Thanks to Brad Humphreys for his post below on exchange rates and franchise values. There has been a plethora of “hot Loonie” articles lately. And I fear an important chain of causality is lost by a focus on payrolls measured in Loonies v. U.S. dollars.
IMHO, this important chain of causality goes like this: Owners think about their revenue potential for different team qualities they might choose to put in front of their fans, choose the quality that maximizes profits, and then spend the payroll needed to put that quality of team on the field. The result is higher collected revenues and, if the owners were right, they cover the added costs of higher quality and profits also rise.
From this perspective, it isn’t the exchange rate that matters; surely Canadian owners can do the conversion. It is the revenue that can be collected from Canadian fans, measured in dollars (the currency that buys talent), that determines the level of talent an owner can put on the field, court, or ice.
And that level of expected revenue does appear to have increased over time for owners of Canadian teams with the rise of the Loonie. But more is needed than just a rise in the Loonie relative to the dollar! Canadians could simply keep their new-found real income increase (relative to the dollar) by spending fewer Loonies but the same amount of dollars on their sports teams. So, along with a rise in the Loonie relative to the dollar, it must also be that Canadian fans are willing to spend more (measured in dollars) on their teams.
Missing this linkage by focusing on payrolls leads to explanations that miss the mark. And I’m not trying to pick on Brad since this type of explanation has appeared in many places in the popular print/electronic media.
Here’s one idea: “In the 1990s, when the Loonie was trading under seventy cents to the dollar, Canadian NHL teams struggled financially, as their payroll costs were significantly higher than US based competitors.” But actually the chain of causality would suggest that payrolls measured in dollars would be lower with a down Loonie if sports team output is a normal good. A quick look at the NHL shows this is precisely how it was. Payroll costs of Canadian NHL teams (measured in dollars) are not significantly higher until after the hot Loonie (I had a nice table, but the formatting won’t go through, so here’s a summary):
2003-04: Highest payroll Detroit ($77.9 million). Highest Canadian team payroll Toronto ($62.5 million, 6th place). Average payroll ranking of Canadian teams 15.3 place (50th percentile).
2005-06: Highest payroll New Jersey ($44.9 million). Highest Canadian team payroll Vancouver ($43.7 million, 2nd place). Average payroll ranking of Canadian teams 11.3 place (67th percentile). 26% rise in average ranking.
2006-07: Highest payroll New Jersey ($49.6 million). Highest Canadian team payroll Calgary ($45.8 million, 2nd place). Average payroll ranking of Canadian teams 9.0 place (73rd percentile). 20% rise in average ranking.
Now, perhaps owners of Canadian teams were indeed on hard times (just saying it doesn’t make it so and, as usual, we don’t get to see the informative data). But it wasn’t because payroll costs were higher; indeed, measured in dollars, payroll costs were lower. If they were on hard times, it was because Canadian owners recognized that their fans were only willing to pay for relatively weaker teams.
Here’s another idea: “These events are not surprising, given that Canadian NHL teams have seen their payroll costs drop significantly relative to their US competitors.” But the same summary above shows that, indeed, just the opposite is true. Measured in dollars, payroll costs are higher after the rise in the Loonie but, just as before, it takes more than just a rise in the Loonie to explain this. Following the line of causality–measured in dollars, Canadian fans are now willing to pay more than prior to the rise in the Loonie; owners expect that revenues will be sufficient to cover greater spending on talent. But it is essential that, along with a rise in the Loonie, fans of Canadian teams also are willing to increase their spending measured in dollars.
The rising Loonie gives fans of Canadian teams more control over resources sold in dollars (hockey talent). But it would also appear they find their hockey a normal good. If they didn’t, payrolls would not rise measured in dollars. And, more importantly, it’s not about payrolls, it’s about real income and the revenue potential it represents to owners of Canadian teams.