Euro Crisis Update (Lazy Block-quote Edition)

First, Simon Johnson:

Some financial market participants cling to the hope that the stronger eurozone countries, particularly Germany, will soon help out the weaker countries in a generous manner. But this view completely misreads the situation.

The German authorities are happy to have the euro depreciate this far, and probably would not mind if it moves another 10-20 percent. They are convinced that they must – in fact, should – export their way back to acceptable growth levels.

Competitive depreciation is of course a no-no in international policy circles. But if your dissolute neighbors – with whom you happen to share a credit union – threaten to implode their debt rollovers, and markets react negatively, how can you be held responsible?
[...]
The euro depreciates, the dollar strengthens, and our path to recovery starts to run more uphill.

And if these European troubles start to be reflected in difficulties for leading global banks over the next few days or weeks, the negative impact will be much greater.

Then, Yves Smith:

We do have a factor here that could get the reluctant Europeans, meaning the Germans in particular, to act, namely, that Eurobanks are still wobbly and are not doubt exposed directly and indirectly to a European sovereign debt crisis. There is no way to avoid rescue operations of some sort, it’s merely a matter of picking which poison. Do they want to face the ugly bailout of countries they see as profligate, or wait till it morphs into a crisis and have to put their banks on emergency life support? The problem is the latter is politically more palatable, even though ultimately more destructive, since a lot of collateral damage will occur in the wave that hits the banks.

And just for the sake of reiteration, lastly, Paul Krugman:

Spain is an object lesson in the problems of having monetary union without fiscal and labor market integration. First, there was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

If Spain had its own currency, this would be a good time to devalue; but it doesn’t.

On the other hand, if Spain were like Florida, its problems wouldn’t be as severe. The budget deficit wouldn’t be as large, because social insurance payments would be coming from Brussels, just as Social Security and Medicare come from Washington. And there would be a safety valve for unemployment, as many workers would migrate to regions with better prospects. (Wages wouldn’t have gone up as much in the first place, because of in-migration).

The point is that this has nothing to do with a spendthrift government; what’s happening to Spain reflects the inherent problems with the euro, which now more than ever looks like a monetary union too far.

George Soros Shorting the Pound: What the Christ?

Never one to pass up the chance to write a long-winded post on semi-relevant economic affairs, I thought I'd leave my response not sullied and obscured in the dark alleyways of the comment section unbeknownst to the vast majority of this blog's readership, but out in the clear, clean open as its very own post.
If you're too lazy to scroll down a tad, Dave made the following request:

Could someone (Ben? Lion?) explain, though, what specifically [George Soros] did to the British sterling to make him so much money?

If you're wondering who George Soros is, I'd direct you to the previous post no matter how lazy you are. I assume you know who Dave is.

Anyway, since I'm statistically unemployed and Lion is only unemployed in spirit, I thought I'd allow myself the liberty of taking the first crack at Dave's question. I will undoubtedly leave something insufficiently clear or entirely unexplained and if Lion feels this way, he can add on. In the comment section.

Since I don't actually remember all the nitty-gritty details, unless otherwise cited, I will just be posting excerpts of the Wikipedia page on "Black Wednesday" and then translating as best I can. Perhaps you think that's fairly unprofessional of me. On the other hand, I did mention that I was statistically unemployed, so I don't see how you could really expect otherwise.

First, some background:

European Exchange Rate mechanism

Definition

ERM. A system created in 1979 as a way to reduce the volatility of the various Eurpoean currencies and to create a stable monetary system. The ERM created fixed margins in which a country's currency could operate. It was the predecessor of the European Economic and Monetary Union. (Source: InvestorWords)

Ensuring the relatively stability of an exchange rate helps to ensure the relative stability of foreign trade and investment into and out of a particular country. Likewise, ensuring the relative stability of an exchange rate between a number of countries ensures the relative stability of foreign trade and investment between those specific countries. If you're a German banker who wants to invest in France (think pre-Euro), you want to make sure that between the time that you make the investment and the time that that investment matures, the Franc doesn't tank against the value of the Deutch Mark, and with it the value of your invested money. In this respect, stability ensures confidence and confidence ensures increased interconnectedness, economic or otherwise.

