Friday | March 6, 2015

What impact devaluation?

Published:Friday | June 21, 2013
Wilberne Persaud

By Wilberne Persaud

Great controversies
accompanied advances in economic theory as the discipline grappled with big questions. Prevalent in debates since the great recession following the Wall Street meltdown is the divide between proponents of Keynesian stimulus and austerity. As it stands, Europe took the austerity route - Greece being the poster child now lamented by the International Monetary Fund (IMF) as perhaps an example of policy overreach, though some suggest dogma.

But there have been others, equally if not more important, as for instance, 'What creates value and how to measure it?' 'What constitutes capital, how is it rewarded, how should we aggregate it?' And, of course, merits of the gold standard as the basis for money and settling international payments and indebtedness.

It is this, or rather spin-offs from the latter controversy, we consider from the perspective of current prospects for Jamaican economic growth with a devaluing currency. Before we do, however, it is worthwhile noting that a look at a few pages of any prestigious economic journal would convince the untutored the discipline is a 'hard' science, it is not. Much of the theorems in economics are amenable to manipulation through the logic of mathematics. In this, there exists similarity with physics - but there it ends: superficial similarity.

The physical world exhibits observable reality, unchanging relationships like the pull of gravity and weightlessness of space, understanding of which provides theorems subject to testing. We no longer do the rain dance and are able to batten down hours or even days if we wish, before a hurricane. Scientific advance and technology generate these possibilities. Physics establishes laws which, once refuted by valid testing and experience, disappear from view - from clear-headed mature consideration everywhere, apart from old textbooks and among fringe elements. Thus, the idea that the atom is the smallest particle of an element is no more - the Manhattan Project, atom bomb and Hiroshima put paid to that. Contrarily, human-induced climate change is denied by a radical fringe often funded by misguided, but very wealthy folk benefiting from the status quo.

That said, this is no carte blanche to abandon economic theory or statistical and econometric procedures to gauge economic impacts of policies and projections of world economic growth. What we need is a healthy understanding of limitations, particularly of simplifying assumptions.

When gold ruled

So what does the gold standard have to do with devaluation? Well, until the second European war, at the end of which an economically devastated Britain and an ascendant US brokered the Bretton Woods system of fixed but occasionally flexible exchange rates among world currencies, the gold standard, pure or modified, ruled. Essentially, countries with balance-of-payments deficits shipped gold to cover outstanding debt. Domestic money supply adjusted downward, credit became more expensive and, generally, deflation followed. The gold standard effectively provided an automatic stabilisation mechanism outside the control of the government and politicians. Notions of quantitative easing and monetary control as we know them today couldn't exist. Granted, this simplification is a bit of an exaggeration, but you get the picture.

At war's end, with full blooming of the Marshall Plan and ramping up of the US economy, the world began facing what was then called the 'dollar shortage'. With excess demand for dollars to facilitate world trade and individual country growth, for world liquidity to grow, the United States had to run balance-of payments deficits accompanying the-increasing supply of dollars. At Bretton Woods, Keynes advocated for a world currency - Bancor - understandably, Harry Dexter White and the US would have none of it. Britain, during the days of its empire, enjoyed the benefits of the pound sterling as world currency, so why deny this to the US?

So the issue of gold and the dollar crisis of the post-war world fuelled controversy over the merits of a gold standard and fixed versus flexible exchange rates. Advocates of flexibility argued that the Bretton Woods system provided neither certainty of exchange rates as the gold standard did, nor the benefits of freely convertible flexible exchange rates. Friedman, leading monetarist free-market advocate, argued that a flexible exchange rate didn't mean a constantly changing rate. Rather, rates would simply reflect underlying relationships within and among countries linked to their trade and foreign-investment performances - a flexible exchange-rate regime could provide, in practice, behaviour akin to fixed rates.

Balance-of-payments deficits and surpluses would be isolated from internal domestic policy, which could then be managed without the constraint of having to maintain an exchange rate fixed into the future. The theory developed to analyse impacts of exchange rate changes took two distinct approaches. One relied on insights from individual and firm behaviour - the elasticities approach; the other on macro-economics - the income and absorption approach.

