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Quick economics question

dylancatlow
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7/6/2015 7:22:23 PM
Posted: 1 year ago
Can someone explain why it's bad for a currency when users of that currency (e.g. Greece) have an economic meltdown. I mean, I can see why that would lead to something specific like inflation, devaluation, etc, but how is any of that stuff bad per se? Aren't there always upsides and downsides to such affects?
ResponsiblyIrresponsible
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7/6/2015 10:56:28 PM
Posted: 1 year ago
At 7/6/2015 7:22:23 PM, dylancatlow wrote:
Can someone explain why it's bad for a currency when users of that currency (e.g. Greece) have an economic meltdown. I mean, I can see why that would lead to something specific like inflation, devaluation, etc, but how is any of that stuff bad per se? Aren't there always upsides and downsides to such affects?

I think we would need to separate the upsides and downsides, which probably (unless I'm misunderstanding your post) apply to the broader economy over a period of time, as opposed to the currency itself or investors holding that currency.

The reason a currency falls when an economy tanks is, usually, because the exchange rate is inversely correlated with real interest rates, and those are procyclical: i.e., when the economy is doing well, real interest rates tend to rise (because the Wicksellian real rate is positively correlated to NGDP growth) and when the economy is doing horrid, they fall. In other words, real rates of return are higher during good times and horrid during bad times, and that would induce investors to dump their assets denominated in that currency in a search for yield elsewhere: in many cases, that's either the U.S. dollar or the Swiss franc.

Greece is a slightly different story, though. Obviously growth is anemic and they're suffering through deflation, so real rates of return are somewhat high, *but* they're high not due to strong fundamentals, but to high risk premiums. In other words, investors think Greece is likely to default on its debt and/or leave the Eurozone. Of course, it's a bit hard to isolate precisely the impact that Greece has on a shared currency like the euro - though we could probably, easily, attribute movements over the past few days to the results of referendum - but it's not as though the Eurozone as a whole is doing well.

Now, are their upsides to a falling currency? Sure: exported goods are cheaper, so countries usually are able to export a bit more. Of course, productivity and competitiveness in Greece are positively horrid, so the benefits of that are likely muted. A devaluation did work in Argentina in the early 2000s, as it did for the U.S. in the 1930s and, technically, for Germany in the early 2000s (though, admittedly, an internal devaluation is a tad different).

The downside is usually the fact that imports become more expensive - so, in the case of buying intermediate goods abroad, as is increasingly the case these days, production costs rise, so you may see prices on a broader scale rise (and there are obviously implications for real interest rates and thus the exchange rate in that case). Usually inflation rises as a function of a devaluation boost competitiveness - i.e., a pickup in aggregate demand - but it could be harsh, sharp, and forceful in the case of, say, a balance of payments crisis whereby a country needs to shed its foreign reserves.
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ResponsiblyIrresponsible
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7/6/2015 10:59:58 PM
Posted: 1 year ago
Oh, and one more thing: in a case where a country has debt denominated in a different currency, a devaluation obviously makes those debts harder to pay. This could be an issue if Greece as to temporarily leave the euro or reinstate a new drachma assuming the ECB doesn't un-freeze lending, since obviously their drachma would plummet, even relative to an already weak currency like the euro.
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dylancatlow
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7/6/2015 11:26:46 PM
Posted: 1 year ago
At 7/6/2015 10:56:28 PM, ResponsiblyIrresponsible wrote:
At 7/6/2015 7:22:23 PM, dylancatlow wrote:
Can someone explain why it's bad for a currency when users of that currency (e.g. Greece) have an economic meltdown. I mean, I can see why that would lead to something specific like inflation, devaluation, etc, but how is any of that stuff bad per se? Aren't there always upsides and downsides to such affects?

I think we would need to separate the upsides and downsides, which probably (unless I'm misunderstanding your post) apply to the broader economy over a period of time, as opposed to the currency itself or investors holding that currency.