How is the stability of a currency ensured? Ultimately, exchange rate manipulation falls under the purview of monetary policy. Monetary policy is essentially anything the Central Bank of a country does. When the Fed of the United States lowers the interest rate (incidentally, something it won't be doing again for the next long while), it is conducting monetary policy by making money easier (cheaper) to borrow and theoretically stimulating the economy.

But as China will tell you, interest rates also play an important role in how much money is invested into a country from abroad. If high interest rates in America impose high borrowing costs throughout the domestic economy (and therefore slow economic growth), it also means that foreign investors will receive a higher return on investments made in America relative to any other country. When the foreign money comes rolling in, attracted by higher interest rates, foreign investors are essentially selling their own currency to buy up American dollars (and with those dollars, American bonds--public and private). When this happens over and over with billions of dollars, the value of the American dollar goes up. Likewise, if the Chairman of the Fed lowers the interest rate this leads many foreign investors to seek higher rates in other countries, leading to a depreciation of the dollar. While recent news might lead you to conclude otherwise, under relatively normal market conditions, monetary policy has a significant and positive impact on exchange rates: high interest rates mean a stronger currency, low interest rates mean a weaker currency. In the United States, the exchange rate value is generally the tertiary consideration of monetary policy-making, behind domestic price control (higher rates mean lower inflation, vise-versa) and counter-cyclical economic stimulus (lower rates increase economic activity, higher rates cool things down).

Not so in Europe under the EERM which was therefore not so much a central mechanism as it was a coordinated policy between a number of European Central Bankers. One such Central Bank was the Bank of England:

...John Major, who, with Douglas Hurd, the then Foreign Secretary, pressured Margaret Thatcher to sign Britain up to the ERM in October 1990, effectively guaranteeing that the British Government would follow an economic^[4] and monetary policy that would prevent the exchange rate between the pound and other member currencies from fluctuating by more than 6%. The pound entered the mechanism at DM 2.95 to the pound. Hence, if the exchange rate ever neared the bottom of its permitted range, DM 2.778, the government would be obliged to intervene.

Again, just to keep this fresh in everyone's mind, if the value of the pound stated to slide (why this might happen in a second), the Bank of England would raise interest rates, attract more foreign investment and appreciate the currency back to the prefered level. Unfortunately, as the Wikipedia article has it in the sentence immediately following, British inflation was 3 times that of the German economy. High inflation bodes poorly for the value of any currency, though according to Wikipedia, the EERM policy was intended as a way to curtail that inflation by keeping the currency stable and the interest rates in steady proportion with the German's who have traditionally maintained a relatively high and stable rate of interest in an earnestly and predictably reasonable Teutonic way.

Unfortunately, to some foreign investors, the whole plan lacked credibility. Did the Bank of England, which had been holding down interest rates for years, have the stomach for higher rates? If inflation persisted and the trade balance worsened, would they be willing to continue to increase interest rates at the expense of the rest of the economy's well-being?

From the beginning of the 1990s, high German interest rates, set by the Bundesbank to counteract inflationary effects related to excess expenditure on German reunification, caused significant stress across the whole of the ERM. The UK and Italy had additional difficulties with their double deficits, while the UK was also hurt by the rapid depreciation of the US Dollar - a currency in which many British exports were priced - that summer. Issues of national prestige and the commitment to a doctrine that the fixing of exchange rates within the ERM was a pathway to a single European currency inhibited the adjustment of exchange rates.

To summarize, the higher German rates appreciated the German DM, inducing the Bank of England to raise rates more than they otherwise might have needed to in order to stay within the "band" of accepted values. On top of that, Britain had both a fiscal deficit (which implies inflation which implies devaluation) and a current account deficit (which means they were importing more than they were exporting which also implies devaluation). Likewise, with the depreciation of the U.S. dollar and so much of the British export market (apparently) denominated in U.S. dollars, this meant British exporters were receiving even less for the same goods, putting more downward pressure on the pound.* And lastly, according to Wikipedia, Brits just weren't having the whole idea of the domestic interest rate and economy being influenced by a bunch of dirty foreigners.

