Normal adjustment mechanisms – part five in the Edward Hugh tribute series…

Australia is a commodity sensitive economy.  Greece is tourism sensitive.  Tourism is almost as big in Greece as mining is in Australia. 

But unlike Greece Australia has a really effective adjustment mechanism to a decline in demand for its product.  When metals prices/demand falls the Australian dollar falls.

One way to think about it is that when metal prices halve (a surprisingly common occurrence) then Australian export labor just is not as productive (in the sense that it earns less USD or hard currency per hour of work– not in terms of metal output).  We could solve this problem by paying everyone less (which involves the changing of many internal prices with complex and hard-won contract terms) or by simply changing a single variable – the price of the Australian dollar.  It is much easier for the market to adjust a single variable (the currency) than to adjust many (everyone’s wages) and so – more-or-less – that is what happens – the market takes the easiest available adjustment route.  The wages on the mine tend to fall – but slowly – relative to other wages.  The AUD reacts quite quickly – and as it falls everyone is paid less in USD terms. 

The adjustment really is simple – don’t change everyone’s wage, change the exchange rate.  Suddenly Australian labor can (again) produce commodities profitably… 

America is a large country with many sub-economies on different cycles but with a common currency.  If terms of trade move against Texas (as happened in the mid 1980s when the oil price collapsed) you can’t have the Texas Dollar fall because there is no Texas dollar.  Houston – we have a problem…

There is a solution too – but it is not as neat as the Australian solution.  The Australian solution to a recession in the mining belt is to allow the currency to devalue – the American solution to (say) a recession in Houston is for people to move out of Houston. 

America has an amazingly mobile population – with almost all of the world’s busiest airports inside the US.  Almost nobody seems to live in the town in which they are born.  It is OK for Las Vegas to have a tourism based economy, Los Angeles to be based on entertainment and aerospace and Florida to be retirement because people in the US move when one part of the economy is struggling.   In Australia – a country very similar to the US – internal migration is much less noticeable. 

Alas Europe has neither much internal migration nor any ability for say the Greek or Spanish Euro to devalue against the German Euro.   I exaggerate a little – a cursory look at the racial mix of Spain over the past 15 years will tell you that immigrants to the Euro Zone settled in Spain in large numbers – and presumably they won’t be doing that any more.  But I do not see too many Spanish living in Munich. 

And so Club Med is left with its nuclear-solution to adjustment which is internal deflation to give adjustment.  What Greece needs right now is a flurry of German tourists spending big on retsina and hotels – and it needs to be able to tax that spending.  Alas Greece is expensive now – and whilst a devaluing Euro will make my “ruins tour” cheaper it won’t make it any cheaper for Germans to visit.  What will make it cheaper is lower Greek wages achieved through lots and lots of unpleasant austerity…

Alas I think it is worse than that

As observed the Australian solution to a local slump is to allow the dollar to devalue.  This makes Australian industry more competitive and hence provides the solution to the problem. 

There is one more consideration – Australia – like “Club Med” countries has a lot of external debt.  Indeed Australia has a massive amount of external debt – we are far more (privately) indebted than any of the so-called “PIGS”.   But fortunately (for Australia) that debt is denominated in Australian dollars.  If the Australian dollar devalues that debt devalues with it and it is no more difficult to repay.  If the debt were denominated in (say) US dollars then as the Australian dollar devalued the amount that would need to be repaid would go up and up and up at least when measured against Australian physical output.  If you devalue the debt simply becomes too big. 

It is the core of the Australian miracle that Australia is a small open economy with a floating currency allowed to borrow in that currency.

There is a reason why we are allowed to borrow in that currency – which is that the Chinese (with some justification) see Australian dollars as a claim on all of those minerals (and a history of 100 years of not-too-bad government).

Now Greece and Spain et-al do not borrow in their local currency – they borrow in Euro.  And if they had converted their local economy back to Drachma or Peseta those currencies would devalue against the Euro making their debt unreasonably large measured against Greek or Spanish output.  Private debt denominated in a foreign currency where it is just manageable prior to currency devaluation becomes entirely unmanageable once the currency loses a third of its value.

But the currency is pegged and whilst it remains pegged the nominal value of the debt – measured in Peseta or Drachma cannot increase….  But we know what the adjustment mechanism is – it is internal deflation.  Prices will fall in Spain and the rest of the PIGS – they are already falling in Spain.  And whilst this is a necessary part of the adjustment it has a side effect of increasing the effective amount that needs to be repaid vis say Spanish wages – just as surely as it would if Australia had borrowed in US dollars and the Aussie dollar devalued. 

Essentially club-med is in the position of a country with a floating currency too indebted in foreign currency when their currency collapses.  Except that it is worse – because the crisis will get drawn out -

Internal devaluation – the only adjustment mechanism Club Med has – will drive up the value of that debt measured against Club Med output just as surely as external devaluation drove up the value of Thai US Dollar denominated debt from the perspective of the Thai.

Even with internal devaluation there is alas no real equilibrium.  This is just a pug-ugly situation.

 

 

 

John

Post script: one reader reminds me that there is one remaining Finnish bank – but it has almost no cross-border business – and the general point – that Scandinavia got rid of currency union on a banking crisis and today only Finland with a small domestically owned banking sector is uses the Euro.