I gave a lecture to Georgetown MBA and public policy students here this morning, on the travails of the eurozone. Preparing this presentation forced me to collect the data and assess how “adjustment” is going so far in the Club Med economies. When I say adjustment, I mean getting prices in line with some notion of a fundamental equilibrium with the rest of the world. If prices are too high, the economy is uncompetitive. (If prices are too low … that’s another story, which belongs to East Asia. For better or worse, the strains from being too expensive are not symmetric with the strains of being too cheap, and this has been a source of difficulty for the international monetary system throughout history.)
Obviously in the case of Club Med, prices are too high. How’d they get there? Well, these economies grew on the basis of non-traded sectors, so being competitive didn’t matter. What did matter was steady inflows of credit, and of course this was plentiful because these economies for the first time enjoyed the same interest rates as does Germany, thanks to the common euro currency. As I’ve explained before on this site, the seeming absence of exchange-rate risk misled market participants into under-pricing credit. Where’s the exchange-rate risk if there’s no country-specific (nominal) exchange rate? Well, it’s there. You just have to recognise a shadow exchange rate. Also missing was one of the key measures markets use to sniff trouble in the currency: foreign reserves. With no visibly shrinking stockpile of foreign reserves to focus on, markets lost sight of the shadow exchange rate. Sheer unfamiliarity with currency unions explains a large part of this. (1/)
The measure of an economy’s price position internationally, and thus its need or otherwise for adjustment, is the real-effective exchange rate, or reer. “Effective” and trade-weighted are synonyms. The reer is simply a composite index of the exchange rates between the local economy and all of its key trade partners, weighted by trade share and adjusted for differentials in inflation between the home economy and that of the trade partner. If you didn’t look at the effective index, you’d be misled by a currency peg into thinking nothing was happening to the currency. If you didn’t adjust for inflation differentials, you’d miss the price divergence between the home and abroad countries, and thus their relative divergence in competitiveness.
Before jumping straight to the reer indices for the Club Med, it’s worth considering how these dynamics played out in previous strains of fixed-currency systems, in crises as well as non-crises. A key non-crisis was Hong Kong. Although this economy was surrounded by devaluations in the midst of the 1997-98 East Asia financial crisis, it did not break the US dollar peg. In fact, it was almost totally unique in hanging on. You should already know that by definition it must have accomplished this through “internal devaluation”, otherwise known as deflation. (If you can’t devalue, and everyone else around you devalues, then the only way to get the reer back into alignment is to deflate.) And indeed that’s what it did. Hong Kong experienced a prolonged and deep episode of deflation, which suceeded in eliminating the local currency’s overvaluation, at least as measured here by the reer index (souce: BIS). The vertical line is June 1997, the month in which the Thai baht fell, which was the proximate start of the crisis.
If Hong Kong was the most noteworthy success, then Argentina was the the most noteworthy failure. Argentina had a lot at stake in this struggle. For whatever reason, monetary management has never been a strong suit in Argentina. After many failed currencies (failed in the sense of hyperinflationary), the central bank by the early 1990s had seemingly exhausted its credibility. And yet the new age of financial globalization, in the wake of the collapse of the Soviet Union and the triumph of the Washington Consensus, demanded a wholehearted international engagement, meaning open trade and financial accounts. Yet a fixed currency was also desirable, lest a floating one become a source of continuing depreciation-induced inflationary pressure. The only way to ‘square’ this circle, seemingly, was to adopt a particularly rigorous form of currency arrangement, known as a ‘currency board’. The point of the currency board is to eliminate the central bank: control of the domestic money supply is not possible under a currency board (it becomes ‘endogenous’). The currency board’s defining feature is a legally mandated fixed relationship between domestic money and foreign money. In other words, the currency board must allow outflows of capital to shrink the money supply (whereas normally a central bank is free to replace these outflows with new money, thereby preventing the monetary contraction — a technique known as ‘sterilization’). It must not emit new money except in proportion to new money entering via the foreign-exchange market. And the fact that it holds these monies in fixed relationship means that there should never be a panicked flight from the currency: there’s always enough reserves to cover capital flight because the quantities are mandated by law.
No doubt the sucess of Hong Kong’s currency board, even before the 1997-98 crisis, was an inspiration for Argentina. We can learn a lot from the failure in the one and success in the other. Foremost, it is not the trappings of monetary arrangement but the idiosyncracies of the economy and political-economy that sustain it. This is crucial. It is not merely because it had a currency board that Hong Kong sustained a fixed exchange rate through periodic crises. It has sustained the fixed exchange rate because it is Hong Kong. What do I mean by that? Probably there’s no better summary than the consistent declaration by the Heritage Foundation that Hong Kong’s economy is the “most free”. This economy is uniquely able to absorb international pressures on the back of domestic prices — for goods, wages, capital and land. Crucially, that means the ability for these to deflate in instances of severe and chronic over-valuation, such as befell the currency in 1997. (Deft monetary management and, yes, the currency board were certainly helpful. The monetary authority, for example, jettisoned the laissez-faire playbook at the height of the crisis to commit public money to the stock market, thereby severely burning speculators and chastening them.)
Put briefly: Argentina ain’t Hong Kong. Currency board notwithstanding.
So how are our Club Med countries faring? I’ve got the analogous charts for them and will put them up soon. There are some surprises — good and bad. The main thing I wanted to impart in this post is to understand their burden(s) of adjustment in light of the successes and failures of recent memory. Remember, to succeed in this mission, Greece et al need to be more Hong Kong, less Argentina.
1/ Which is one reason why the gold-standard incarnations of international monetary system (or regional) are useful templates for analysing what’s happening in the eurozone. As in the eurozone, countries’ entry into the international gold standard implied an “irrevocable” system of fixed exchange rates. Until they weren’t. Also like the eurozone, the dogmatic defence of the monetary order under a gold standard was breathtaking. The first few posts in this blog (from 2010) go into this a bit. I’ll re-post on this as well.