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Thursday, March 5, 2015

The Real Problem is Strong Central Banks - Not Strong Currencies

One myth driving the irrational policies of central planners is the idea that a depreciating currency is good for a domestic economy.  Presently, this myth is fueling a so-called "currency war" in which each country attempts to depreciate its own currency relative to others.  In essence, the idea is that if you make your currency cheaper relative to other currencies, then people in the other country will buy more of your stuff.  In turn, this will help the export industry in your country thus constituting an economic advantage.  Of course, this idea is hundreds of years old and a major feature of the infamous economic theory known as mercantilism.

Bastiat and Hazlitt taught us that most economic myths persist because people only focus on one direct effect of a policy rather than on all the direct and indirect effects or unintended consequences.  In fact, the value of currency depreciation can be debunked with a simple example.  Let's assume on Day 1,  the currency exchange rate between euros and dollars is 1 to 1 and let's focus on the German company BMW selling one car for 100 euro:

Day 1

     Exchange rate = 1 $/Euro
     BMW (euro) = 100 Euro
     BMW (dollar) = 100 euro * 1 $/euro = $100

Say the Germans depreciate their currency, and further assume that BMW produces all of its cars in Germany and uses all of its inputs from other German companies, and maintains its euro price at 100.

Day 2

     Exchange rate = 0.25 $/Euro
     BMW (euro)  = 100 Euro
     BMW (dollars) = 100 euro * 0.25 $/euro = $25

In the U.S., the BMW now only costs $25!  The total American demand for cars was $100 and at the previous rate, Americans could afford to buy 1 car.  But now, Americans can afford 4 cars at $25 each and be no worse off.

     BMW revenue (Dollars) = 4 cars * $25 = $100
     BMW revenue (Euro) = $100* 1/0.25 Euro/$ = 400 Euros

BMW and its employees are thrilled!  They have made $100 which is now worth 400 Euros whereas before, they were likely to only make 100 Euros from the sale of 1 car. BMW's stock price (in euro) may even go up as would other company's stock who are similarly affected.  BMW is better off, but is the German economy better off in aggregate?

Well, what does BMW do with the $100 it received?  It can only spend the $100 in the U.S.  Even if BMW converts the currency and gets the 400 euros, then the exchanger paid out 400 euros to BMW and now has the $100.  What can the $100 buy?  The $100 can only buy the same amount as before in the U.S., even though it costs 4 times as much for a German in euro.   For example, let's look at this from the perspective of a German who wishes to buy a US Farm Tractor.    

Day 1

     Exchange rate = 1 $/Euro
     US Farm Tractor (dollars) = $100
     US Farm Tractor (euro) = $100 * 1 euro/$  =  100 euros

Day 2

     Exchange rate = 0.25 $/Euro
     US Farm Tractor (dollars) = $100
     US Farm Tractor (euros) = $100 * (1/0.25) euro/$  =  400 euros

The German tractor buyer's cost has gone up to 400 Euros.  While BMW is thrilled that it is making 4 times more money selling its cars, the German farmer has to pay 4 times as much for the same American tractor.  BMW benefited, but the German farmer lost.

In general, the $100 received by the Germans will be spent in the U.S. for something - if not by BMW or a farmer, then by someone further down the line in Germany who exchanged the euros.  If the purchaser of the $100 does not want a consumer product, they would deposit it in a U.S. bank or more likely, buy a U.S. dollar bond.  But whether they buy $100 worth of U.S. bonds or $100 worth of U.S. products, since it now costs them 400 euros, they get 1/4 as much U.S. stuff on day 1 as on day 2.  On Day 1, in aggregate, Germans produced 1 car in exchange for 1 tractor.  Now they have to produce 4 cars in exchange for 1 tractor.  How is this good for the German economy?

Even from this contrived example, you'd have to conclude that currency depreciation is at best a zero sum game in which some (exporters) benefit at the expense of others (non-exporters).  In fact, it's much worse than a zero sum game as Robert Murphy and Patrick Barron demonstrate in more detail. In Bad Idea: Devaluing Currency to Help Exporters, Frank Hollenbeck demonstrates the negative effects of currency depreciation on workers who must "pay higher import prices resulting from depreciation" reaching a familiar conclusion when analyzing central banking:
Few journalists seem to understand that a policy to reduce the foreign exchange value of a currency is, in reality, a policy to transfer wealth from workers — the middle class and the poor — to the wealthier owners of export industries. It is another example of the central bank acting as a reverse Robin Hood, taking from the have-nots to give to the haves.
So why would the central planning bureaucrats engage in "currency wars?"  The reason is that central planners are politicians who do what is in their own short term best interest.  In this case, they seek to politically appease their domestic export lobbies cheered on by Keynesian cranks like Paul Krugman.

As central banks engage in currency depreciation and the so-called "race to the bottom" goes on, it becomes even more clear that the real threat to any economy is not a strong currency, but a strong central bank.  The solution is to end the regime of central banking and to replace political control of our money with a private banking system based on a 100% reserve gold standard.  

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