And then there was the news. And everyone, especially rattled investors scouring headlines for a source of what might in the future possibly given certain contigencies lead to a trend in the market which would by the way be completely justified by market fundamentals, reads the news.

In the wake of the rejection of the Maastricht Treaty by the Danish electorate in a referendum in the spring of 1992, and announcement that there would be a referendum in France as well, those ERM currencies that were trading close to the bottom of their ERM bands came under pressure from foreign exchange traders.

Lucky George Soros. He, along with a number of other currency traders, saw that the British Pound "should" devalue, that it would be potentially very costly for the Bank of England to keep it from doing so, and therefore bet that the Pound eventually would.

How does one "bet" against the value of a currency? These financial acts of wizardry are, I think, at the heart of Dave's question. I know he listens to Planet Money, so he knows what "short-selling" is, but does everyone else?

Counter to the way that most people think of the stock market should and does work (people pick stocks of companies that look like they might do well and buy shares in those stocks), short-selling is a way to profit from a stock decreasing in value. If it sounds criminal, it's only because it perhaps should be. Here's how it works:

On Monday, Ben the Baller wishes to short-sell the stock of Grandma Philanthropy's House of Cheer and Puppies. Ben goes to Lion the Lowrider on Monday, who happens to own some prime GPHCP stock, and borrows 1000 shares while signing off on the agreement that he will return the stock plus interest on Thursday. Perhaps Ben pays Lion some additional fees as well. Regardless, once Ben has borrowed the shares, he sells all 1000 immediately at the going price. In a few days, Ben buys back the shares at the price then and pays Lion back plus interest. If between Monday and Thursday the price of GPHCP stock has fallen, say from $100 a share to $80 a share, Ben truly is a Baller worthy of the title. On Monday, Ben borrowed the 1000 shares for free, sold it all for $100,000. On Thursday, he buys back the 1000 shares for $80,000 and gives them back to Lion plus the interest he owes. A little less than $20,000 for Ben in less than a week. Lion the Lowrider wins too, since he gets the interest payment for doing absolutely nothing. Of course, if the value of the stock had gone up and not down, Ben would have been in trouble since he would have had to pay more to get the stock back. But that's a different story and I don't want to talk about it.

To explain "Black Wednesday" then, George Soros and many of other international currency traders essentially did the same thing to the Pound that Ben the Baller did to GPHCP stock. Except thousands and thousands of times and with billions and billions of dollars.

If George expects to value of the British pound to go down between Monday at noon and Monday at 2pm, he borrows £10,000,000 British pounds, exchanges them for DM 29,000,000 at a rate of 2.9DM to the pound, waits two hours and, if he is correct, exchanges back the deutchmarks for £10,740,740 British pounds at the new lower rate of 2.7DM to the pound. He pays the lender back with interest and then, finally, takes his £740,740 minus interest and quickly exchanges it back into a currency that he has any confidence in. And that is how George makes over £700,000 between lunch and tea. Except now the tea is more expensive if you're in England because it's imported from India.

It isn't perfectly accurate to call this maneuver a "bet" though. The term implies taking a position against something either happening or not happening and that this act of betting itself has no impact on the outcome. This is not strictly true of currency speculation on the Sorosian-scale just as it might not true (and totally illegal) of short-selling a stock. When a lot of people (or a few people with a lot of money) get together and to short stock, they borrow a lot of that stock, and sell it at once. This has the immediate effect of decreasing the value of the stock. How fortuitous then that in a few days when the contract is due, these investors are then able to buy back the stock at a lower price. Of course this is unlikely to happen in such a straightforward way since, believe it or not, there is regulation to prevent this sort of coordinated cheating.

I don't know if such regulation exists in foreign exchange markets and, if it does, I don't know who enforces it. Regardless, even in 1992 George Soros had more money to throw around than God and, given the fact that so many investors were just waiting for the first signs of a dip in the British pound to send all their money Eastward to the continent, he didn't have to start short-selling much to get a tidal wave of investors, flighty and speculative, to conform around him and validate all of his bets.

On the receiving end of that tidal wave was the Bank of England, thrashing away with about as much success as you might expect from the metaphor:

On 16 September the British government announced a rise in the base interest rate from an already high 10 to 12 percent in order to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15 percent, dealers kept selling pounds, convinced that the government would not stick with its promise. By 19:00 that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would remain at the new level of 12 percent.

