How to become a scratch golfer with one club

I decided in retirement that I should become a scratch golfer. I am not sure what that means but it sounds good to combine playing golf with something fun like scratching. So I went to my friend Bob and he gave me one club – a nice driver that was in the corner of his garage. I dusted off the cobwebs and he looked at it fondly remarking that was all I needed. If I could master that wooden driver, I would become a scratch golfer. He then pointed me in the direction of a golf course.

Is any of the above true? Of course not. But it reminds me of what I am reading frequently about exchange rates. If Greece could just replace the euro with the drachma again all things would be okay. With the dollar rising against the euro, US pharmaceutical exports to the EU will be dramatically hurt. If China would just revalue the renminbi against the dollar, then the US would become a major exporter again. People who are saying these things should be smacked with a wooden driver. You can’t be a great golfer with one club and you can’t salvage a country’s economy by depreciating its currency.

How can I make fun of exchange rate wisdom? Is it wrong? Actually it isn’t technically wrong but it clearly suffers from either wishful or overly simplistic thinking. Let’s suppose that Jose lives in Paris and he really loves French wine. If the value of the dollar falls, will Jose stop drinking French wine and buy a couple of cases of Mogen David? Probably not.

So what’s this exchange rate idea all about? It begins with the idea that some goods are highly tradable across country borders. To some people, a bottle of merlot is a bottle of merlot. They don’t care where it got produced. They walk up and down the wine store aisle talking to themselves until they finally make a choice. To many people, the beauty of the label might be the deciding factor. To others, the price makes a big difference. So if the French wine costs $12 and the California wine of roughly equivalent quality and label beauty costs $10, then this time they buy the local USA product.

So where does the exchange rate come in? The US wine’s price of $10 (from our example) will be determined mostly by domestic factors in the USA – cost of grapes, labor, etc. The dollar price of the French wine sold in Kroger in Bloomington Indiana (the $12 in the example) is based on two things – (1) the cost of the wine bottle in France in euros (mostly determined by local French wages, cost of grapes, etc) and (2) the euro/dollar exchange rate. Putting this all together, the decision to buy the French or the US wine depends on three things:

1. The price of the USA wine in dollars

2. The price of the French wine in euros

3. The euro/dollar exchange rate

This little story helps to understand one thing – the exchange rate is only one of several factors that might impact international trade. For example, let’s suppose Greece has a drachma and suppose they let the value of the drachma depreciate. Would that help Greece sell more exports to the world? On the surface it seems it would. If nothing else changed, that would make Greek goods and services less expensive to consumers living in Europe, America, and the rest of the world. Cool. But as some of my intelligent friends are used to saying – “ceteris aint paribus”. Which is another way of saying that too many people have PhDs – and another way of saying that not everything stays constant.

For example, one reason the drachma might be depreciating today is because local conditions yesterday in Greece made Greek goods very uncompetitive. Thus the drachma price of goods might be very high in Greece. Sure, the depreciation of the drachma might help restore Greek competitiveness, but it might not fall enough to make a person in France want to buy the Greek wine over the more efficiently produced French variety. Or…suppose the drachma depreciates and people begin to buy more Greek wine. How might French wineries react to this? If they don’t want to lose business they might react competitively and reduce the price of French wine. That would make Greek wine less desirable and would reduce Greek exports.

Putting with a wooden driver isn’t very smart if you have some other clubs in your bag. Depreciating a currency might not be enough to improve your exports if international trade also depends on prices of goods and services at home and all over the world.

I wish that was the end of the story since it is getting close to the time of my daily afternoon nap. But let me just say a little more. Let me pull out my nine iron. J LOL…Anyway, there’s more to the story. Let’s suppose the drachma depreciates – how does that affect all those Greek companies that buy materials and resources from other countries? The weaker drachma makes everything these companies buy from abroad more expensive. So if these companies pass along these increased costs into their goods, then it causes more inflation in Greece and makes their goods less competitive globally. Surely this is not good for Greek exports. Finally, if the drachma depreciates, think about what happens to foreign companies who produce goods in Greece. Those companies regularly convert their drachma profits back to the currencies of their home countries. When they do, the depreciated drachma makes their earnings in home currency smaller. Yikes, the profits of a Greek location look worse compared to producing in Latvia or Croatia. What happens if these companies pull up stakes and do their production and exporting in other countries?

Okay – so hopefully I made my point. You wouldn’t go golfing with one club – so please don’t listen to these snake-oil salesmen who want you to believe that a simple appreciation/depreciation of some currency is going to solve all our problems.