TCS Daily


Is This Any Way to Grow an Economy?

By Christopher Lingle - September 3, 2004 12:00 AM

In a fruitless and pointless exercise, economic policy makers and businesses fret endlessly over the international value of currencies. This is because interventions to guide foreign exchange valuations tend to be costly and may have only temporary effect, at best.

The dollar's value measured by a trade-weighted index against a basket of currencies has been in decline for more than a year. Some economists, businessmen and politicians in America believe that a weaker dollar will be "good" for the US economy.

They apparently believe that a depreciating dollar will boost exports of US manufacturing production while increasing employment and creating economic growth. Meanwhile, central bankers and finance ministers in Japan and China have been accused of playing games to block the appreciation of their currencies from appreciating against the US dollar.

It turns out that the arguments used in these harangues reflect political expediencies rather than sound economic logic. The most obvious evidence of this is that the balance of trade is not the best measure of the overall welfare of a country.

Part of the problems comes from the dubious claims that a depreciating currency can increase the competitiveness of domestic producers. In fact, currency depreciation should never be a policy objective since it leads to economic immiseration.

It is chimerical to think when citizens of a country receive fewer real imports for a given amount of real exports is an improvement in competitiveness. The country with a depreciating currency may receive additional units of foreign currencies, but it will possess less real wealth in the form of goods and services.

In the adjustment to the declining foreign value of a currency, exports tend to rise while imports tend to fall. This means that consumption must decline for citizens of the country with the depreciating currency since they receive less for is sold to foreigners and more is paid for what is bought from foreigners. By any measure, this is a decline in overall living standards.

In all events, the supposed advantages created by depreciating currencies upon export sales or increased tourism are temporary. This is because domestic prices and wage rates eventually rise due to the new foreign exchange values. Obviously, a persistent rise in prices harms consumers while undermining long-term business investment, rising wages may also contribute to higher unemployment.

It turns out that most adherents of a weak dollar believe that economic growth depends upon aggregate demand for goods and services, both from both domestic and foreign sources. According to this logic, increases in demand for goods and services can push up economic growth rates by triggering the production of goods and services. The implication is that policies that focus upon overall demand can promote economic growth.

This notion is also behind the "export-led" growth policies of many developing countries. Since exports are seen as contributing to economic growth while imports are portrayed as a drag on economic growth, they seek a weak currency so that the prices of domestic output are more attractive to foreigners.

These notions are based upon a misguided belief that increases or decreases in production can be traced to rising or falling overall demand for goods and services. The suggestion that consumption can precede production is based upon both logical impossibility and economic infeasibility.

It might be helpful to trace the impact of monetary policy on foreign exchange markets to see how a currency might depreciate. If the central bank or finance ministry wishes to push down the international value of the domestic currency, they buy foreign currencies. Increased supply of the domestic currency in money markets combined with increased demand for the foreign currency pushes down the value of the former while raising the value of the latter.

At this point, producers are better able to sell more exports. But it is important to know the source of the funds used to intervene in the foreign exchange markets. If they are drawn from existing currency supply, there would be a reduction in liquidity in the financial system. It is likely that the central bank would purchase government bonds, causing more local currency to be available.

As producers seek to respond to increase demand for exports, they find that commercial banks can offer loans at lower interest rates due to the loose monetary policy. In turn, producers find it cheaper to borrow to acquire resources for expanding their output of goods. This newly-created credit allows these producers to divert resources from other productive activities. Initially, exporters experience increased profits, until domestic prices begin to rise under pressures of the bidding war to control access to inputs.

Ultimately, loose monetary and credit policy cause the domestic prices of goods and services to rise. And then there will be a decline in profits earned from exports as well as domestic sales. And so it is that rising prices ends the illusion that prosperity can be conjured out of thin air by pumping new pieces of paper money into an economy.

A supreme irony emerges from the above logic. It turns out that monetary policy responses arising out of obsessions with international currency values increase the volatility of foreign exchange markets.

So, what we are left with is that government interventions in markets at one level create a demand the government to intervene at another level. And this cycle continues; ad infinitum and ad nauseum.

Christopher Lingle is Visiting Professor of Economics at Universidad Francisco MarroquĂ­n in Guatemala and Global Strategist for eConoLytics.


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