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Catching a Falling Financial Knife

Krugman's Magic Solution to Budgetary Woes

Economics / Economic Theory Nov 13, 2009 - 01:01 PM GMT

By: Robert_Murphy

Economics

Best Financial Markets Analysis ArticleLong-time readers know that I am second only to Bill Anderson in my constant criticism of Paul Krugman. Indeed, I quite recently defended the gold standard from Krugman's ridicule.

Given this context, I am very surprised to confess that Krugman has convinced me of the virtues of currency debasement. As I was reading his blog post on the tragic fate of Ecuador, I applied Krugman's lessons to my personal life, and suddenly everything became clear. In a flash, all of my household's financial stresses were solved.


Please allow me to share Krugman's tale — and my own personal salvation — so that you too may be freed from the bondage of creditors and scarcity.

Krugman Explains the Problem with the Gold (and USD) Standard

In a late October blog post titled "Fixed Rates and Protectionism, 2009 Edition," Krugman explained that the horrible trade wars of the early 1930s were the fault of — you guessed it — the gold standard. Herbert Hoover, for example, had no choice but to sign into law the Smoot-Hawley Tariff, because he stubbornly refused to let the US dollar depreciate against gold. I'll let Krugman explain:

Barry Eichengreen and Doug Irwin have a new paper challenging the conventional wisdom about protectionism in the 1930s. It wasn't about economic ignorance, or at least not about microeconomics; it was about the attempt to escape the "golden fetters" of the exchange rate. The most protectionist countries were those that tried to keep their peg to gold.

Fortunately in our times, no government foolishly pledges to pay a certain weight of a commodity in exchange for the pieces of paper it prints up and gives the force of legal tender. We've long since left behind that bit of "economic ignorance." (Phew!)

Alas, just as you kill one superstition about "hard money," another rises to replace it. For example, apparently a bunch of developing nations with histories of volatile paper currencies try to inspire faith by linking their own money to the US dollar.

In fact, some countries with very bad inflationary histories have gone so far as to literally replace their own currencies with the US dollar. Krugman has seen the awful ramifications firsthand:

I'm blogging from Quito, Ecuador. Ecuador is dollarized — no currency of its own, just US dollars. And this leaves the country with very limited room for maneuver during the current crisis. And here's what happened:

In January 2009 Ecuador announced a series of stiff import restrictions on 630 tariff lines, affecting 8.7 percent of its 'tariff universe' and 23 percent of the volume of imports. Duties were raised on 369 tariff lines and quota restrictions imposed on 271 others for a one-year period. They cover products ranging from processed foods and shoes to cars, mobile phones and sunglasses, as well as many other goods that can be manufactured in Ecuador.

Ecuador insisted that the measures it proposed were necessary to balance its widening current account deficit. GATT Article XVIII allows developing countries to impose temporary import controls to "forestall the imminent threat of, or to stop, a serious decline in its monetary reserves; or, in the case of [a Member] with very low monetary reserves, to achieve a reasonable rate of increase in its reserves."

Can you really say that Ecuador was wrong to do this, given its lack of other policy tools? At the very least, you have to say that there's a pretty good second-best case for the policy — and the WTO has reached a compromise allowing Ecuador to keep the measures in place at least for now.…

Anyway, no deep moral here, except to say that the problems that faced nations on the gold-standard in the 1930s are being replicated in countries pegged to the euro or the dollar today.

Now I have to admit, at first my knee-jerk Krugman-phobia kicked in, and I thought the above arguments were silly. First of all, the whole reason a country pegs its currency to the dollar (or better yet, gold) is to reassure investors, both domestic and foreign.

No one wants to open a factory in a distant country if there's a decent chance that a military coup will crash the currency and cut his property value in half overnight. By building up reserves in a foreign currency that is supposed to be much more reliable, the governments (or central banks) of volatile countries can allay that fear.

Since the whole point of pegging a currency is to reassure investors, Krugman's analysis ignores the downside of his proposal. Namely, investors are going to be much more cautious about exposing their wealth to a foreign government that has already burned them once by breaking its peg.

However, there's something even stranger going on in the case of Ecuador. Everything I said so far would be applicable to a country that had its own currency, but then pledged to redeem it in a certain ratio against a foreign currency like the US dollar.

After a string of trade deficits, there would be increasing pressure on the domestic currency to depreciate, which would ultimately fuel speculative attacks against the country's reserves of the foreign currency (such as the dollar). In this case, Krugman would simply be saying that if a country prints too much currency, its attempts to artificially peg that currency above market exchange rates will lead to disaster.

Yet this standard analysis doesn't seem to be applicable in Ecuador. There, as Krugman himself suggests in his blog post, the people literally use the US dollar as their currency. In other words, the people in Ecuador don't "peg their currency to the dollar," but actually walk around with US dollar bills in their pockets. (I have confirmed this fact with both a cosmopolitan world-traveling economist, and the infallible Wikipedia, so I hope it's true.)

Now in this case, Krugman's analysis seems especially nonsensical. To say that Ecuador is running trade deficits and hence running low on its "foreign reserves" of US dollars — when its official currency is the US dollar — makes as much sense as saying Governor Schwarzenegger declared a fiscal emergency because his government is running low on dollar reserves, and therefore needs to prevent Californians from spending their money on goods made in Nevada or Oregon.

I'm hoping that even Paul Krugman would recognize this as an absurd interference with trade, when the real solution would be for the California government to balance its budget. (Ha ha, a little joke there for you. Of course Krugman wouldn't say that.)

Let It Begin With Me

As I mentioned in the beginning of the article, I eventually came around and saw the wisdom of Krugman's analysis, but only after I applied his principles to my own life. You see, up until now I've been in a rat race: when the family budget was tight, I thought my only options were to either earn more income, or spend less money. But thinking about Krugman's analysis of Ecuador and applying it to California, I had a flash of insight.

The real problem with my household finances wasn't that we were underearning or overspending. No, the real problem was that our superstitious bank decided to peg its unit of account rigidly to the dollar at 1:1.

So, for example, if I had earlier deposited $2,000 into my checking account, then I would go around writing checks on that. But if I wrote a check for, say, 500 units of currency, then my bank would dutifully pay out at the rate of 1:1! Thus I would only have 1,500 US dollar bills left in my stockpile of reserves, which would seriously crimp my sushi purchases.

I have since forwarded a copy of Krugman's blog post to the managers of my local bank. I informed them — in case the boobs didn't already know — that Dr. Krugman not only teaches at Princeton, but is a Nobel (Memorial) laureate, for goodness' sake. Taking his advice, I henceforth want to devalue my checking account, so that when I write a check for 500 units, the bank only transfers $250 to the person whose goods I am purchasing.

This step solves so many problems; I can't believe I didn't think of it earlier. Immediately, my household's budget crisis is solved, for I now have double the effective reserves as I previously did. Making my mortgage payment is no longer a struggle!

But this isn't just about me. With my depreciated bank currency, I can spend more freely on local merchants, thus boosting business in my community. Before removing the absurd 1:1 dollar peg, my wife and I would have had to sharply curtail our consumption. This is no longer a concern, thanks to the magic of modern monetary analysis.

Thank you, Dr. Krugman! Now if only governments and central bankers would heed your words of wisdom, the worldwide recession would be ended immediately.

Robert Murphy, an adjunct scholar of the Mises Institute and a faculty member of the Mises University, runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. Send him mail. See Robert P. Murphy's article archives. Comment on the blog.


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Catching a Falling Financial Knife