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To peg or not to peg: That's not the question

Published:Sunday | November 14, 2010 | 12:00 AM
Greek Prime Minister George Papandreou announces Greece's decision to request activation of a joint eurozone-International Monetary Fund financial-rescue plan on April 23.
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David Wong, Contributor

The recent discussion by Jamaican economists at the Gleaner's forum, "Economic Growth and the Role of a Pegged Exchange Rate", about whether Jamaica's economic growth would be better promoted by a fixed or floating exchange rate seems to have missed the point completely. As a consequence, only a very superficial discussion of the problems of the exchange rate of the Jamaican dollar took place, while the very needed discussion about how to promote economic growth, jobs, and prosperity in Jamaica did not.

To appreciate the simple truth of the above indictment, let me sketch the background of the real problem facing the Jamaican economy transparently and, along the way, indicate the source of the instability of the exchange rate of the Jamaican dollar, and why to peg or not to peg the exchange rate is not the question.

The long-standing problem of Jamaica is this: It produces Y dollars of income and regularly spends Z dollars where Z is bigger than Y. (For simplicity, dollars will be taken to mean United States (US) dollars.) In order to do this, the country needs to borrow Z-Y dollars regularly.

Over time, the accumulated borrowing of Z-Y adds to a massive debt, D, in proportion to income, i.e., D/Y, is large. At some point, those who lend to finance the regular Z-Y gaps will begin to lose confidence in the country's ability to repay the debt, and the country will find its ability to borrow severely constrained.

At such times, the country may have to seek to borrow from non-commercial lenders (multi-lateral agencies) that offer credit on easier terms, but who will insist on restructuring the country's financing so that the looming bankruptcy is held off. Even before that unhappy day arrives, the country's exchange rate will be under regular pressure to depreciate whether or not it is fixed or floating.

supply and demand

A country's exchange rate is a price. It is the price of a unit of foreign currency (US dollar) in terms of the local currency (Jamaican dollar). Right now, it takes about J$86 to buy US$1:00. As a price, the exchange rate is determined by supply and demand.

Jamaican residents who want to buy goods and services from abroad, or acquire foreign assets supply Jamaican dollars and demand US dollars. Foreigners who want to buy goods and services from Jamaica, or to acquire Jamaican assets supply US dollars and demand Jamaica dollars.

Given that Jamaica's income, Y, is chronically less than its planned expenditures, Z, there is a chronic problem of excess demand for US dollars in Jamaica, which pressures the value of the Jamaican dollar down, and raises the price of the US dollar in terms of the Jamaican dollar. Thus, the tendency of the Jamaica dollar to depreciate is the result of the perennial positive gap, Z-Y.

If the Jamaican exchange rate is to be pegged effectively, then the Bank of Jamaica (BOJ) must have access to a large pool of US dollars (probably infinite) that it can regularly sell to Jamaican residents who want to buy US dollars. Otherwise, as soon as the BOJ's existing pool of US dollars starts to fall below a certain critical level, as judged by currency speculators, the demand for the US dollar will explode, and the Government will have to abandon the US dollar peg more rapidly than Usain Bolt can run 100 metres. The fact is: No peg of the exchange rate can be defended if expenditure in US dollars is chronically bigger than income in US dollars.

The real problem of the Jamaican exchange rate is to eliminate the chronic gap between Y and Z. This can only be done by increasing Y faster than Z in the long run. In simple words, Jamaica needs to grow its real income faster than its real expenditures. There is no other sustainable way of achieving stability in its exchange rate.

Instead of discussing how Jamaica can grow its income faster than its expenditures and achieve exchange-rate stability, the Gleaner forum discussion inverts the question and ask what role can a pegged exchange rate play in promoting economic growth? Talk about putting the cart before the horse, or the tail wagging the dog!

competitive

While it may be true that a pegged exchange rate may make it easier for Jamaican firms to plan their production and sales better, it does not follow that they will thereby become more competitive in the global economy and be able to grow their income faster. After all, Greece and Italy have pegged their currency to the euro at full parity, but that has not increased their competitiveness in the euro-zone, never mind their competitiveness in the global economy. Paul Krugman, for example, has argued that adoption of the euro by Greece and Italy has actually reduced their ability to grow their economies by making them less competitive than they would otherwise be.

While a free floating or managed floating (dirty floating as detractors call it) of the exchange rate does not constrain competitiveness in the way that a pegged exchange rate does, and may therefore seem less inimical to economic growth, it cannot ultimately compensate for a fundamental lack of productivity in the economy. By the way, it is this fundamental lack of productivity and the unfortunate associated tendency of government to gloss over the class conflict, that arises between employers and workers over how to share out the small pie resulting from low productivity, by putting more money than warranted by the actual level of production into circulation, so as to support the illusion that the country is more productive than it actually is, that leads to the chronic inflation, and not the declining exchange rate per se.

Lack of fiscal discipline by government surely contributes to the chronic excess of Z over Y, and therefore, is a contributory factor to the gravitational pressure on the exchange rate to fall. However, as with the tendency of government to cover up the underlying lack of productivity in the economy, by putting more money into circulation than strictly warranted by actual production, government oftentimes is forced to support a larger social welfare establishment than strictly warranted by its actual revenue alone, in order to maintain social peace.

Manifestly, the expediency of holding on to political office for another term is not compatible with braving the vicissitudes of the naked-class struggle in a low productivity economy. Discretion is the better part of valour, and you have to live to fight another day appears to be wise counsel to beleaguered government in a low-productivity economy.

At the end of this discussion, we are back to the basic question: How to get out of the situation of a perennial shortfall between the country's income, Y, and its expenditure, Z? This is where the next Gleaner forum needs to go. Answering this question requires a serious debate about how to integrate Jamaica into the modern global economy, and grow the per capita income of its people on a continuous basis.

Any policy of integration in the global economy will bring costs in terms of what some would term national sovereignty and Jamaican culture, but any alternative policy to strike out on a path of national distinctiveness, or even exclusiveness, will be costly as well.

David C. Wong is a professor of economics at California State University, Fullerton and a participant in the online forum Caribbean Dialogues. Feedback may be sent to (dwong@fullerton.edu) or columns@gleanerjm.com