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Collective ignorance (part I)

The mainstream media continue to be clueless about the origins of the current eurozone debt crisis and with them the ordinary people remain ignorant too. Day in and day out people are fed with the idea that the eurozone is in the brink of collapse because of Greece and its reckless fiscal policies and unproductive model. Greece has been vilified, ridiculed and looked down upon as a nation and a state by its richer eurozone partners. Sadly, these critics could have bitten their tongue, as the whole debt fiasco is just about to blow in their faces. I will try to explain why is that in this series of posts, starting with a primer on exchange rates, necessary for the absolute beginners in economics.

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In a closed economy without international trade, money circulates among individual agents (people, companies, the government) in exchange of i) goods and services, including labor and ii) capital (or assets). The diagram below shows in a simplified way how money flows into this economy.

The blue arrows indicate money flows for the purchase of goods while the green arrow shows flows for the purchase of assets. For example, Albert dines at Bill’s restaurant, then Bill with the money he earns from his business buys his car from company Carmakers, the car company in turn uses the money to automate some processes in its plant and for that purpose hires consultancy firm Developex (this is the green arrow) which employs Albert as an analyst. Interestingly, Albert with the money that he paid at Bill’s restaurant he gets two things, the dinner being the obvious first. The second, is a functioning economy where money is recycled and destined to come back to him in some form, either through his offer of his services, or through an improvement of the economy’s output potential by the car company modernizing its manufacturing processes. The more the economy produces, the bigger the cake for everyone to share.

Now, how does the government fit into this picture? The government imposes taxes on most economic activities, reallocating part of the money. This is shown by the red arrows added below: The government uses the money from taxes on e.g. the restaurant’s and the car company’s revenue and then uses this money to subsidize the automation of the car plant and to pay for Albert’s education.

The last and most important thing to mention in relation to this example, is that this mechanism works automatically, without any intervention, and also by necessity. The money will necessarily flow into the economy back to Albert even if takes a much longer path than the four steps described. Money is always in motion: even if it is deposited in a bank, the bank lends it to someone who needs it; even if Albert loses his job, someone else will get it, Albert will get unemployment benefits and everything will continue rolling; it might just flow through different channels, making some people rich and some other poor. But it will always flow within the economy, like the molecules of H2O in a glass of water. And because it flows, the government is able to collect revenue by taxing each transaction (through VAT for instance) and each agent (through income and corporate tax).

Let’s consider now an open economy where trade is allowed between agents in different countries. Our model will look like this (red arrows removed for simplicity, you know anyway now how this works):

In this instance, Carmakers is hiring a foreign consultancy firm, which employs a foreign analyst who is then going to dine at Bill’s restaurant during his holiday. It gets bit more complicated though because Carmakers makes its revenue in currency XXX, while the consultancy firm wants the payment to be done in currency YYY. The apparent problem is solved easily: Carmakers will convert their XXX’s into YYY’s in the foreign exchange (FX) market, in the same place where the foreign analyst is also going to change his YYY’s into XXX’s. The system seems to work smoothly. But what if the foreign analyst does not want to dine at Bill’s restaurant? What if nobody in economy Y wants to dine at Bill’s restaurant? What if nobody in economy Y wants anything produced by economy X? Some form of adjustment has to be done then to maintain the functionality of the system and this adjustment is in the exchange rate. In this case, the currency of economy X will decrease in value relative to YYY, Carmakers will opt for a smaller scale, cheaper project for its plant and the foreign analyst will find holidays in economy X more affordable. Obviously, in the real world there are far more agents than the ones in the example but the actions of each of them collectively pushes the exchange rate into the right level.

The simplicity of the mechanism is what makes it perfect. Without any intervention, individual agents in the two economies will manage through numerous transactions to find the appropriate price for their currency. This is how it is made sure that economy X will not consume more than it produces… or actually not. We have not yet talked about capital flows.

Our open economy model so far only had blue arrows. Let’s focus on the foreign exchange part of the diagram and introduce capital flows.

It is not true that one country cannot consume more than it produces. It can do so if it gives something else in return. If not goods what? Assets. Capital. A claim on future production. This might be for example shares in listed companies, government debt or land. When investors in a foreign country want to invest in the domestic economy, domestic agents will receive money (foreign currency) which they can use for the purchase of products from abroad. The diagram above shows with a blue arrow the net flow of money for the purchase of goods and the green arrow shows the flow of money for the purchase of assets. Each arrow shows the net flow of money, so in this case economy X exports perhaps a lot of products to economy Y but yet it imports more. National statistics agencies record these transactions in two accounts, the current account and the capital account.

The current account includes the trade of goods and services but also investment income. The largest part of it is most commonly the trade of goods, reflected in the trade balance. The capital account records the flows of money for investment purposes. When a country has a negative current account balance (a deficit) we say that it is not competitive, because the agents in the economy want to have more than what they produce. But if a country is not competitive in the goods market then by necessity it will be competitive in the capital market, and vice versa. Why is that? Consider the following case:

If economy X wants to consume more than it produces and the economy Y does not want to invest in economy X, an imbalance would arise. Economy X wants to give away XXX’s but nobody wants to have it on the other side. The problem is solved easily again with the adjustment of the exchange rate. XXX will slide in comparison to YYY, economy X will buy less products from Y, Y will buy more from X and will find X’s assets cheaper to invest in. Again, the coordination of the two economies occurs automatically, without any central intervention.

The exchange rate is the simple way that an economy will always and by necessity be competitive in one of the two basic markets, the market for goods and the market for capital. Any current account deficit (or surplus) will be covered by a capital account surplus (or deficit).

Here are some real life examples of the floating exchange rate system: Norway is an oil-producing country, which exports most of its oil production. The norwegian krone faces a natural upward pressure due to the demand of oil, which is not matched by a demand of the Norwegians for foreign products. Norway’s Sovereign Wealth Fund uses the money earned by the oil exports to buy assets abroad. Foreign currency flows in through the current account and then flows out for the purchase of assets through the capital account. If Norway would not buy assets abroad, its currency would appreciate and Norwegian oil would be less competitive. This way Norway is “giving up” its capital market competitiveness in exchange for competitiveness in the goods market.

Poland is the opposite story. Poland is a large, less developed country than its western neighbors. It therefore attracts a lot of foreign investment due to the many business opportunities it offers. Because of the high demand for polish zlotys, the Poles find themselves with plenty of foreign currency to use for imports. This is why Poland maintains a capital account surplus and a current account deficit. Brazil is another example of this case.

Going back to our model, there is one last thing to note about the economies X and Y, that even in the case of open economies and foreign trade, the money of each economy keeps circulating within their economies. Even when foreign investors from country Y buy assets in X, their foreign currency denominated assets are utilized within economy X. The government of each country is happy about it because as the money keeps circulating within their economies it can tax various parts of the economy to generate revenue and pay for its expenses.

If you already know all this you probably found the post a bit boring. But there are two key take-away points I would like you take from this post. First, that money always circulates within an economy making it easy at the same time for the government to raise revenue through taxation. Second, that each economy thanks to a floating exchange rate mechanism always maintains its competitiveness in one and only one of two markets, the one for goods and the one for capital. Remember these points for part II of this post when we take a look at a fixed exchange rate regime or when countries share the same currency, like the eurozone.

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