Currency Devaluations

There is a great deal of confusion among economists about what forces are in play when a country devalues their currency like Iceland did a couple of years ago, or the economic factors at play when a country does not devalue their currency like the path Greece is currently following. Both Iceland and Greece got into their financial difficulties by overspending by their national government. We call this situation a "sovereign debt" crisis. It is simply a situation where a country borrows more money than it can repay or allows currency speculators to overvalue their currency.

Iceland's solution was to decrease the value of their national currency. This allowed their export products to be less expensive increasing trade, and reduced the "real" income of their citizenry so they could not buy as many imported products. The result is people saved more increasing bank deposits and spent more on local products spurring the national economy. With the cash flow increases Icelandic businesses were able to reward their employees with more money gradually restoring the relative earning level of their citizenry to that of their competitors. Iceland appears to be well on their way to extracting themselves from the currency crisis that overwhelmed their financial system.

Greece does not seem to be finding its way. Although most citizens in Greece have suffered wage losses, the losses have not benefited Greek exporters since businesses still sell products at the same price. The rescue by other European countries has stigmatized Greek products and the demand is falling. The result is Greek companies have less business and must enforce harsh wages terms on their employees. Since the employees have less money to spend they cannot stimulate the consumer economy. The Greek situation is likely to get worse and end with their expulsion from the Euro zone or an internal strife. Neither will benefit the economic situation in Greece.

One of the great advantages of N Theory is that it provides a simple explanation of why currency devaluation is a better path to follow. In N Theory money is tied to earnings. If a currency is not accepted at the stated value it is because the amount received for work is excessive. A currency devaluation brings all present and past earnings into line with the earnings paid in other currencies. One step and it is done. By taking this step the Icelandic business sector adjusted to the new currency valuation and renegotiated with their suppliers and increased their exports. Simple. This adjustment corrected the error of over payment of wages in Iceland and solved the problem to the satisfaction of people inside and outside Iceland.

The technique Greece is trying does not work since it affects only current and future earnings, not past earnings. Greece cannot make the ultimate step since their currency valuation is set by the ECB. Greece and the ECB  are myopic. The two parties are only looking at the problem from the viewpoint of the government. The government wants to pay their bond holders so they are seeking a way to keep the same revenue streams. Unfortunately, this is impossible when their action is strangling the business sector making economic growth impossible. Without economic growth the government's tax revenues will gradually slide until default is inevitable. By focusing on the Greek government's ability to repay its debt, the ECB is suffocating the business sector. Growth of the business sector is the only way shown to restore a tax revenue stream sufficient to repay a capricious spending government sector.

Greece paid government workers more than they were worth and created far fewer business sector jobs than their spending required. N theory explains all this in the Rule of Money: It must be earned. Unearned wealth must be repaid. It is a debt after all.

Upside Down Asset Pyramid

The Icelandic Banking Crisis is a good lesson for every financial manager to remember.  In a country of 300,000 people the banks grew assets from $1 billion in 2000 to $140 billion in 2006.  Little of this money came from depositors.  Most of the funds came from the issuance of bank bonds.  All of which needed to be paid back with interest.  It was attractive to bond investors to make these purchases since the market prospects for the banks looked so positive.  The bonds looked extremely secure since the bonds paid a 3% interest in Yen or Euros, and money could be lent at 15% in Icelandic Kroner (the prevailing interest rate for Icelandic loans).

Unfortunately, the interest spread is only stable if the currency values do not change relative to each other.  When the inevitable currency collapse occurred the loans in Kroner were returning less than the interest due.  Unfortunately, without a central bank Iceland had no way to protect their currency. Since the bank depositors were making deposits in Kroner and the bank needed to pay back their loans in Yen and Euros the situation only got worse and worse.

Although the poor financial decision making of the Icelandic banks caused the crisis, their decisions like the investments in RMBS during the housing boom of the early 21st century were not egregious or fraudulent.  The time for throwing stones should come to an end and be replaced with a thoughtful strategy to avoid the problems reoccurring.  The easy, but incorrect solution is to throw the bums out.  The problem with that approach is there are always going to be bums.  It is human nature.  What we need is a system that prevents the bums from getting into positions of authority.   That is probably impossible also.  Our next best alternative is a system that prevents the bums from taking advantage of the system.

I suggest we return to the original solution that led to the creation of central banks, spreading the risk.  The original purpose of central banks was not to control the Money Supply or set interest rates or the most ridiculous of all, increase employment, it was to spread the risk of a bank run across the entire banking industry. 

What we are discovering with the European Debt Crisis is even a continent is not larger enough to absorb the losses of a financial mistake of a single country.  Therefore, why not expand the community of banks to include the entire world.  The banking industry could achieve this without government assistance.  It would simplify regulation and with a large Private Sector insurance agency providing the backstop for the banks it would remove government from a business they do not understand and they could focus their resources or building missiles and outfitting Presidential jets.