Exchange rates, my bicycle pump, and a rubber crutch

My front bicycle tire went flat. So I took out my trusty bicycle pump and put more air into the tire. Each day my tire would go flat overnight. I kept putting more air into it. It was getting flatter sooner and sooner and so in desperation I decided to get a new pump. Guess what – that didn’t make any difference. The tire kept getting flat. Why? Because the tire had a hole it that kept getting bigger and bigger. The problem was not the pump. The problem was the tire.

Some of you are saying. Davidson – you don’t even have a bicycle. But the truth is that I do though it does not have a hole in its tire. Some of you are saying – where is the macro? So here it is. I believe that exchange rates are like my bicycle pump. The pump might be the remedy for some minor adjustments in tire pressure but it is no match for a fundamental problem like a hole in the tire. A bicycle pump is not a solution to a hole in a tire and the exchange rate has nothing to do with a country’s competitiveness. If you want to fix a country or fix the international trade of a country you should not try to do it with a bicycle pump or with a change in the exchange rate.

This point has some relevance to us all because many people prefer to believe the opposite. Some folks would love to see Greece leave the Eurozone so it could have its wonderful drachma back. Depreciating the drachma, the story goes, will restore Greece’s competitiveness and it again will be the world’s greatest exporter of gyros and historic buildings. Other people would love to see China appreciate its renminbi so that the US dollar would depreciate – and restore US company’s competitiveness in exporting Playboy Magazines and slot machines. Brazil wants the US to stop printing money and thereby making the dollar depreciate and hurting Brazil’s ability to export caiparinhas and topless beaches.

There is some rationale for using an exchange rate to help offset short-term and relatively minor changes in a country’s competitiveness. An exchange rate tells you how much your currency is worth in terms of other currencies. So when the dollar goes from obtaining 1300 Korean won one day to getting 1400 the next day, we say the dollar appreciated against the won (and the won depreciated against the dollar). In this case someone with dollars can now get with $1 the 1300 won creampuff they usually get on the way to the bus stop on Monday and Wednesday mornings at Anguk Station plus have another 100 won left over. With the new exchange rate (1400 instead of 1300) that $1 can buy even more Korean stuff. That is, you can now get the usual cream puff and a new Equus. Okay – a new Equus costs more than 100 won but hopefully you get the point here. Big rule –

o   If your currency depreciates, your goods and services can be obtained with fewer amounts of foreign currency. Thus your stuff looks cheaper to the rest of the world.

o   If your currency appreciates, your goods and services can be obtained only with more foreign currency. Thus your stuff looks more expensive to the rest of the world.

o   Many governments are driven by the fact that they want their goods and services to appear more competitive to foreigners – so they often favor depreciating the currency.

These three facts help us to explain why (1) the Greeks might want to have a drachma that they can depreciate, (2) why the US wants China to let its renminbi appreciate, and (3) why the Brazilians want the dollar to appreciate. Like the bicycle pump and the tire, these desires are founded by short-sighted and incomplete analysis. And therefore, they are probably not going to lead to the results they want.

For example, let’s explore why these ideas could be self-defeating. Let’s suppose Brazil gets its wish and the US manipulates foreign exchange markets in a way that the value of the dollar rises and the value of Brazil’s currency, the real, falls. The governments could accomplish this by selling reals and buying more dollars in foreign exchange markets – that is the US or Brazil buys enough dollars to significantly appreciate the dollar (depreciate the real). This tends to help Brazil’s exports. But the story doesn’t end there. In doing this action, dollars move out of the economic system and reals move in. That is – the US money supply decreases and the Brazilian money supply increases. Left in place, these monetary changes should tend to increase inflation in Brazil and reduce it in the USA. Thus while the exchange rate manipulation seems to favor Brazilian goods – the implied monetary changes tend to do just the opposite. And to make things worse – both countries may not enjoy the fact that an international action has caused them to change their monetary policy. It is like each country loses control over its own monetary policy whenever it tries to manipulate its exchange rate.

If you are still following me (yawn) you might say that if the country doesn’t like the loss of control over their money, they can always offset or neutralize the international impact described above with a domestic monetary policy operation. In the above case the US money supply is decreasing so the Fed can use its usual tools to increase the money supply. The Brazilian Central Bank can absorb some of the excess reals by a domestic operation that decreases its money supply. This has some merit but notice that this too is temporary. The tire has a hole in it. That is, whatever caused the trade imbalance between the US and Brazil will continue. What appears to be a one-time event becomes a more continuous one with the US constantly encountering disinflation and increasing its money supply and Brazil facing inflation and then tightening its money supply. If you are still awake you can see how crazy all this is.

This is because there is a hole in the tire with respect to trade. Brazil says that their trade problem is caused because of a highly accommodative US monetary policy that causes a global depreciation of the dollar. If this is correct, then the solution is for the US economy to return to normal monetary growth and interest rates. Of course, Brazil might consider that at least part of their loss in competitiveness comes from a world slowdown that has reduced the global demand for the commodities that Brazil exports. The hole in Brazil’s tire is, therefore pretty big. It may take some time for the US and the world to return to strong growth In the meantime, Brazil can work harder at internal factors that might promote its global competitiveness. But simply manipulating exchange rates is going to do very little and most likely will lead to reduced competitiveness as monetary effects increase Brazilian inflation and worsen their situation.

The same can be said of the issues with respect to Greece and the Eurozone and the issues between the US and China. Greece needs a currency depreciation like it needs a hole in the head. If Greece wants to be in the EU then it needs to try to be more like other EU countries. When Greece gets is labor and product markets as well as its government wages and pensions a little closer to the average EU country, then perhaps it has a chance of overcoming imbalances in its dual deficits in trade and government accounts. If Greece even pretends a tiny bit like it is going along with the prescription, both the EU and the IMF will likely continue to help them. That will buy them time to get fixed. The drachma and a depreciation might also give them time but notice that they still would need to fix their problems. And in the meantime all hell would break loose in Greece when they left the Eurozone.

The same can be said about the US and China. In this case there is a 16-wheeler full of tire holes. No one REALLY believes that a further depreciation of the dollar against the renminbi is going to succeed in restoring the trade balance. The US has had global trade deficits for decades despite a trade-weighted dollar that has done nothing but decline. Most economists believe the US saves too little and China saves too much. Neither of these tendencies is going to change anytime soon. Depreciating the dollar will likely do nothing but cause inflation in the US as we pump even more dollars all over the world. The US needs to pay attention to saving and to the other adjustments that could make us more productive, innovative, and competitive. China needs to rebalance its economy away from saving toward more consumption. Only when these savings imbalances are corrected in the US and China will headway be made with the trade balance with China and the world.

The exchange rate is a rubber crutch. Countries need to tend to their knitting or tire mending.