Positive impacts of devaluation

When Jamaican commentators speak of the positive impacts of devaluation in our quest for growth, they refer to the impact of lowering export prices upon foreigners' demand for what we produce and sell abroad and nationals' demand responding to increased prices of imports. As this column had remarked before, the period 1977 - in which the Jamaican dollar exchanged at about par with the US dollar - and 2013 in which it takes J$100 to buy US$1, presents ample evidence that devaluations shall not cause a flood of exports and drought of imports. Even the least perceptive amongst us should see that.

The question is, why? The answer has to do with the assumptions that price-elasticity theory relies upon for its predictions. A devaluation acts like the one-hour rollback of the clock for daylight saving time. It affects everything. People respond not merely to prices. Money is a form of wealth holding. Every time the Jamaican dollar devalues, Jamaicans holding local currency savings suffer losses. By now, they must have grown wise to the pitfalls of inaction. They hoard US dollars; it would be foolhardy not to. Unless and until therefore, we change the outlook of Jamaicans about the future value of the currency, we shall experience periodic and apparently inexplicable runs on the US dollar.

How did we get here?

How did we get here? This is a story too long for complete exposure in this column, but a few salient points will assist. First, a short-sighted administrative convenience established the Jamaican dollar as more 'valuable' than the US dollar at the ridiculous rate of J$1 to US$1.20. With Jamaica's highly skewed income distribution and proximity to Miami, a weekend of fun and shopping paid heaping dividends to the privileged few visa holders. As this group grew, or their wealth and income increased, arbitrage of the stronger Jamaican than US dollar proved devastating as the boom years of import-substituting industrialisation gave way to oil crisis and stagflation in the major economies.

Michael Manley and the People's National Party's approach to income inequality and poverty facing Jamaica as many as 10 years after Independence met with a coordinated pushback against what was perceived as a frontal assault on capital and privilege. The political directorate was behaving as if it had come to power in revolution and not by the ballot box. Five flights a day to Miami were indeed the norm. And that norm enshrined the serial devaluation of the Jamaican dollar initially mandated by the IMF. The IMF, no one could credibly deny, was at that time doing the bidding of its masters in the miserable atmosphere - for underdeveloped countries - of the fog of Cold War. Prudential, alternative wealth holding by Jamaicans has never ceased since those times; indeed, it is well known that a major proportion of Jamaica's foreign-denominated debt is held by Jamaican nationals.

Jamaica's 40-year no-growth economy relied on borrowing by the state to keep people afloat. Indeed, we borrowed to pay interest on debt and shore up the net international reserve defending an exchange rate rendered downwardly unstable by evolving expectations. Productive invest-ment in the goods and services sector were, if not heavily subsidised by government, virtually abandoned in many instances - government paper paid such dividends the opportunity cost of productive investing was too high.

A colleague of mine, Alfred Francis, 13 years ago put his finger on the problem this way: "Ultimately, the accumulation of debt in a stagnating economy is unsustainable. Clearly, the Government has to break the cycle of a high interest rate, no growth and accumulating debt. The current focus of policy is evidently the achievement of a relatively stable price level and a related stable exchange rate. The no-growth predicament in which the economy finds itself is hardly surprising; the current macro-economic conditions are inimical to growth.

A change of focus is needed. The focus on a stable price level and a stable exchange rate, above all else, has got to be modified. The refocus has to be primarily on investment, employment, and growth, with a low inflation and a relatively stable exchange rate as secondary issues in terms of priority."

In that paper as well, Francis spoke of the declining real interest rate that should follow a change of focus in policy. He described this as a "precondition to real investment undertaking". JDX and NDX have achieved some of this. The next moves must be investment in infrastruc-ture, both physical and institutional - in this we include corruption and bureaucratic malaise. There are, as yet, significant opportunities for savvy investing in Jamaica.

Wilberne Persaud, an economist, currently works on impacts of technology change on business and society including capital solutions for innovative Caribbean SMEs.Email: