Naked Economics: Undressing the Dismal Science pdfdrive com

Act III. The Icelandic krona lost half its value. The stock market fell by 90

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percent; GDP fell 10 percent; unemployment hit a forty-year high. People were
angry—just like in Argentina. One woman told The Economist, “If I met a
banker, I’d kick his ass so hard my shoes would be stuck inside.” And she was a
preschool teacher.
10
Even the Big Mac Index had a sad postscript in Iceland. In October 2009,
Iceland’s three McDonald’s restaurants closed after becoming victims of the
financial crisis. McDonald’s required that its Iceland franchises buy their food
inputs and packaging from Germany. Because the krona had plummeted in value
relative to the euro and because the government had imposed high import tariffs,
the cost of these inputs from Germany roughly doubled. The owner of the
Iceland franchises said that to make a “decent profit,” a Big Mac would have had
to sell for the equivalent of more than six dollars—higher than anywhere else in
the world and an untenable price for a country in the midst of a deep recession.
McDonald’s closed its doors in Iceland instead.
11
The economic wreckage that results time after time as investors flee a country
suggests an obvious fix: Maybe it should be harder to flee. Some countries have
experimented with capital controls, which place various kinds of limits on the
free flow of capital. Like many obvious fixes, this one has less obvious
problems. If foreign investors can’t leave a country with their capital, they are
less likely to show up in the first place. It’s a bit like trying to improve revenues
at a department store by banning all returns. A group of economists studied fifty-
two poor countries between 1980 and 2001 to examine the relationship between
financial liberalization (making it easier to move capital in and out of the
country) and economic performance. There is a tradeoff: Countries that impose
some kind of capital controls also grow more slowly. The Economist
summarized the study’s findings: “An occasional crisis may be a price worth
paying for faster growth.”
12
Okay, what if we all had the same currency? Wouldn’t that help avoid
currency-related headaches? After all, Iowa has never had a financial meltdown
because Illinois investors took their capital back across the Mississippi River.
There are benefits to broadening a currency zone; this was the logic of the euro,
which replaced most of the individual currencies in Europe. A single currency
across Europe (and in the fifty U.S. states) reduces transaction costs and
promotes price transparency (meaning that it’s easier to spot and exploit price
discrepancies when goods are all priced in the same currency). But here, too,
there is a tradeoff. Remember, monetary policy is the primary tool that any

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government possesses to control the “speed” of its economy. A central bank
raises or lowers interest rates by making its currency more or less scarce.
Countries that share a currency with other nations, such as the European
countries that adopted the euro, must give up control over their own monetary
policy. The European Central Bank now controls monetary policy for the whole
euro zone. (Obviously Louisiana and California do not have their own monetary
policy either.) This can be a problem if one part of the currency zone is in an
economic slump and would benefit from lower interest rates while another
region at the same time is growing quickly and must raise rates to ward off
inflation.
We don’t really care about currencies per se; what we really care about is the
underlying flow of goods and services. These trades across international borders
are what make us better off; currencies are merely a tool for facilitating mutually
beneficial transactions. In the long run, we would expect the value of the goods
and services that we send to other countries to be more or less equal to the value
of what they send to us. If not, someone is getting a really bad deal. Even little
kids trading snacks in the lunchroom recognize that what you give up should be
worth what you get back.
Except for the United States. We’re the guys in the lunchroom giving up
liverwurst sandwiches and getting a turkey sandwich, plus chips, cookies, juice,
and a peanut-free snack. The United States has been running large and persistent
current account deficits with the rest of the world, meaning that year after year
we are getting more goods and services from the rest of the world than we sell to
them. (The current account measures income earned abroad from trade in goods
and services, plus some other sources of foreign income, such as dividends and
interest on overseas investments as well as remittances sent home by Americans
working abroad.) How are we getting away with that? Might it be a problem in
the long run? The answer to the second question is yes. The first question is
more complicated.
As noted in Chapter 9, there is nothing inherently bad about a current account
deficit, nor anything inherently good about a current account surplus; countries
like Algeria and Equatorial Guinea were running current account surpluses in
2007, but that does not make them economic powerhouses. Still, there is an
unavoidable economic reality lurking here: A country running a current account
deficit is earning less income from the rest of the world than it is paying out.
Consider a simple example: If we buy $100 million in cars from Japan and sell
them $50 million in planes, then we’ve got a $50 million current account deficit.
The Japanese are not sending us an extra $50 million in merchandise because
we’re friendly and good looking; they expect us to make up the difference. To

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do that, we have only a couple of options. One option is to sell our Japanese
trading partners assets instead—stocks, bonds, real estate, and so on.
For example, we might sell Japanese firms $25 million in Manhattan real
estate and $25 million of equity in American firms (stocks). Now the ledger
makes sense. Americans get $100 million of goods and services from Japan; in
exchange, we send over $50 million in goods (the planes), and another $50
million in assets. That’s an even deal. It comes with a price, however; the assets
that we’re giving up (real estate and stocks) would have generated income for us
in the future (rents and dividends). Now that income will go to our trading