Soros clearly wasn't alone in this operation, but he is notable both for the scope of his participation ($10 billion continually recycled in pounds) and the obscene monetary scale of his success:

Finally, the Bank of England was forced to withdraw the currency from the European Exchange Rate Mechanism and to devalue the pound sterling, and Soros earned an estimated US$ 1.1 billion in the process. He was dubbed "the man who broke the Bank of England."(Source: Wikipedia, Soros' site)

It's difficult to say just how bad the effect of Black Wednesday was. On the one hand, the value of the British currency was in the tank for some time (which may have been good for exports, but being an island and all, not great for a host of other reasons), but the Pound appreciated fairly rapidly (oddly enough) throughout the rest of the 1990s.

The high interest rates were the real kicker. Coming out of a big financial and housing boom, the U.K. went through a relatively nasty recession as a result. On the other hand, the speculative attack on the pound--and the high interest rates used to defend against it--can just as much been seen a symptom of bad monetary and fiscal policy in this respect. Nobody trusted the Pound because inflation was high, the government was in debt and the trade balance...wasn't. The Bank of England and the government could have allowed the economy to come off the EERM, at least temporarily before assigning it a new or broader band, but instead chose to fight by increasing rates.

I'm not really prepared to go all counter-factual on the Bank of England. What I will say, however, and unequivocally, is the following: the concept that a single person could so dramatically tinker with the economic future of an entire country is totally fucked. And that is my conclusion.

*If on Monday £1 = $2, a radio sold to Norway for $50 = £25. If the U.S. dollar depreciates so that on Tuesday, £1 = $3, all of a sudden that radio sold to Norway for $50 only equals £16.66. This is I think what the Wikipedia article is getting at, but I might be misinterpreting.

Currency Values: What the Christ?

In the comment section of my last post, Dave asked me to clarify a few things about how imports affect currency values. Having given it some thought, I now realize that not everyone reading this blog has spent the past few years of their lives learning about the virtuous optimality of a Dickensian distribution of income (i.e. study economics) or happen to suffer from that particular form of brain worm that leads a person to voluntarily immerse oneself in economic literature (Lion). Therefore, I'd like to take this opportunity to explain for those who are interested that whole deal with currency values. If my explanation resorts to asinine metaphor or a patronizing tone of voice, it isn't because I think anyone here is an idiot. Those who study economics are lucky enough to be a part of discipline which straddles the line between the byzantine abstraction of most academic fields and actual, real-life relevance. That is, economists get to be confusing on the news, not just in the lecture hall. I'm sure if there was a global crisis of post-modern literature, I'd be scratching my head along with everyone else.
So here we go: Exchange Rates. I apologize beforehand if this is all really boring.
Studying it myself, I find it much easier to wrap my head around exchange rates by thinking of currency as if it were any other commodity. The price of this particular commodity happens to be its exchange rate (that is, how valuable it is relative to all other currencies), and that price is determined by those ever-present crossing-swords, supply and demand.
When I talk about the "demand" and "supply" for a currency, I am talking about a few things:

a) Trade of Goods and Services: To give a tremendously oversimplified example, if I wanted to buy a Mexican-made radio, I, as an American, would be purchasing a radio imported from Mexico just as the manufacturer in Mexico is exporting that radio to the United States. When Mexico exports that radio, demand for the peso goes up. Why? I spend the money and somewhere along the supply line that money is converted into pesos. Within the foreign exchange market (not any one place, but an aggregate of thousands of different banks and financial institutions carrying out similar transactions for all trade between the U.S. and Mexico), this constitutes one additional "pull" on the Peso v.s. the American dollar; that is, one more person who wants X amount of Mexican pesos rather than the proportionate amount of Dolla-Dolla-Bills. If Mexican exports are suddenly all the rage and there are millions of stupid Americans like me buying cheap Mexican stuff, looking at trade as a factor alone, that demand for Mexican goods (and therefore pesos) will increase the "price" or "value" of the peso--the peso will "appreciate," so that it takes more American currency to buy the same amount of Mexican currency.
Likewise, during the same process, all the importation of Mexican goods to the United States increases the supply of American dollars on the foreign exchange market. This enormous supply, under these simplified conditions, should lead to a decline in the "price" of American dollars--the American dollar will "depreciate."

