The Great Divide

Is a stable exchange rate always good?

For a sense of the Great Divide in Central Asia between journalists and policymakers on matters economic, you can’t go wrong by perusing The Conway Bulletin.

Recently, its business editor wrote: “Despite some devaluations and depreciations, most of [the currencies in the region] have kept steady in 2016, which is a sign that governments want to keep their economies stable and will spend their [foreign currency] reserves to prop them up.”

But on the previous page of the Bulletin, the new head of Georgia’s central bank, Koba Gvenetadze, says: “Part of the population thinks that a steady foreign exchange is a synonym of stability, but that’s wrong.”

Who’s right? Gvenetadze, of course. In fact, a gyrating exchange rate is a vital sign of economic stability over the long run. The reason is this: When a shock hits an economy, something’s got to give – prices or output. If prices absorb the shock, then output can hold steady, and employment along with it.  Well, the exchange rate is just a price. In particular, it’s the price in terms of foreign currency of our home currency.

Here’s an example of the general principle. Suppose that the world economy crashes again. Then demand for Kazakhstan’s exports will fall. If the exchange rate for the tenge holds steady, exporters here will have to lay off a lot of workers, since they can’t sell nearly as much oil as before. But suppose instead that the tenge depreciates – say, from 200 tenge per dollar to 300. Then the dollar price of a barrel of oil will fall – from $50 (say) to about $33 (see the Notes). This will revive oil demand somewhat, although the world recession probably will still prevent us from selling as much oil as before.  Exporters will lay off workers, but not as many as they would have in the case of a steady exchange rate. 

(In principle, oil prices could fall so quickly that the quantity demanded of the stuff won’t fall at all; the decline in price will fully compensate for the loss of demand due to the recession. In reality, global oil markets are not this flexible, since central banks of oil exporters often fix their exchange rates within corridors.)

Winston’s blunder

Historical examples abound of steady exchange rates that rocked the economic boat. In the mid-1920s Winston Churchill, then Britain’s chancellor of the exchequer, decided to revalue the pound sterling until it was worth just as much gold as before World War I. His reasons were patriotic – but patriotism is not always reasonable. Thanks to Churchill, the price of British exports, in terms of the gold that other nations paid for them, rose by a tenth. Britain lost its edge in competing with other nations for global buyers. To become competitive once more, the cost of producing exports would have to fall. This meant cutting wages. And that required a rise in unemployment, since the jobless would bid down their wage demands, forcing the employed to accept a cut in pay. Churchill’s patriotism helped to plunge Britain into a persistent depression.  “The Chancellor of the Exchequer has expressed the opinion that the return to the gold standard is no more responsible for the condition of affairs in the coal industry than is the Gulf Stream,” observed John Maynard Keynes. “These statements are of the feather-brained order.”

So, a steady exchange rate is always bad? No. Ceteris paribus, a stable exchange rate cuts the cost of trading with other nations, thus raising competitiveness and creating jobs. But when global shocks buffer the economy, a flexible exchange rate can insulate us all, even journalists.   --Leon Taylor, tayloralmaty@gmail.com

Notes

If the dollar price of a barrel of oil is $50, then the tenge price (before depreciation of the currency) is 200*$50, or 10,000 tenge. If the exchange rate rises from 200 tenge per dollar to 300 tenge, then the new dollar price of oil is 10,000 / 300, or $33.33.

Good reading

John Maynard Keynes. The economic consequences of Mr. Churchill. 1925. Reprinted in Keynes, Essay in persuasion. W. W. Norton and Company. 1963.

References

The Conway Bulletin. Georgia Central Bank chief says he may let lari value fall.  July 22, 2016. Page 7.

The Conway Bulletin. Region’s economies sputter into life. July 22, 2016. Page 8.