The reason a currency falls when an economy tanks is, usually, because the exchange rate is inversely correlated with real interest rates, and those are procyclical: i.e., when the economy is doing well, real interest rates tend to rise (because the Wicksellian real rate is positively correlated to NGDP growth) and when the economy is doing horrid, they fall.

I don't understand. This implies that a bad economy causes the exchange rate to go up - isn't an increase in the exchange rate the opposite of devaluation?
ResponsiblyIrresponsible
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7/6/2015 11:29:10 PM
Posted: 1 year ago
At 7/6/2015 11:26:46 PM, dylancatlow wrote:
At 7/6/2015 10:56:28 PM, ResponsiblyIrresponsible wrote:
At 7/6/2015 7:22:23 PM, dylancatlow wrote:
Can someone explain why it's bad for a currency when users of that currency (e.g. Greece) have an economic meltdown. I mean, I can see why that would lead to something specific like inflation, devaluation, etc, but how is any of that stuff bad per se? Aren't there always upsides and downsides to such affects?

I think we would need to separate the upsides and downsides, which probably (unless I'm misunderstanding your post) apply to the broader economy over a period of time, as opposed to the currency itself or investors holding that currency.

The reason a currency falls when an economy tanks is, usually, because the exchange rate is inversely correlated with real interest rates, and those are procyclical: i.e., when the economy is doing well, real interest rates tend to rise (because the Wicksellian real rate is positively correlated to NGDP growth) and when the economy is doing horrid, they fall.


I don't understand. This implies that a bad economy causes the exchange rate to go up - isn't an increase in the exchange rate the opposite of devaluation?

Oops, I misspoke. My apologies for that. I must have gotten myself confused since I had three numbers in mind - GDP, real rates, and the exchange rate. Let me try to rephrase it.

When the economy sucks, real rates obviously tend to fall. As a result, exchange rates fall, meaning that exchange rates are positively related to real rates of return.

Sorry about that.
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dylancatlow
Posts: 12,254
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7/6/2015 11:30:15 PM
Posted: 1 year ago
At 7/6/2015 11:29:10 PM, ResponsiblyIrresponsible wrote:
At 7/6/2015 11:26:46 PM, dylancatlow wrote:
At 7/6/2015 10:56:28 PM, ResponsiblyIrresponsible wrote:
At 7/6/2015 7:22:23 PM, dylancatlow wrote:
Can someone explain why it's bad for a currency when users of that currency (e.g. Greece) have an economic meltdown. I mean, I can see why that would lead to something specific like inflation, devaluation, etc, but how is any of that stuff bad per se? Aren't there always upsides and downsides to such affects?

I think we would need to separate the upsides and downsides, which probably (unless I'm misunderstanding your post) apply to the broader economy over a period of time, as opposed to the currency itself or investors holding that currency.

The reason a currency falls when an economy tanks is, usually, because the exchange rate is inversely correlated with real interest rates, and those are procyclical: i.e., when the economy is doing well, real interest rates tend to rise (because the Wicksellian real rate is positively correlated to NGDP growth) and when the economy is doing horrid, they fall.


I don't understand. This implies that a bad economy causes the exchange rate to go up - isn't an increase in the exchange rate the opposite of devaluation?

Oops, I misspoke. My apologies for that. I must have gotten myself confused since I had three numbers in mind - GDP, real rates, and the exchange rate. Let me try to rephrase it.

When the economy sucks, real rates obviously tend to fall. As a result, exchange rates fall, meaning that exchange rates are positively related to real rates of return.

Sorry about that.

Haha, it's okay. I thought I was going crazy for a second.
dylancatlow
Posts: 12,254
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7/6/2015 11:32:49 PM
Posted: 1 year ago
At 7/6/2015 10:59:58 PM, ResponsiblyIrresponsible wrote:
Oh, and one more thing: in a case where a country has debt denominated in a different currency, a devaluation obviously makes those debts harder to pay. This could be an issue if Greece as to temporarily leave the euro or reinstate a new drachma assuming the ECB doesn't un-freeze lending, since obviously their drachma would plummet, even relative to an already weak currency like the euro.

