Naked Economics (33 page)

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.”
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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.
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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 dollars 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.”
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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.

In 1933, Franklin Roosevelt ended the right of individual Americans to exchange cash for gold, but nations retained that right when making international settlements. In 1971, Richard Nixon ended that, too. Inflation in the United States was making the dollar less desirable; given a choice between $35 and an ounce of gold, foreign governments were increasingly demanding the gold. After a weekend of deliberation at Camp David, Nixon unilaterally “closed the gold window.” Foreign governments could redeem gold for dollars on Friday—but not on Monday. Since then, the United States (and all other industrialized nations) have operated with “fiat money,” which is a fancy way of saying that those dollars are just paper.

Floating exchange rates.
The gold standard fixes currencies against one another; floating rates allow them to fluctuate as economic conditions dictate, even minute by minute. Most developed economies have floating exchange rates; currencies are traded on foreign exchange markets, just like a stock exchange or eBay. At any given time, the exchange rate between the dollar and yen reflects the price at which parties are willing to voluntarily trade one for the other—just like the market price of anything else. When Toyota makes loads of dollars selling cars in the United States, they trade them for yen with some party that is looking to do the opposite. (Or Toyota can use the dollars to pay American workers, make investments inside the United States, or buy American inputs.)

With floating exchange rates, governments have no obligation to maintain a certain value of their currency, as they do under the gold standard. The primary drawback of this system is that currency fluctuations create an added layer of uncertainty for firms doing international business. Ford may make huge profits in Europe only to lose money in the foreign exchange markets when it tries to bring the euros back home. So far, exchange rate volatility has proven to be a drawback of floating rates, though not a fatal flaw. International companies can use the financial markets to hedge their currency risk. For example, an American firm doing business in Europe can enter into a futures contract that locks in some euro-dollar exchange rate at a specified future date—just as Southwest Airlines might lock in future fuel prices or Starbucks might use the futures market to protect against an unexpected surge in the price of coffee beans.

Fixed exchange rates (or currency bands).
Fixed or “pegged” exchange rates are a lot like the gold standard, except that there is no gold. (This may seem like a problem—and it often is.) Countries pledge to maintain their exchange rates at some predetermined rate with a group of other countries—such as the nations of Europe. The relevant currencies trade freely on markets, but each participating government agrees to implement policies to keep its currency trading within the predetermined range. The European Exchange Rate Mechanism described at the beginning of this chapter was such a system.

The primary problem with a “peg” is that countries can’t credibly commit to defending their currencies. When a currency begins to look weak, as the pound did, then speculators pounce, hoping to make millions (or billions) if the currency is devalued. Of course, when speculators (and others concerned about devaluation) aggressively sell the local currency—as Soros did—then devaluation becomes all the more likely.

Borrowing someone else’s strong reputation.
At the end of 1990, inflation in Argentina was more than 1,000 percent a year, to no one’s great surprise given the country’s history of hyperinflation. Is that a currency you want to own? Argentina had long been the world’s inflation bad boy—the monetary equivalent of someone who stands you up for three straight dates and then tries to tell you that the fourth time will be different. It won’t be, and everyone knows it. So when Argentina finally got serious about fighting inflation, the central bank had to do something radical. Basically, it hired the United States as a chaperon. In 1991, Argentina declared that it was relinquishing control over its own monetary policy. No more printing money. Instead, the government created a currency board with strict rules to ensure that henceforth every Argentine peso would be worth one U.S. dollar. To make that possible (and credible to the world), the currency board would guarantee that every peso in circulation would be backed by one U.S. dollar held in reserve. Thus, the currency board would be allowed to issue new pesos only if it had new dollars in its vaults to back them up. Moreover, every Argentine peso would be convertible on demand for a U.S. dollar. In effect, Argentina created a gold standard with the U.S. dollar substituting for the gold.

It worked for a while. Inflation plummeted to double digits and then to single digits. Alas, there was a huge cost. Remember all those wonderful things the Fed chairman can do to fine-tune the economy? The Argentine government could not do any of them; it had abdicated control over the money supply in the name of fighting inflation. Nor did Argentina have any independent control over its exchange rate; the peso was fixed against the dollar. If the dollar was strong, the peso was strong. If the dollar was weak, the peso was weak.