Monday, June 21, 2010

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.





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.


狂猪 said...

Another very important adjustment missing in the above discussion is inflation outside of club-med.

Suppose, Spain has an annual internal inflation of -5%. Further suppose Germany, because it is doing so well and also uses the Euro, has an internal inflation of 3%. Spain in this scenario would have annual adjustment of 8% relative to Germany. Germany's inflation can be a significant contribution to Spain's internal adjustment. It is also one of the few painless adjustments for Spain.

The euro is the currency for both club-med and Germany. Therefore, it's inflation policy must accommodate both and is suboptimal for both (deflation for one and inflation for the other). If ECB really wants to help club-med, it should take on more inflation bias. Ultimately, inflation in Germany is less painful and can change much more smoothly than deflation in Spain.

Stepping back, John do you think club-med can really borrow in their own currency had they not join the Euro?

I believe the probability of that luxury is very low for small economies in general. I think Australia is a happy exception. Without joining the euro, the labor cost adjustment will be much smoother. However, the debt burden would go through the roof as the club-med currencies tank. I doubt the sovereign solvency crisis would have been any less severe. In fact, it could be much worse. The market can force a sovereign default with a run on the local currency (Asian financial crisis of 1997). Is it correct to think the euro has reduced the probability of a market forced sovereign default?

John Hempton said...

You are spot-on. My instinct is to bet on inflation in Germany (housing related consumer stocks would be good) and deflation in club med.


No I do not think they could have borrowed that much in Pesetas. Australia can because the governments have 100 year record whereas Spain does not. And the AUD is seen as a claim on all those commodities...


That said - New Zealand -a country that almost called the IMF in in 1984 - and which has little claim - manages to borrow a lot of dosh in its own currency.

What is the NZD other than a claim on all those sheep.

(Insert kiwi joke here. My favourite: how do kiwis find sheep in long grass? Very nice...)

Anonymous said...


It would be good to have a post on Austalia. What do you think of the proposed mining tax?

Joel Parsons said...

Jane Jacobs, the rather eccentric urbanist and economist, had a great discussion of currencies as regional adjustment mechanisms in "The Economy of Cities". Her argument highlights the social cost of currency unions to cities: one could argue that with a floating currency of its own Detroit would have undergone a series of devaluations over the past thirty years, overcoming the rigidity of its labour cost structure and maintaining its competitiveness as a manufacturing location. Ditto, if you had Sydney dollars and Perth dollars then you might have alleviated the two speed economy differential seen between Western Sydney and WA.

Charles Butler said...

All text book true, John.

But I'd suggest that the comparison between the mining industry and tourism requires that two other factors be included - industry structure and business culture.

Mining - large corporations with contractually enforced labour costs. They'd better be operating in a country with a floating currency.

Tourism in Greece (et al) - dominated by myriad small businesses paying huge proportions of their wages and booking much of their profits in cash. Labour costs are incredibly flexible and elastic. No business, don't come in. Busload of tourists shows up unannounced, get out the cell phone. Business stays low over a long term, pay less to the skeleton staff. No record in either the tax office or the stats.

None of this is to say that a series of other problems aren't engendered by these differences, but assuming a non-existence equivalence ensures that your result exaggerates.

John Hempton said...

Mr Butler

I have a warehouse of Retsina funded by debt denominated in Euro.

Can you please find me a German to buy it.



John Hempton said...

Not to mention a mortgage in Euro.

My wages might be flexible down but the Euro debt is not.


Will said...

The big question is how does this all unravel-
The European banking system has been the conduit by which german deposits has been transformed into speculative spanish real estate loans.
The euro allowed every bank to take a little bit of credit risk/ pick up a peso premium and a little bit of interest rate risk and act as layers in this huge exercise. Individually the banks thought they could handle the risks, but in aggregate the cumulative effect of all these peso premiums has added up to a massive carry trade across europe.
The simplest example is that a caja lends to a real estate project, funded by covered bonds which it sells to a french bank. French bank invests in covered bonds, funded by some subordinated debt, German bank invests in that french subordinaed debt, funded by deposits... In reality is a much more complicated and larger layering exercise. But the principle is the same- German deposits have been squandered on risky activity.
And the big question is- who takes the losses? Who is senior to whom? How does this get resolved without a liquidation of the whole system. I think we all understand the economics- its the law, the politics, the game theory that is going to determine the outcome.

