If you pick up an older economics textbook you’ll find a model of currency values that claims they’re based on trade flows. If your economy, as a whole, is exporting more goods than are coming in, your currency should appreciate in value. If your economy, as a whole, is importing more goods than it is exporting, your currency should depreciate in value.
That ideal world is indeed an ideal world, because there are significant benefits to an economy which operates that way. When you’re exporting more than you’re importing the rise in your currency makes goods produced by other economies cheaper – encouraging you to import. Since the first step in import replacement is to, well, import something – that’s good. When you’re importing more than you’re exporting your currency will devalue making your goods more competitive on the market – hopefully selling more.
I discussed the cycle of import replacement in a prior post). The key thing is that import replacement tends to happen in bursts – an import replacement cycle in an economy rarely affects just one import – it affects a myriad of them in a cycle that generally lasts a few years, as the new work feeds off of itself. So during an import replacement binge the host currency generally increases significantly because a lot of imports are being replaced. When the import replacement binge ends the currency is significantly higher and over a period of years the new prosperity is used to import new goods – hopefully, in the end, leading to another import replacement binge.
In other words an import replacement binge will lead to higher demand for imported goods in the long run – but obviously they won’t be the same goods as the ones that used to be imported.
That’s in an ideal world, but alas, we do not live in the best of all possible worlds.
In the real world the main problems are twofold. The first is that trade doesn’t drive currency except, perhaps, in the very long run (longer than the cycle of import replacement in a healthy economy). Foreign exchange markets drive it and central banks drive it. There’s too much hot money and it isn’t trade related – it goes to the highest return and it’s very fickle, literally able to move into and out of markets in minutes, days or weeks at the very most. Those foreign exchange markets are driven by return – and for short term money return is short term interest rates – these rates are almost always effectively set by the various national banks like the US Federal Reserve, the Bank of Canada or the European Central Bank. In addition, countries buy large amounts of foreign currency in direct manipulation of currency values (China, for example has spent as much as 10% of GDP in a year on keeping the Yuan stable against the dollar.) The volume of hot money and government intervention is magnitudes larger than the amount of money that is actually used in trade, and as a result it tends to overwhelm the effect of trade flows, at least in the short to middle run.
The second problem is the way we decide what areas get a currency. It’s political. As Jane Jacobs has pointed out, on the face of it, any system of measuring economies and assigning currencies that treats Singapore and the United States the same would appear to have some problems.
Economically active regions don’t have to correspond to countries. In fact they tend to correspond to metropolitan areas (not so much cities anymore). In Canada you would have an area around Montreal, the Golden Horseshoe centered on Toronto, the Lower Mainland (centered on Vancouver) and an area around Edmonton.
That’s really it. The problem is that those areas share one monetary policy and one currency. So, as Jacobs pointed out in Dark Age Ahead, in the early nineties you had Vancouver booming while the rest of the country was in recession – it was in an import replacement period. What should have been happening is that the Canadian dollar should have been rising. But since the other areas (especially the Toronto area) are much larger, the dollar was dropping instead.
That means that Vancouver was getting inappropriate feedback. More than that it was getting inappropriate feedback as well because the Bank of Canada was pursuing monetary policies suitable to an economy in recession – not one that was booming.
This sort of thing happens all the time. Europe is not one economic area, for example, yet the members of the currency union share one currency and one central bank. The argument for this, that it encourages trade within the country and that it means that local governments can’t use monetary policy when fiscal is called for (as the US has done over the past years) is true. The downside is that internal economic areas aren’t getting the feedback they need – either from trade flow caused currency feedback or from monetary policy that takes into account that what’s appropriate in one regional economy may not be appropriate in another.
If a region that has undergone an import replacement binge doesn’t get the higher currency rate it needs after the binge, then it can’t bring in as many new imports as it wants to – which means the next import replacement binge may not occur and it isn’t buying as many goods from other areas as it otherwise would – which is bad for them.
If, on the other hand, an area has imported a lot of goods and not yet done an import replacement period, but the currency stays lower than trade flows would mandate, it may not have that import replacement period – because the goods are too cheap for local producers to compete with. Dropping currency is a de facto support not only for exports but for local production – for import replacement.
As a practical matter what happens is that the strongest economy gets the feedback it needs. England used to have many vibrant cities, but one by one they were strangled by feedback appropriate only for one of them – London.
And this is why I didn’t support the Euro – it’s also why I do support putting some sort of international tax on hot money. Systems that don’t receive the feedback they need respond in inappropriate ways and over time responding inappropriately will kill them. The benefits of universal currencies do not, in my opinion, outweigh the disadvantages of them and as for the currency market, it has gone far beyond any sort of useful hedging function into the realm of massively destructive speculation (you may wish to ask the Thais about that.)