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Updated: October 23, 2010 15:19 IST

Simple analogies demystifying economics

D. Murali
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The famous melancholic monologue of Jaques in act II, scene VII of ‘As You Like It’ begins with, “All the world’s a stage, and all the men and women merely players…” Ominously reminding one of the Bard’s lines, the title of a chapter in ‘The Little Book of Economics’ by Greg Ip (www.wiley.com) is ‘All the world’s an ATM.’

With economic borders melting, in particular for borrowers, ‘factory workers in Shanghai, mutual fund investors in the US, 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,’ writes Ip. Which explains why the recent housing collapse in the US affected not only its financial system but also ‘IKB, a once sleepy German bank that ran out of opportunities to lend to local businesses,’ plus ‘French, Swiss, and British banks, Australian hedge funds, and Norwegian municipalities.’

Free-for-all

Just as modern jet travel allows viruses to cross oceans, modern capital markets rapidly transmit one country’s problems to others, analogises the author. He adds a note of caution that unlike with exports and imports, the currency and capital markets are not governed by shared rules of the road: ‘They’re a free-for-all prone to crisis.’

According to data from the Bank for International Settlements, cited in the book, 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, explains Ip. “US investors, for instance, can diversify their portfolios by owning mature, stable US companies and riskier but faster growing companies from Brazil and China, while US companies can finance their expansion by raising money from Brazilian hedge funds and Chinese banks.”

To the author, the risks posed by the stunning scale of capital movements are as real as the possibility of spilling, when carrying ‘a cookie sheet filled with water across the kitchen floor.’ Just the slightest trip and water sloshes over the sides, he warns. “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.”

Currency price

In a section on ‘the currency market,’ the author notes that of all the thousands of prices in a modern economy, the most important may be the price of its currency, because it is 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 a method to their madness. The currency of a country that persistently runs higher inflation than its trading partners will fall.”

Over time, as Ip traces, 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. “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.”

Parity guidance

Business readers would have seen a common ‘quick-and-dirty measure of currency’s purchasing power parity,’ in the form of the Big Mac index of The Economist magazine, tracking 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 US, reminisces the author. He observes that to equalise those prices, the dollar would have to trade for 9.24 pesos, whereas in fact it traded for 13.6 pesos, implying the peso was about 33 per cent undervalued against the dollar.

Frets Ip, however, that purchasing power parity is a lousy guide to a currency’s movements in the next few years; because, 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.”

Fixed exchange rate

There is also the widespread phenomenon of ‘price-fixing’ that happens as ‘fixed exchange rate,’ practised by over 60 countries, from China to Belize, which peg to the dollar in some way. Such ‘fixing’ cannot last when the fundamentals are all wrong, such as excessive inflation or persistent current account deficits, Ip reminds.

To some extent, as he elaborates, the central bank may support its currency by purchasing it in the open market in exchange for foreign currencies in its reserves; and if reserves run low, it may 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 control, in effect threatening to jail anyone who trades the currency outside its official value.”

An apt example mentioned in the chapter is of Hong Kong, which has successfully pegged its currency to the US dollar since 1983 thanks to a gigantic hoard of foreign exchange reserves and a willingness to endure a deep recession to keep it there. The only sure way, though, for a country to lock in an exchange rate is to surrender its monetary passport and adopt another country’s currency altogether, Ip instructs. “Ecuador, Panama, and El Salvador use the dollar, while 16 European countries exchanged their currencies for the euro.”

What is the price of giving up your monetary citizenship? You then begin to live by the interest rates of the economy you adopted, as the author outlines. “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.” On a related note, in the case of euro, he foresees a foggy future, with the possibility that some countries may renounce its use.

China puzzle

Studying the case of China’s steady yuan or the renminbi, Ip lists the many factors that have contributed to its success. Such as, capital controls (‘currency dealers who trade in the black market to avoid those controls have been busted on television’); artificially low level of the currency (‘to force the currency higher, speculators would have to buy up a lot of it’); and high savings by Chinese households and companies (the savings are ploughed into ‘foreign assets like Treasury bonds, which props the dollar up against the yuan’).

Apart from the positive effects of China’s exchange rate policy, such as higher exports that have enabled millions of workers to move from subsistence farming to better paying, more productive factory work, there is also the flip side, the book documents: it contributed to the economic crisis. How so? China needed to put its excess savings somewhere, and the US needed the money; so China put a huge chunk of its money into Treasury bonds keeping the US’ long-term interest rates artificially low, fuelling the housing bubble, Ip narrates.

He forecasts that eventually China will want to abandon this system, in which by roping its currency to the dollar it has outsourced much of its monetary policy to the US. “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.”

Storing savings

The chapter dissects the critical decision-making of central bankers, and makes the options understandable for dummies. The default choice, as you are aware, is the dollar, because of the share of the US in the global GDP, and also the country’s legal and political stability, so much so that ‘anyone with dollars is pretty sure the country that printed them will still exist when the time comes to spend them.’

For a central bank to keep its reserves in yuan would be like you keeping your savings in ‘frequent flyer miles,’ the author distinguishes. He reasons that because of China’s capital controls, the yuan is mostly useful for buying stuff from China. As for the euro, a pertinent poser of Ip is, ‘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?’

And that brings us back to the US Treasury bond market, which the author likens to money market mutual funds that cater to ordinary investors: ‘a safe, dull place to store cash you need in a hurry.’

Packed with ready insights, and educative examples.

**

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