In my previous post, I attempted to explain how a fluctuating interest rate can help right an economy that is overheating or falling into despair, and that our various cities are, at any time, in need of vastly different exchange rate policies. In order to allow for this, our cities would need their own currencies, because the central bank can only charge one interest rate with our one currency. Separate city currencies would have another benefit: the exchange rates between currencies could reflect changing economic conditions, and provide another stabilizing force alongside the differential interest rate policies.
Instead of math and graphs, however, this time I’m bringing the intuition (okay and a little math). The basic premise of exchange rates is that they allow a large range of relative prices to change simultaneously, rather than waiting for the price of all of the individual goods produced by all the firms in a city to change their prices together. I’ll try to explain why this is good thing, and could help save seemingly hopeless cities like Detroit. Here goes.
We currently have a single currency. When people in the US as a whole become less interested in buying what Detroit sells (eg cars), it hurts the economy of Detroit, and Detroiters themselves. Businesses like GM tend to react to this decrease in demand by lowering their prices to sell what they have, and cutting back production to so that they have fewer unsold cars in the future. “Cutting back production” of course means “laying off employees.” It also often means paying employees less. These now unemployed workers will have trouble finding jobs in Detroit, because Detroit is built around the car industry, which is in decline–and that decline is the problem that started the whole thing off. This means that they can try to start a new business in Detroit, or leave. Securing business loans in Detroit is tough, because, again, the economy is hurting, so banks are less willing to lend–after all, with all those layoffs, what sort of business plan would succeed?
This means that a lot of people will be leaving. And they have been! However, that leaves unanswered questions. Chiefly, where are they going? What will they do when they get there? In the early part of this decade, the answers were “Las Vegas” and “build houses”, but that turned out to be unsustainable too. These workers are not necessarily equipped for jobs as computer programmers, financiers, nurses, or many of the other currently growing fields. This means that many of those laid off are continuing to hurt, with somewhat limited prospects for improvement. Not to mention, a massive exodus from a city leaves property values much lower (and therefore inhabitants much less wealthy) than before, which only serves to reinforce decline and make the problem worse for those still behind.
Imagine, on the other hand, if Detroit had its own currency. As an example, say that before the decrease in car demand, one Detroit dollar (D$1) is worth one New York dollar (NY$1). With a massive decrease in car demand, it might end up that D$1 is now worth only NY$.50, for mathematical simplicity. This would occur because if New Yorkers (and others) are buying fewer cars, then they don’t need Detroit dollars for anything, putting downward pressure on the currency.
This instantly relieves pressure on the car companies: while demand for their cars has gone done, instead of paying their employees the equivalent of NY$50,000 a year, they only have to pay NY$25,000 a year. Talk about cost savings! Obviously, this has good and bad impacts: on the bad side, Detroiters are being paid in money that isn’t as valuable as it was previously: indeed, on a salary of D$50,000, they can only afford half as much from outside Detroit as they could before. Mitigating that are three important factors:
First, that only matters for outside purchases–the portion of their income that they spent in the city will continue to buy as much as it did before. Second, because the change in exchange rates means that they have already cut their costs by a huge portion, car companies won’t need to lay off nearly as many (or any) employees, preventing a sever amount of economic (and geographic) dislocation. Third, and most importantly, financial incentives will serve to encourage Detroiters to adapt in ways that help the local economy evolve positively, rather than pushing them to leave the area and further weaken the prospects of the city. Let me spell this out in a bit more detail.
By way of example, suppose that of the D$50,000 annual salary, a pre-crisis worker spent $30,000 in Detroit and $20,000 elsewhere. After the crisis, the things that they bought from elsewhere have all doubled in price because of the changes in exchange rates! Some things they will continue to buy–food, for instance, and gasoline. However, they will be likely to cut back on a lot of other things: books and movies ordered on Amazon, vacations to Disneyland, and beer from Colorado will all be dropped from plans. Furthermore, while they could continue to split their income exactly as before–D$30,000 on Detroit goods, D$20,000 on goods from elsewhere–the changing prices would make it attractive to spend more inside Detroit, and less money outside. Because of the necessity of things like food and energy, let’s say that they now spend D$10,000 on goods from the outside, and D$40,000 in Detroit.
What this means is that they are going to be trying to buy substantially more inside Detroit. Instead of movies on Amazon, they might by tickets to a theater production. Instead of a vacation to somewhere else, maybe they’ll go to more festivals inside the city, and spend money there. Instead of beer from the outside, maybe they’ll get more People Mover Porter. In other words, in response to the decreasing demand for some goods from Detroit (cars) by people elsewhere, there will be an increase in demand for other goods. Specifically, for goods that people in Detroit value. And that’s just in the short term. In response to these changes, merchants in Detroit who are selling more will want to increase production–perhaps hiring some of the unfortunate few laid off by the car companies. In response to increasing demand for Detroit Beer Company, perhaps some employees or other homebrewers will strike out and open their own breweries. Perhaps the local actors will book a bigger space, and put their show on for more Detroiters. In response to rising prices for gasoline and heating fuel, perhaps other entrepreneurs will rise to the occasion with innovative transportation alternatives and architectural efficiencies.
And that’s just the medium term! As the new breweries expand, they will probably seek to sell outside Detroit; the theater troupe will take their show to the Second City, and the architects will land commissions in Seattle: in short, Detroit will have found new ideas that are good enough to export, helping to replace the long-standing role of the automobile at the top of that list. As Detroit finds more of these ideas, and outsiders demand more of these new goods, the fall in the exchange rate will begin to reverse itself–replacing some of the lost purchasing power. However, Detroiters will likely not return to the same spending habits–some will have developed a taste for the theater! But they will be able to import more of the goods that other cities have innovated in the meantime–goods that perhaps some Detroit entrepreneur has some ideas for improving upon, allowing the virtuous cycle to continue.
At the same time as all these internal changes are going on, the halving of the exchange rate will have produced another effect: cars are now half as cheap to everyone else in the country! Of course, this will lead to a soften the decrease in demand for Detroit-made cars that kicked the whole process off, meaning that far fewer workers would need to be laid off than in the current, one currency scenario. This would substantially ease the transition as Detroit attempts to move from its car-based regime to the new, beer/theater/architecture economy that I have dreamed up.
Now, of course, flexible exchange rates are not a panacea. When the Detroit currency falls relative to everyone else, it means that Detroit auto workers are being paid money that isn’t worth as much–they’ve taken a real pay cut, even if they’re still earning the same number of Detroit dollars. However, you’ll note that auto industry workers are currently taking a similar pay cut in our single currency economy: however, instead of the path I outlined in my multiplie-currency scenario, that pay cut features a huge number of layoffs and plant closings in Michigan and simultaneous expansion in southern states (and other countries) where workers are paid much less than Detroit’s UAW members.
Exchange rates allow price changes that might trickle through the economy over a long period of time–such as the slow replacing of $50,000 Detroiters with $40,000 Alabamans–to take place at one fell swoop, and without the geographic distortions and wasteful plant closings. This provides timely information to everyone about the relative value placed on different goods and services, and allowing individuals to adjust their behavior to these new realities more quickly–rather than waiting it out and attempting to find a new path in the midst of broader economic decline.
They also provides a stabilization mechanism whereby the city as a whole can attempt to right itself early, rather than slowly bleeding out over years and decades. In much the same way that the interest rate mechanism I discussed in my last post can allow an economy to adjust to temporal shocks and fluctuations, these sorts of exchange rates can allow for adjustment to geographic shocks and fluctuations–which would be a great benefit in light of the hugely disparate conditions many in our cities.