When Weak Economies Have Strong Currencies

by: Scott Sumner

Those who are as old as I am, and who have read The Economist for more than three decades, can recall dozens of economic crises in far-flung places all over the world. Thailand, Mexico, Turkey, Indonesia, Brazil, Korea, Russia, etc, etc. And in almost every case the collapsing economy and banking distress are associated with sharply falling currencies.

But every so often you find a peculiar case; a feeble economy associated with a strong, muscular currency. I posted this right after my Japan post, because I wanted readers to ponder just how unusual it is for a currency to be strong in an economy that is so weak. Another example occurred in the US during 1929-33, when the trade-weighted dollar rose in value, even as the real economy collapsed. The same thing occurred in Argentina in the late 1990s and early 2000s. Let’s consider what these odd cases have in common:

1. Deflation.

2. Real economies that had been doing well prior to the crisis. Japan was the envy of the world in the 1980s. The economy of the US in the 1920s was one of the most efficient the world has ever seen, in terms of economy policy. The business press was very optimistic in mid-1929, as we had trade and budget surpluses, low taxes, weak unions, stable prices, free markets, etc, etc. Argentina did some neoliberal reforms around 1990 and grew rapidly in the 7 years before the crisis hit.

3. All three crises saw banking problems.

How can we explain these perverse cases—weak economies and strong currencies? Perhaps the usual direction of causation was reversed. Perhaps the strong currency caused the weak economy, by causing deflation. Indeed, it’s now almost conventional wisdom that money was too tight in the US during 1929-33. Some blame the drop in M2; some blame the ideology of pegging the dollar to a metal that was itself appreciating in real terms. But most experts see the problem as monetary, broadly defined. The same is true of Argentina, which attached its currency rigidly (through a currency board) to the US dollar during a period when the dollar was appreciating from the tech boom. And of course many economists such as Paul Krugman criticize the Japanese central bank for being too conservative, for pursuing deflationary policies.

So it seems to me that the profession does have an answer to the mystery of strong currencies in weak economies. When this phenomenon occurs, the strong currency is itself the cause of the problem. It seems that deflation can severely damage a formerly quite productive economic machine.

But (like TV detective Colombo asking “just one more question”) here’s what bugs me. Didn’t the US economy go down the toilet between July and November 2008? And didn’t the dollar not collapse, but rather soar in value against the euro during that 4 month period? So why do almost no economists consider tight money to have been the problem during that period? Why isn’t that like the US in the early 1930s, Argentina in the early 200os, and Japan in the 1990s?

I’d love to put on a rumpled raincoat and ask Mr. Bernanke that “one last question.”