Good point. But does Greece even plan on repaying its debt if it decides to drop the Euro? It seems like the only reason it would continue paying off its debts was if it could keep the Euro.
ResponsiblyIrresponsible
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7/6/2015 11:33:11 PM
Posted: 1 year ago
At 7/6/2015 11:30:15 PM, dylancatlow wrote:
At 7/6/2015 11:29:10 PM, ResponsiblyIrresponsible wrote:
At 7/6/2015 11:26:46 PM, dylancatlow wrote:
At 7/6/2015 10:56:28 PM, ResponsiblyIrresponsible wrote:
At 7/6/2015 7:22:23 PM, dylancatlow wrote:
Can someone explain why it's bad for a currency when users of that currency (e.g. Greece) have an economic meltdown. I mean, I can see why that would lead to something specific like inflation, devaluation, etc, but how is any of that stuff bad per se? Aren't there always upsides and downsides to such affects?

I think we would need to separate the upsides and downsides, which probably (unless I'm misunderstanding your post) apply to the broader economy over a period of time, as opposed to the currency itself or investors holding that currency.

The reason a currency falls when an economy tanks is, usually, because the exchange rate is inversely correlated with real interest rates, and those are procyclical: i.e., when the economy is doing well, real interest rates tend to rise (because the Wicksellian real rate is positively correlated to NGDP growth) and when the economy is doing horrid, they fall.


I don't understand. This implies that a bad economy causes the exchange rate to go up - isn't an increase in the exchange rate the opposite of devaluation?

Oops, I misspoke. My apologies for that. I must have gotten myself confused since I had three numbers in mind - GDP, real rates, and the exchange rate. Let me try to rephrase it.

When the economy sucks, real rates obviously tend to fall. As a result, exchange rates fall, meaning that exchange rates are positively related to real rates of return.

Sorry about that.

Haha, it's okay. I thought I was going crazy for a second.

Ha, na, just me. It was probably because Greece looks such an anomaly to the conventional textbook story - or, even, the U.S. in its current position (though real rates are relatively high on a global scale and will likely rise soon) somewhat defies that story since short rates have been at zero for so long, yet the dollar has been rising.
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ResponsiblyIrresponsible
Posts: 12,398
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7/6/2015 11:38:56 PM
Posted: 1 year ago
At 7/6/2015 11:32:49 PM, dylancatlow wrote:
At 7/6/2015 10:59:58 PM, ResponsiblyIrresponsible wrote:
Oh, and one more thing: in a case where a country has debt denominated in a different currency, a devaluation obviously makes those debts harder to pay. This could be an issue if Greece as to temporarily leave the euro or reinstate a new drachma assuming the ECB doesn't un-freeze lending, since obviously their drachma would plummet, even relative to an already weak currency like the euro.

Good point. But does Greece even plan on repaying its debt if it decides to drop the Euro? It seems like the only reason it would continue paying off its debts was if it could keep the Euro.

There are probably political implications to that I'm not privy to, though I know Tsipras ran on maintaining the euro and the vast majority of the Greek people don't want to leave. The German Finance Minister even recently suggested that Greece's departure may be temporary, so paying back its debt - or at least devising a long-term plan to do so - may be conditional on a long-term plan to stay the course on the common currency, though nevertheless Greece declared a bank holiday, the ECB capped emergency lending, and ATM deposits have been frozen at about 60 euros a day. In order to actually pay salaries, Greece may need to go on another currency - even I.O.U's - temporarily, irrespective of whether it intends to stay on the euro or not.

I think the idea of a Grexit is revered by Ivory Tower academics like Krugman - and that's coming from me, lol - but it just isn't practical, nor feasible, nor desirable. A common currency is horrible economics; as Scott Sumner wrote today, when Paul Krugman and Milton Friedman are on the same side of something, there's at least merit in the suggestion. But there really is no chance in hell, at least in my opinion, that Greece will actually exit the euro, at least not right now. If anything, a new, temporary currency would aid the "woe is me" narrative.
~ResponsiblyIrresponsible

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