the door of the Federal Reserve. She explained, “The policy response in the current episode, in contrast [to the 1930s], has been swift and bold. The Federal Reserve’s creative and aggressive actions last fall to maintain lending will go down as a high point in central bank history. As credit market after credit market froze or evaporated, the Federal Reserve created many new programs to fill the gap and maintain the flow of credit.”

Did we drop cash out of helicopters? Almost. It turns out that the Princeton professor who advocated this strategy (not literally) a decade ago for Japan was none other than Ben Bernanke (earning him the nickname “Helicopter Ben” in some quarters).

Beginning with the first glimmers of trouble in 2007, the Fed used all its conventional tools aggressively, cutting the target federal funds rate seven times between September 2007 and April 2008. When that began to feel like pushing on a wet noodle, the Fed started to do things that one recent economic paper described as “not in the current textbook descriptions of monetary policy.” The Fed is America’s “lender of last resort,” making it responsible for the smooth functioning of the financial system, particularly when that system is at risk of seizing up for lack of credit and liquidity. In that capacity, the Fed is vested with awesome powers. Article 13(3) of the Federal Reserve Act gives the Fed authority to make loans “to any individual, partnership, or corporation provided that the borrower is unable to obtain credit from a banking institution.” Ben Bernanke can create $500 and loan it to your grandmother to fix the roof, if the local bank has said no and he decides that it might do some good for the rest of us.

Bernanke and crew pulled out the monetary policy equivalent of duct tape. The Federal Reserve urged commercial banks to borrow directly from the Fed via the discount window, gave banks the ability to borrow anonymously (so that it would not send signals of weakness to the market), and offered longer term loans. The Fed also loaned funds directly to an investment bank (Bear Stearns) for the first time ever; when Bear Stearns ultimately faced insolvency, the Fed loaned JPMorgan Chase $30 billion to take over Bear Stearns, sparing the market from the chaos that later followed the Lehman bankruptcy. In cases where institutions already had access to Fed capital, the rules for collateral were changed so that the borrowers could pledge illiquid assets like mortgage-backed securities—meaning that when grandma asked for her $500 loan, she could pledge all that stuff in the attic as collateral, even if it was not obvious who would want to buy it or at what price. That gets money to your grandma to fix the roof, which was the point of all this.
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Monetary policy is tricky business. Done right, it facilitates economic growth and cushions the economy from shocks that might otherwise wreak havoc. Done wrong, it can cause pain and misery. Is it possible that all the recent unconventional actions at the Federal Reserve have merely set the stage for another set of problems? Absolutely. It’s more likely, at least based on evidence so far, that the Fed averted a more serious crisis and spared a great deal of human suffering as a result. President Barack Obama appointed Federal Reserve chairman Ben Bernanke to a second four-year term beginning in 2010. At the ceremony, the president said, “As an expert on the causes of the Great Depression, I’m sure Ben never imagined that he would be part of a team responsible for preventing another. But because of his background, his temperament, his courage, and his creativity, that’s exactly what he has helped to achieve.”
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That’s high praise. For now, it seems largely accurate.

I
n 1992, George Soros made nearly $1 billion in a single day for the investment funds he managed. Most people need several weeks to make a billion dollars, or even a month. Soros made his billion on a single day in October by making a huge bet on the future value of the British pound relative to other currencies. He was right, making him arguably the most famous “currency speculator” ever.

How did he do it? In 1992, Britain was part of the European Exchange Rate Mechanism, or ERM. This agreement was designed to manage large fluctuations in the exchange rates between European nations. Firms found it more difficult to do business across the continent when they could not predict what the future exchange rates would likely be among Europe’s multiple currencies. (A single currency, the euro, would come roughly a decade later.) The ERM created targets for the exchange rates among the participating countries. Each government was obligated to pursue policies that kept its currency trading on international currency markets within a narrow band around this target. For example, the British pound was pegged to 2.95 German marks and could not fall below a floor of 2.778 marks.

Britain was in the midst of a recession, and its currency was falling in value as international investors sold the pound and looked for more profitable opportunities elsewhere in the world. Currencies are no different than any other good; the exchange rate, or the “price” of one currency relative to another, is determined by supply relative to demand. As the demand for pounds fell, so did the value of the pound on currency markets. The British government vowed that it would “defend the pound” to keep it from falling below its designated value in the ERM. Soros didn’t believe it—and that was what motivated his big bet.

The British government had two tools for propping up the value of the pound in the face of market pressure pushing it down: (1) The government could use its reserves of other foreign currencies to buy pounds—directly boosting demand for the currency; or (2) the government could use monetary policy to raise real interest rates, which, all else equal, makes British bonds (and the pounds necessary to buy them) more lucrative to global investors and attracts capital (or keeps it from leaving).

But the Brits had problems. The government had already spent huge sums of money buying pounds; the Bank of England (the British central bank) risked squandering additional foreign currency reserves to no better effect. Raising interest rates was not an attractive option for the government either. The British economy was in bad shape; raising interest rates during a recession slows the economy even further, which makes for bad economics and even worse politics.
Forbes
explained in a postmortem of the Soros strategy, “As Britain and Italy [with similar problems] struggled to make their currencies attractive, they were forced to maintain high interest rates to attract foreign investment dollars. But this crimped their ability to stimulate their sagging economies.”
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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,
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but the essence is straightforward: Soros bet heavily that the value of the pound would fall, and he was right.
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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.
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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) and 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.”
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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.