Charles Butler said...

With all due respect, you're the one that made the comparison between tourism and mining. I can only assume that the inclusion of retsina and mortgages ex post is an implicit confirmation of my argument.

Barbed banter aside, the flexible, bottom rung of the employment ladder don't have mortgages. They live with their parents. That's why BNG passes your examination with flying colours.


Andrew said...

Why have the Baltics been able to manage an internal deval without more difficulty? Aren't they in the same boat as the club meds? Yes, the GDP hits were enormous, but most analysts now believe at least 2/3 have turned the corner. Perhaps you aren't amongst "most analysts"?

John Hempton said...

Interesting - but I think the Baltics are recovering in the sense that debt is going bad at less fast a rate - but are not recovering much economically... unemployment is still vicious.

Now what is happening here is that the people are defaulting on loans at a massive rate in the Baltics and the Swiss banks - which have raised capital - are eating the losses...

That is fine - Baltics small -

But economic recovery is slow - credit recovery faster because the defaults are paid. Defaults are a capital injection from Sweden to Baltics.


Anonymous said...

I'd be curious how Singapore and Hong Kong fit in here.

Juan said...

"But fortunately (for Australia) that debt is denominated in Australian dollars"
I may be wrong but I am not sure this point is correct. I suspect JPY and USD denominated issuance makes up a significant proportion of Australian banks liabilities which then goes into funding Australia's housing market/bubble. Sort of a variation of the CHF denominated mortgages in Eastern Europe but with the big 4 banks hedging the fx exposure and pocketing some of the carry (with Aussie interest rates always higher than those in Japan/US)

John Hempton said...

You are wrong on that... the funding is swapped instantly back to AUD with the many people who are happily wanting to speculate on the AUD... and there are MANY of you...

The banks will not wind up with a currency mismatch...

Australia is amongst the smallest countries that borrow effectively in their own currency and run HUGE current account deficits.

New Zealand is the smallest - and it is a problem - a big problem - which one day I will write up if I have the time.


Anonymous said...

So new zealand has a big problem - what about australia?

IF said...

Well, I've heard a lot of rough Kiwi jokes from Australian friends. I only knew two Kiwis and they were both very kind personalities. Hence the following joke repeated to their defense:

There's a Kiwi rugby fan, an Australian rugby fan and a beautiful woman sitting next to each other on a train.

The train enters a tunnel and everything gets dark. Suddenly there is a kissing sound and then a slap! The woman and the Kiwi are sitting there looking perplexed. The Kiwi is bent over holding his face which is red from an apparent slap.

The Kiwi is thinking, "That Australian must have tried to kiss this lady, she thought it was me and slapped me."

The lady was thinking, "That Kiwi must have moved to kiss me and kissed the Australian instead and got slapped."

The Australian was thinking to himself.... "If this train goes through another tunnel, I could make another kissing sound and slap that fucking Kiwi in the head again."

yul said...

Greece is not only tourism sensitive country....
It is NO:2 having largest fleets of merchant ships in the World behind Japan !!
It has : 3.079 ships..
It has : 170.millions dw tons..
65% of them under the foreign flag..


Monko Anime said...

2 things, 1 global, 1 Aussie specific.

Firstly I am of the view, and quite lonely in this respect I believe, that the great productivity bounce of the last decade (2000-2009) for the West was due to imported "productivity" or deflation from China & India. We have for a few years now seen significant erosion of the "cost effectiveness" of IT sourced services from India and now we are seeing similar outcomes for manufactured goods out of China. Unfortunately the turning point in the cycle (wage pressures & (China/India market power) will mean that inflation (and hence lower productivity) will be imported for Western countries stoking inflation in a way that increases in domestic interest rates will do little to affect. Does there need to be some more discussion of this affect (+ increase revalue of yuan..)

Secondly, Bonte Capital definitely needs to do an economics review of hooker prices in Sydney & Australia generally. If there is ever an indicator of price and latent inflation pressures it would be hooker prices. I generally use Japan as a comparison where you can easily see the affects of deflation. But Australian prices over the last 6 months have moved marketedly into the "expensive" range. Probably a better RBA indicator of overheating in the Australian economy.

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