(from Monday, 31 August 2009 17:14)
[I haven’t read the classic texts (Robert Mundell, for example) on currency theory, so this is very much busked from my own instinctive market understanding. For what it’s worth.]
My letter to the FT, published 31st August, argued that whatever grim future awaits Iceland holds no auguries for Britain or other advanced nations. There’s a basic mistake easily made when trying to interpret ‘big’ situations (say: whether the market will be repulsed by the USA’s debt) with ‘little ones’ (whether a stranger would lend you a fiver): certain rather important features of an economic situation cannot be abstracted away simply by dividing through by GDP. Some things change a lot with size.
And so predicting the future of the advanced nations on the basis of what happens next to Iceland is rather like looking at the London Borough of Lambeth and extrapolating from there to EU nations. If Lambeth had a currency . . .
What are the differences? The most important is surely the ability to borrow in your own currency. If you are America, and, say, 20% of the world’s transactions take place in dollars, there will be a lot of people who actually need instruments denominated in your currency, in order to hold said dollars in a profitable, secure way while waiting to use them: they may be waiting many years, or just a few days. Hence you get stories like this: foreigners snapping up US dollar debt despite its growing supply.
Now imagine that Lambeth decided to issue its own currency, Florins*. Population, 272,000 – about the same as Iceland’s. In order to get people to put money into Florins, they’d need a high interest rate – again, like Iceland‘s. Of course, if the exchange rate gets stronger, investors in Lambeth Florins are on a winner – high interest rates on their cash, low rates on their borrowings, increased capital value. But despite this, Lambeth would be highly likely to need to borrow to a great extent in foreign currency – sterling, dollars, euros. Moreover, in order to maintain convertability, Lambeth would have to keep a store of foreign currency. So maintaining confidence in the ‘world’ market would remain critical.
This is where it gets precarious. No matter how prosperous Lambeth may be – as an economy, it produces around £5-7bn, is my guess (confirmed here), the worldwide demand for things made in Lambeth is pretty small. Moreover, the things that Lambeth needs, from the cars they drive in, the petrol in the tanks, the food on the shelves – is pretty much all made overseas. The services are probably a different matter: the haircuts come with “made in Lambeth” – but the banking, telephone, etc are all likely to be foreign-produced as well. Note that even if Lambeth is running a comfortable export-surplus on the current account, it would need a ready store of liquid foreign currency just to feed its people.
But what happens if Lambeth gets into debt problems – say, invests in a massive entertainment complex that goes twice over budget, or bids unsuccessfully for the World Cup? It has no federal help from the London government. With all those debts in foreign currency, it has to somehow extract a ‘surplus‘ from its captive population of Lambeth taxpayers, to produce enough exportable-stuff for the foreigners to be satisfied. Even if it were producing a current-account surplus, investor nervousness would be very likely to take hold on any excuse – because, at just 0.5% of the UK economy (and therefore 0.01-0.02% of world GDP), investors would feel little need to hold Florins, and plenty of reasons to fear looking stupid if they were caught in possession of a lot of them.
Moreover, the smaller the country, the easier it is for people to leave. Few of them would want to remain in ‘debt-slavery’ (see this Iceland story). And the more people leave, the higher the burden on those left behind, the greater the chance of default – a continuous self-fulfilling spiral. Why would people stay around to pay massive taxes, when the next-door authority, Wandsworth, might be willing to entice the really productive individuals to move across the border? (this is happening with Nevada and California).
How is it different for big countries? The emigration risk is surely lesser – the larger the country, the less the “rest of the world” can compete with it as a place to stay. Then, even those in deficit, investors need to have a position in large country currencies because of their size relative to GDP. The US, still by far the world’s biggest manufacturing nation, is in this position.
Savings, moreover, have to go somewhere. There is a real demand for safe investments, the payoffs from which are in a currency that has things you need. Pension funds don’t have to go into tiny countries’ currencies, unless they have some unique resource – unlikely. Small country currencies can be substituted. Then there is also liquidity. If you are small, markets never really reach critical mass and so trading in and out of your position is really expensive – and in a crisis, risky.
I also think that some coordination issues work against small countries. Confidence is self-fulfilling. Imagine a game** in which, so long as 76% of the players stay in the game, they earn 1 point per round. If a player drops out, it gets 0 points – but if it stays in and 25% or more drop out, it gets minus 10. Now, first imagine there are 100,000 players. Each start with “confidence” – earning 1 every round. You could imagine them keeping confidence for many rounds. But now imagine there are four people. It only takes one to drop out for the others to all lose out. Even an accidental leaving could bring the game into negative territory. Knowing this, all the players are likely to be quick to leave. I strongly suspect that this sort of psychology takes place in small-currency situations.
Ultimately, this leaves all small countries as ‘takers’ in the world macroeconomic scene. Their fiscal stimuli leak abroad. They have to accept whatever world interest rates tell them. Finally, the self-fulfilling lurches in investor confidence can throw them up and down. No wonder they queue up to join the Euro – even if it means terrible austerity for small countries like Ireland that get in and then screw up.
So – what a long-winded post – there is nothing strange or unfair or suspicious about small countries with weak, uncertain currencies getting very different treatment from markets than strong countries. (Compare IMF advice in 2008 to their form in the 1997 Asian crisis. Interestingly, Professor Wade has written on the 1997 crisis – clearly in no need of a lecture from me on this subject). There is huge inefficiency and risk in trying to run your own small country currency. Which is why I find Hayek’s competing currencies idea ultimately implausible – they have to be big to avoid real problems.
These inefficiencies render macroeconomic extrapolation from the small to the large almost meaningless. In fact, the same gales of speculation that drive money away from the likes of Iceland are able to sustain the USA and UK in their emergency fiscal straits.
PS: Campbell’s Soup is now as credit-worthy as the US government. Discuss. I think this is not as mad as it sounds. Campbell’s soup are not issuing their own currency. They have a reliable franchise, don’t depend on getting Congressmen to agree to raise revenues, and are not obliged to fight a war in Afghanistan or fund Medicare. As far as I know.
*Mad? Tell the people of Lewes
**I doubt I invented this, but can’t find a source in a rush at 10:30pm.
Since writing this blog post, I have had more thoughts on the “confidence” game scenario. Now imagine that several simultaneous versions of this game are taking place in a room. In one corner of the room, there are 100 people playing, and they are consistently scoring 97-99% “confidence” – so that people who join that game are very likely to score 1 point per round. Then in another corner, is another game with just ten people. They keep struggling around 7-8, with dives down to zero as people lose confidence. Obviously, given the choice, you’d head off for the first game.
So what do the people running the second game do? They would probably increase the payoffs for staying. Which means . . . increasing the interest rate. This is exactly like choosing between investing in dollars and Icelandic Krona