Mercury Rising 鳯女

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Krugman on the coming currency crisis

Posted by Charles II on January 4, 2010

Paul Krugman wrote an important piece on currency crises. He describes currency crises in three “generations” of economic analysis.

The first generation is an uncomplicated case. Countries need reserves of foreign currencies in order to conduct trade. But suppose a country’s reserves decline to a threshold that makes others afraid to get caught out. Then they will dump the native currency to buy the foreign currency, creating a short-term squeeze.

The second generation is a more complicated case where speculators, recognizing that a country’s currency policy isn’t consistent with its national objectives, create a run on the currency, forcing policy makers to decide between sustaining their currency or getting re-elected. The model for this was the sterling crisis where George Soros made his bones.

The third generation crisis incorporates the real-world effects seen in severe currency crises, which includes a severe decline in GDP with high unemployment. That is what happened in Argentina and may be occurring today. To excerpt from Krugman:

The key argument was that a currency depreciation set off by speculative attack would sharply worsen balance sheets, as the domestic-currency value of foreign-currency debt rose. This in turn would damage the economy, e.g. by depressing investment, which would feed back into further currency depreciation, and so on….Or to put it a different way, what happens in a third-generation currency crisis is a vicious circle of deleveraging.

He argues that the choice offered is between bad (devaluation) and worse (deflation). Either way, wages are forced down, but with deflation, not only does foreign debt service burden rise, which forces up the cost of all debt. On top of it, capital flight intensifies the problem. The one benefit for emerging markets is that export industries are stimulated, which helps reverse the GDP decline. [For the present crisis, that won’t help us partly because our own economy is so large and partly because the rest of the world is also in a slowdown and unable to absorb exports.] Again Krugman:

And despite the praise being handed out to those who helped us avoid the worst, we are not handling the crisis well: fiscal stimulus has been inadequate, financial support has contained the damage but not restored a healthy banking system. All indications are that we’re going to have seriously depressed output for years to come. It’s what I feared/predicted in that 2001 paper: “[I]ntellectually consistent solutions to a domestic financial crisis of this type, like solutions to a third-generation currency crisis, are likely to seem too radical to be implemented in practice. And partial measures are likely to fail.”

So, if we consider the US to be in a currency crisis, how does it modify the financial analysis of a few days ago? It only depends on whether one sees the current level of the dollar as substantially too high or whether it is only slightly high, but vulnerable to attack.

The reason is this. Suppose you hold a $10000 asset which is $3000 capital gains and have the choice of swapping it for another asset at this moment. You know the dollar will drop, say, 20%, but then it will pop back up. If you sell the asset now, you automatically pay very roughly $500 (taxes, broker fees, and CPA fees). If you reinvest the remainder in an asset which appreciates 20% for reasons of exchange rate (to 11,400) and then sell again after one year, paying the capital gains of roughly $300, you net $1,400 for an 11% profit (if you don’t sell, the asset drops in value to $9,120, so you must sell). This is a best case scenario. More likely, you will miss the top and the bottom and clear perhaps half that much.

If the currency shift is permanent, then it probably makes sense to leave the asset in the foreign currency. So, you make a 14% profit.

But suppose the expected drop doesn’t happen? In that case, the person who makes the trade into the foreign asset loses 5% in taxes etc… but the one who stands pat has no profit, but also no tax bill.

The point is that the larger and longer the currency drop, the more it makes sense to sell assets ahead of the drop and buy foreign assets. But if the drop is temporary, then it’s more profitable to exploit it as a trade, expecting that it won’t be very profitable (and therefore focusing on quality of purchases).

Looking back at the financial analysis, it looks very general. It accounts for the possibility of a major disaster, but balances risks between many different outcomes. A year from now, the strategy may look idiotic, but as Paul Krugman says, “Normandy!” The market makes fools of us all.

4 Responses to “Krugman on the coming currency crisis”

  1. jo6pac said

    The again you might not be allowed to get to your asset when you need them the most, just what happened in Argentina. The govt. silently making rule changes in the back ground.

  2. Charles II said

    Well, it’s probably always wise to have a certain amount of cash on hand, Jo. Even natural disasters or illness can make getting one’s money out of the bank temporarily impossible.

    And, for that matter, no change in regulations is necessary to suspend withdrawals in a time of crisis. FDR did it during the Great Depression by declaring a bank holiday. I wonder how much T-bills would be worth in an environment in which the Full Faith and Credit of the federal government were seriously in doubt.

    Examining the proposed rule change, I am not sure what Tyler Durden is excited about (frankly, I rarely am sure what Durden is excited about). It does not forbid you from holding whatever assets you like. If you think that spotted Guernsey cows are a sufficiently liquid asset, you may buy them and call them “money market funds”… as long as you don’t sell them to the public.

    And that’s what the regulation apparently accomplishes. It forbids banks from using illiquid assets in money market accounts by forcing them to use short-term, high quality, liquid investments, the shortest-term, highest-quality, most liquid of which is, of course, money.

    In typical USG fashion, it then locks the barn door after the horse has bolted by providing a procedure for orderly wind-down. But the more money-like the funds are, the more that provision is irrelevant.

    No, the currency crisis that Krugman sees as on its way has been in process for a number of years. I think it’s near to being over, indeed, that it would have been over if the Chinese had just let the yuan float. If the Chinese float, then the rest of Asia would probably follow suit, but their export-dependent economies cannot allow their currencies to strengthen as long as China pursues a weak-currency policy.

    A rise in the yuan is a catastrophe for the American family. Can you imagine the pain in the middle class and below if Wal-Mart re-priced 30% higher? Even pretty well-to-do people could feel the bite in, for example, consumer electronics.

    A rise in the yuan means an end to consumerism. It also means that Americans will have to start organizing to stop the relentless drop in wages. It’s a necessary transition and it will benefit the country over the long run, but it will qualify as a crisis.

    • jo6pac said

      Yep, I remembering reading some were a few yrs ago that shopping at walmart will become like shopping at Nordstrom it’s amazing that I’ve listen to people say we need to lower wages to compete with the rest of the world. I was just fired a few months ago and my job out sourced and the outsourcer would have hired me back at a lower wage, my young coworkers didn’t have a choice but I took the good-bye package and I can live on unemployment. I’m lucky compared to the rest of Americans that are or soon to be lay off. The company surveys showed 70% of employees didn’t have their product and you weren’t good employee if you didn’t. I asked a senior manager at a meeting if the reason this might be so, because everyone salaries were cut every yr. He was shocked that I would ask that question but it was true we all shopped around for the product and went with what we could afford. It’s like no one see the whole idea of lower wages coming full circle to we don’t or can’t spend any extra money. At CR today they had comments from the Fed and the complaint was people are saving and not spending, WTF they’ve seen what’s happening all around them and they could be next. Sad but greed is the bottom line. I do now have time to build a green house this spring.

      • Charles II said

        I’m sorry, Jo. I hope a better opportunity pops up.

        Henry Ford understood the link between good wages and good sales almost a century ago. The leadership of America no longer understands such a simple thing. They are unfit to lead.

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