Wednesday, October 07, 2009

An Ugly New Age Struggling to be Born?

[Credit Anstalt Bank]
According to the Wall Street Journal yesterday the Latvian government held a treasury auction of government debt to finance its deficit. The bids had to be in euros, not lats, the national currency. There were no bids.

So what? Small country. Far away. Who cares? Here's why it matters.

Since it cannot borrow money, the government will have little choice but to devalue the lat. A devaluation makes imported goods more expensive and exports cheaper for foreigners. It improves the balance of trade while raising the cost of living. It makes the country poorer but solvent. Export industries thrive and hire more workers.

The problem is that the improvement comes at the expense of the country's trading partners. Cheaper imports from Latvia and fewer exports to them hurts the balance of trade of each country they do business with. Every euro of improvement in Latvia's balance of trade is a euro directly out of the balances of trade of its trading partners. For a fixed amount of trade it is a true zero-sum game.

For a small country like Latvia it might not matter much - unless the neighboring countries, Estonia, Lithuania, Poland, Belarus, Slovakia - were each also heavily in debt and a step away from being unable to finance their own debts and currencies. The Latvian devaluation would hurt their already weak balances of payments and force them to devalue too, to defend their economies against the other countries' devaluations. Which becomes a domino effect.

The other response they can take is to put tariffs and other trade barriers on Latvian goods. Which reduces Latvia's ability to export to that neighbor and hurts Latvia's balance of trade with them. To get back to balance, Latvia has to put tariffs and other trade barriers against the country which but the tariffs on their goods. Latvia is not acting out of anger here, just defending their balance of trade. This too has a domino effect.

This is not theoretical. This is exactly what happened between 1929 and 1932 all over Europe. Country after country competitively devalued its currency and country after country competitively enacted trade restrictions to protect its balance of trade and its currency. The devaluations and the dramatic reduction of trade deepened and prolonged the Great Depression. The British expression for it was "beggar thy neighbor" economics. In the end it beggared everyone.

To avoid the same thing happening again the GATT was created, the General Agreement on Tariffs and Trade. It has worked pretty well. But GATT addresses only trade, not currency devaluations.

A series of defensive devaluations among the weaker economies of eastern Europe could lead to problems for the Eurozone countries. A large reduction in the cost of eastern European goods and services, notably including labor, would lead to large numbers of workers moving from Eastern to Western Europe, and a large transfer of wealth from West to East. One can imagine how happy Western European voters are going to be about that.

Their governments are bound by the obligations of membership in the European Union to not restrict the flow of money nor of goods nor of workers freely within the 27 countries comprising the EU.

To visualize this situation, imagine that not only unemployed Mexican campesinos were flooding into the US, but Mexican optometrists, school teachers, caterers, plumbers, consultants, and whatever-you-the-reader-do-for-a-living-ers. And that they were coming legally and that their credentials were guaranteed by treaty to be accepted here. Now imagine that the Mexican economy had just collapsed and that the US economy already had high unemployment. That is what Europe is facing.

It is a straw in the wind that the Latvian government could not sell its bonds. It might not mean anything. It might be the first puff of wind of a coming hurricane. Which is why gold rose on the Latvian announcement but only somewhat.

Just because all that could happen does not mean it will. It is just a hint that the pile of sludge that is market momentum may have budged. If it begins to slide, there is not much that can stop it a major pile of err... sludge when it begins to slide and the way down will be steep if it happens.

The Dollar
The United States and the market have been devaluing the dollar right along relative to the euro. When the euro was introduced in 1999 it was worth $0.89. Today it is worth $1.47. Whether the euro has gone up or the dollar down is only a matter of which side of the Atlantic one is on.

So long as China keeps the yuan pegged to the dollar, the two function as one currency. And the balance of payments of the US and China combined, the dollarzone, is nowhere near as poor as that of the US alone. Our trade issues are with Canada and China, not the rest of the world. Significantly altering the terms of trade among the three would lower the living standards of both American and Chinese workers. Which is why neither side dares alter a relationship that is bad for both countries.

Our trade deficit with the OPEC countries is also serious but at least it is clear what to do about it. The problem there is mounting the political will to do it.


1 comment:

  1. Anonymous11:26 PM

    Jack, which Owner's Manual did you get this from?

    It couldn't happen here!? Neah!