The Little Book of Economics

THE MESS CREATED by subprime mortgages issued to people of doubtful credit should have been the United States’ private headache. After all, the loans were dreamed up to satisfy the American obsession with home ownership. Yet, to leverage themselves to the hilt, Americans had to borrow. If they could only borrow from other Americans, the competition for money would have driven up U.S. interest rates and snuffed out the frenzy.

But, as we learned in the previous chapter, economic borders are melting, in particular for borrowers. Factory workers in Shanghai, mutual fund investors in the United States, sovereign wealth funds in the Persian Gulf, and banks in Düsseldorf are all connected to a global ATM that continuously channels money from savers in one part of the world to borrowers in another. Thus, when U.S. homeowners and the U.S. Treasury needed money, the global ATM matched them to Germans, Chinese, and Saudis who needed a place to invest their savings.

When home prices turned down, the pain was felt not just in the U.S. financial system but by the banks and investors of every country that helped finance the housing boom. IKB, a once sleepy German bank that ran out of opportunities to lend to local businesses, loaded up on subprime mortgage-backed securities. In 2007, it had to be bailed out by the German government. It was joined in the injured ward by French, Swiss, and British banks, Australian hedge funds, and Norwegian municipalities.

The subprime mortgage crisis eloquently demonstrates how the global markets for assets, debts, and currencies have knit the world together. It provides many benefits, such as helping countries finance investment when they don’t have enough saving and enabling investors and borrowers alike to spread their risks around. But just as modern jet travel allows viruses to cross oceans, modern capital markets rapidly transmits one country’s problems to others. And unlike with exports and imports, the currency and capital markets aren’t governed by a shared rules of the road. They’re a free-for-all prone to crisis.

Financing Deficits and More

If you spend more than you earn, you cover the difference by running up your credit card, running down your savings, or cashing in some investments. For a country, the equivalent is running a current account deficit—paying foreigners more for imports, interest, and dividends than it receives from them. To finance such a deficit, a country has to either borrow or sell some assets, such as stocks, bonds, Rockefeller Center, or a beer company to foreigners, with the result that the country’s foreign debt mounts.

There’s nothing wrong with a current account deficit. Just as a start-up company needs outside investors to develop its technology, a country often lacks the savings to exploit its bountiful investment opportunities. Foreigners lend it the money or purchase shares in its companies so that they can build railroads, dig mines, or erect factories. The investments make the country wealthier, generating wages and profits it can use to repay the foreign investor.

Nowadays, though, far more capital crosses borders than what’s needed simply to finance deficits. In 2009, for example, foreigners bought and sold about $40 trillion worth of U.S. stocks and bonds, more than 10 times the total trade that year. According to the Bank for International Settlements, foreign exchange trading now averages more than $3 trillion per day. These flows do more than transfer money from a saver in one country to a borrower in another; they make it possible for both investors and borrowers to diversify. U.S. investors, for instance, can diversify their portfolios by owning mature, stable U.S. companies and riskier but faster growing companies from Brazil and China, while U.S. companies can finance their expansion by raising money from Brazilian hedge funds and Chinese banks.

Still, the stunning scale of capital movements poses huge risks. Imagine carrying a cookie sheet filled with water across the kitchen floor. Just the slightest trip and water sloshes over the sides. The global capital market is like that cookie sheet. Enormous amounts of money flow effortlessly across borders around the clock but even a minor disturbance can divert huge sums from one market to another, sending stocks, interest rates, and currencies sharply up or down.

The easy availability of global capital means a country can finance bigger deficits for longer than when capital was less mobile and harder to get. Most of the time that’s good, but sometimes it lets a country dig itself deeper into debt. In the late 1990s, the United States ran current account deficits reflecting its companies’ hunger for capital to invest in new technology. In the 2000s, it kept on running current account deficits, but this time to finance our lifestyles, such as suburban McMansions with granite-topped kitchen counters. They did nothing to enhance future growth.

Foreign borrowing binges almost always end badly, as the United States’ did. It could have been worse. In small countries, foreign investors suddenly flee a country, sending its interest rates up sharply and its economy into recession; it happened to Mexico in 1994 and throughout east Asia in 1997. Large countries like the United States are spared that trauma but the result is still miserable.

