Naked Economics Wheelan, Charles (books to read for 13 year olds TXT) 📖

have a pattern, usually a play in three acts: (1) A country attracts significant foreign capital. (2) Something bad happens: a government borrows too heavily and stands at risk of default; a property bubble bursts; a country with a pegged exchange rate faces devaluation; a banking system is exposed as rife with bad loans—or some combination of all of these things. (3) Foreign investors try to move their capital somewhere else—preferably before everyone else does. Asset prices fall (as foreigners sell) and the currency plunges. Both of these things make the underlying economic problems worse, which causes asset prices and the currency to plunge further. The country pleads with the rest of the world to help stop the downward economic spiral.

To get a sense of how this all plays out, let’s look at the most recent victim: Iceland. Iceland is not a poor, developing country. In fact, Iceland was at the top of the UN Human Development Index rankings in 2008. Here are Iceland’s three acts, as best I can figure them out:

Act I. In the first decade of the twenty-first century, Iceland’s currency, the Icelandic krona, was extremely strong, and real interest rates were high by global standards. Iceland’s relatively unregulated banks were attracting capital from all over the world as investors sought high real returns. At the peak, Iceland’s banks had assets 10 times the size of the country’s entire GDP. The banks were using this huge pool of capital to make the kinds of investments that seemed very smart in 2006. Meanwhile, the high domestic interest rates induced Icelanders to borrow in other currencies, even for relatively small purchases. An economist at the University of Iceland told CNN Money, “When you bought a car, you’d be asked, ‘How do you want the financing? Half in yen and half in euros?’”9

Act II. The global financial crisis was bad for the world and disastrous for Iceland. Iceland’s banks suffered huge losses from bad investments and nonperforming loans. By the fall of 2008, the country’s three major banks were defunct; the central bank, which had taken control of the largest private banks, was technically in default as well. The New York Times reported a story in November 2008 that began, “People go bankrupt all the time. Companies do, too. But countries?”

As the krona plummeted, the cost of all those consumer loans in foreign currencies skyrocketed. Think about it: If you borrow in euros, and the krona loses half its value relative to the euro, the monthly payment in krona on your loan doubles. Of course, many of the assets that Icelanders had purchased with those loans, such as homes and property, were simultaneously plummeting in value.

Act III. The Icelandic krona lost half its value. The stock market fell by 90 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 trade-off. Remember, monetary policy is the primary tool that any 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