b) Financial Activity: to assume that exchange rates are determined simply by the trade of actual goods is to overlook the enormous amount of currency trading that goes on in financial markets. Some estimate that 90% of currency flows result from capital market activity. This kind of activity is often speculative and generally extremely complicated, but it suffices to say that if someone in America wants to invest in Mexico (either in stocks, bonds, etc, which is called portfolio investment) or in physical goods (such as a factory or a hotel or a housing development, which is called foreign direct investment), again, he or she has to exchange American dollars for pesos. This, all other things held constant, will increase the demand for pesos and the supply for American dollars respectively, and will contribute to a relative deprecation of the American dollar against the Peso.
Bringing it all back to the China-America issue one last time:
When I wrote that one blogger was speculating that the drop off in exports would put downward pressure on the Chinese yuan, I said this because of "factor a" above. If the United States and Japan and Germany and everyone else is in a recession and can't by Chinese stuff, the demand for the Chinese RMB falls as well.
What is the significance of this? China's exchange value is not determined by the foreign exchange market. Because a lower exchange rate (for a while around 8 Yuan for every 1 American dollar, now closer to 7:1) means that Chinese goods in America are cheaper, China has for some time actively kept its exchange value low to facilitate that lop-sided trade relationship. While this certainly complicates matters if someone in China wants to buy anything not from China, such a policy is unquestionably good for those Chinese firms in the business of manufacturing. So how do the Chinese keep their currency low?
Turning to "factor b" above, the Chinese government buys (partially with the money they recieve for all their exports) American (and European) financial assets. These purchases have largely been of U.S. government bonds (basically interest-bearing IOUs from the Federal Government), but also bonds of government sponsored enterprises (Fannie Mae, etc) and the commercial paper and equity of private firms. Regardless of where the money is going, the effect is the same: by buying up American financial assets, they are increasing the demand for American dollars, while flooding the market with Chinese yuan. Tinkering in the market this way, they are able to set a "peg" on their currency; a value or band of values from which the currency is not allowed to deviate.
A drop in exports however, which would decrease the upward pressure on the Chinese currency--so wrote the blogger--would mean that the Chinese government would no longer be so hard-pressed to buy up American financial assets. The consequences of such a shift, he wrote, could be serious for the American economy, since its all that financial activity--namely the buying up of American Treasury Bills (T-Bills being, once again, IOUs to the Federal Government)--that allows the Federal government to borrow so much so cheaply. As soon as the Chinese recognize that it is no longer in their interest to lend to (buy bonds from) the Americans, the Americans either have to stop borrowing or start offering a higher interest rate. The ramifications of this are manifold and mani-fucked, but I won't get into it too much.
What I was writing, on the other hand, was based on a BBC article which pointed out that while Chinese exports are indeed dropping, their imports are dropping further. Why? Countries buy imports when the people and the firms there have money to spend. Since the Chinese economy is so heavily reliant on exports, a decline in exports leads to a decline in consumer and business expenditures, which leads to a drop in imports. The significance of this for currency values--what Dave was asking about in a comment from a post below--is that if a decline in exports leads to a decline in demand for Chinese currency, a decline in Chinese imports also leads to a decline in demand for the currencies of China's import partners relative to the RMB. The net effect, with some oversimplification, is potentially zilch. The depreciative pressure resulting from a decline in demand for Chinese exports/RMB is countered (perhaps overwhelmed, given that the net exports of China during December were at record high levels) by the decline in supply of RMB in foreign exchange (forex) markets resulting for a decline in imports into China.
I hope I've made some sense of all this for those of you who couldn't make sense of my previous article. Exchange rate determination is probably one of the more complex processes in the world of trade and finance, so I've undoubtedly left out of a few factors. I just wanted to explain the basics so that, in the future, if I or anyone else talks about why it is that the American dollar is so strong right now (for instance), everyone will know more-or-less what the hell is going on.