The Currency Market

Of all the thousands of prices in a modern economy, the most important may be the price of its currency. It’s a real-time vote of confidence in a country’s economic health and a transmission channel for prices, investment, and production.

Currencies move about as predictably as a toddler in a toy store, as investors at home and abroad shift their money based on the latest bit of data or on a whim. Yet there is method to their madness. The currency of a country that persistently runs higher inflation than its trading partners will fall. In the 1970s and 1980s Britain’s inflation was persistently higher than Germany’s, and so the pound declined against Germany’s deutsche mark, the currency it used until 2002 when it adopted the euro.

Why? Suppose a Briton wants to buy a Volkswagen. If higher inflation raises its price at home, she’d exchange her pounds for deutsche-marks and buy it in Germany. Eventually, that selling will drive the pound down and the deutsche-mark up—until the Volkswagen was just as expensive in Germany. Over time, then, currencies move toward their purchasing power parity, which is the theoretical value of a currency that would make a basket of goods cost the same in two countries.

The Economist magazine’s Big Mac index is a quick-and-dirty measure of currency’s purchasing power parity. The magazine tracks the cost of a Big Mac in over 20 countries. In July 2009, a Big Mac cost 33 pesos in Mexico, and $3.57 in the United States. To equalize those prices, the dollar would have to trade for 9.24 pesos. In fact, it traded for 13.6 pesos, implying the peso was about 33 percent undervalued against the dollar.

Purchasing power parity is a lousy guide to a currency’s movements in the next few years. In the short term, the outlook for economic growth, inflation, and interest rates is more important. If Sweden is entering recession, its central bank will probably cut interest rates. That makes Swedish krona bonds less attractive. Another factor is a country’s terms of trade: If oil prices soar, that raises the value of Canadian exports and sucks capital into its oil industry, feeding demand for Canadian dollars.

In Search of Stability

Erratic exchange rates can be a pain, as you know if you’ve ever had to decide whether to buy euros when you book your French vacation or wait until you travel. For a business trying to decide where to open its next branch the uncertainty is even more debilitating. And a country is always tempted to drive down its currency to boost its exports at the expense of its trading partners.

Fixed exchange rates eliminate both uncertainty and the temptation of competitive devaluation. When countries all fixed their currencies to gold, they in effect fixed them to each other, as well. The gold standard collapsed in the 1930s but world leaders resurrected it in modified form under the Bretton Woods agreement, named for the New Hampshire resort where they met in 1944. Participating countries fixed their currencies to the dollar and the United States fixed its dollar to gold; it would convert another country’s dollars to gold at $35 per ounce. The International Monetary Fund would police the system, lending money to a country that struggled to finance a current account deficit, and permitting it to devalue if necessary to eliminate the deficit altogether.

The system fell apart when the United States began to run current account deficits in the 1960s, which left foreigners holding a lot of dollars. Eventually, it dawned on everyone that the United States didn’t have enough gold to redeem all those dollars. In 1971, Richard Nixon shut the gold window: the United States would no longer exchange its gold for dollars. The world entered a period of generally floating exchange rates.

Since then, the global monetary system has been a free-for-all. Several times a year, the heads of state, central bank governors and finance ministers of the biggest economies—the G7, and, increasingly, the G20—meet to discuss the global economy. Afterward they issue long, anodyne statements promising cooperation and a resolute attack on their various economic flaws. Occasionally this makes a difference. In 1985, what was then the G5 kicked off a big decline in the dollar, and in 1987, the G7 brought that decline to a halt. In 2008, their pledge not to let any more big banks fail helped end the panic that began with the collapse of Lehman Brothers. Usually, though, it doesn’t matter. There’s no one to enforce the commitments. The IMF has no leverage over countries that are themselves lenders, like China, or even over borrowers that visit the global ATM instead. Unlike the IMF, the ATM doesn’t attach conditions to its money such as freer markets or smaller budget deficits.

Fixed exchange rates didn’t die with Bretton Woods. They are now regularly adopted by individual countries, usually without the consent of the country they peg to. This gives their businesses a predictable investment environment and, by eliminating devaluation as the solution to rising costs, controls inflation. Over 60 countries, from China to Belize, peg to the dollar in some way.

As with any form of price-fixing, a fixed exchange rate won’t last if the fundamentals are all wrong, such as excessive inflation or persistent current account deficits. The central bank supports its currency by purchasing it in the open market in exchange for foreign currencies in its reserves. If reserves run low, it has to raise interest rates to draw investors back in. But it may not have the fortitude to keep rates high if recession threatens. As a last resort, a country can impose capital controls, in effect threatening to jail anyone who trades the currency outside its official value.

Hong Kong has successfully pegged its currency to the U.S. dollar since 1983 thanks to a gigantic hoard of foreign exchange reserves and a willingness to endure a deep recession to keep it there. Yet the only sure way for a country to lock in an exchange rate is to surrender its monetary passport and adopt another country’s currency altogether. Ecuador, Panama, and El Salvador use the dollar, while 16 European countries exchanged their currencies for the euro. But, this adoption process comes at a price—when you give up your monetary citizenship you live by the interest rates of the economy you adopted. You can no longer cushion your economy from domestic misfortune by using a weaker exchange rate to boost exports. You may conclude you can’t live with these fetters and switch back to your old currency. Indeed, the euro’s future is clouded by the possibility that some countries may renounce its use.

The Case of China’s Yuan

First, it has capital controls, which means you need the government’s permission to buy and sell the yuan. Currency dealers who trade in the black market to avoid those controls have been busted on television. Second, it keeps the currency artificially low, not artificially high. To force the currency higher, speculators would have to buy up a lot of it. Yet the central bank can simply print as much as it wants to meet their demand, accepting in return their U.S. dollars, euros, or other currencies. Although this practice would normally lead to inflation, China has avoided that in part because productivity has kept pace with its rapidly rising wages. Third, and most important, Chinese households and companies save a lot. They plow those savings into foreign assets like Treasury bonds, which props the dollar up against the yuan.

China’s exchange rate policy has been a huge boon to its development. It has fueled exports, enabling it to move millions of workers from subsistence farming to better paying, more productive factory work. But it also contributed to the crisis. China needed to put its excess savings somewhere, and the United States needed the money. So China put a huge chunk of its money into Treasurys, keeping the United States’ long-term interest rates artificially low, fueling the housing bubble.

Eventually, China will want to abandon this system. By roping its currency to the dollar it has outsourced much of its monetary policy to the United States. China’s economy may need higher interest rates than America’s but raising interest rates may suck in speculative capital, blowing up property prices and threatening financial instability, inflation, or both.

The American Dollar: The World’s Problem

One of the rewards for the United States for emerging as the economic superpower after the Second World War was its dollar became the place where global central banks liked to park their spare cash. At the end of 2009, the world’s central banks held $8 trillion in reserves between them and 60 percent were in dollars, insofar as could be determined.

The dollar owes its reserve-currency status first to the United States’ leading share of the global economy. Most countries in the world do business with the United States. International trade is routinely priced in dollars even when an American isn’t in on the transaction. The United States’ legal and political stability means anyone with dollars is pretty sure the country that printed them will still exist when the time comes to spend them.

The dollar will lose this status one day as the United States’ share of global GDP shrinks. But for now there are no realistic rivals. Because of China’s capital controls, the yuan is mostly useful for buying stuff from China. For a central bank to keep its reserves in yuan would be like you keeping your savings in frequent flyer miles. As for the euro, are you sure that if you own a 10-year Greek euro bond, Greece won’t have abandoned the euro 10 years from now—and repay you in drachmas?

Thus, the U.S. Treasury bond market is to the world what money market mutual funds are to ordinary investors: a safe, dull place to store cash you need in a hurry. This gives the United States what Valéry Giscard d’Estaing, then the French finance minister, in 1965 called the exorbitant privilege of borrowing astronomical sums in its own currency. If the dollar depreciates, the lender has a problem, not the United States, a point Nixon’s Treasury Secretary made in 1971 to the great irritation of the Europeans.

Of course, being inundated with preapproved credit cards also seems like an exorbitant privilege until the credit card bill arrives. At some point, the United States may wish the world hadn’t let it borrow quite so easily. All that foreign debt has costs, and not just the interest bill that foreigners send us every year. There are political implications, as well.

Knitting Global Markets Together

Financing Deficits and More

The Currency Market

In Search of Stability

The Case of China’s Yuan

The American Dollar: The World’s Problem

Into the Weeds