Bringing sanity to currency idiocy

Business Day ran with an excellent opinion piece yesterday by former Wits finance professor Richard Grant (Grant is professor of finance and economics at Lipscomb University in Nashville, Tennessee, was chief economist at the Chamber of Mines and was a contributing editor at the Financial Mail).  Grant hones in with calm precision on the fallacy that a ‘strong’ rand will hamper SA’s economic recovery.  Human Action couldn’t agree more with Grant and has written about this issue in numerous previous posts. 

The currency debate always hots up in a time of global economic distress as the nationalistic mercantilist urge rises to the surface again.  Alas, most of the debate surrounding currencies is grossly misinformed with the generally accepted view that a weaker currency is a benefit to an economy. 

It would be totally understandable if it was just the government moaning about the stronger rand as the government view of economics tends to be exactly wrong most of the time, but those same whines come from big business as well as top banking strategists.  It is unfortunate that the voices for rand weakness are consistently stronger and louder than those for rand strength.  Grant has a good explanation for this. 

“Those companies that have revenues in foreign currencies, but most of their expenses in rands , will show a slightly greater profit during the period in which the rand is falling relative to the particular foreign currency. (When the rand stops falling, the adjustment of domestic prices will catch up to the exchange rate, thereby removing the price advantage.) 

Importers and local consumers will generally find themselves in the opposite situation, but the harm done to consumers from this particular source is more spread out so that no one consumer can justify the expense of lobbying against the deliberate currency depreciation. 

That explains why exporters have very strong incentives to lobby for this special advantage, while importers never seem to have the same political voice that exporters have. 

Although those harmed by the weakness of the currency almost always suffer more greatly than the total benefits received by those who gain, it is extremely common to hear advisers speak of a “competitive advantage” due to the weakness.” 

Henry Hazlitt talks a lot about this skewed and concentrated lobbying incentive in economics in his book Economics in One Lesson and shows how it often leads to short-sighted policies which actually do more overall harm than good but undoubtedly favour the narrow interests of the particular lobby group. 

The simple reality is that no country can hope to become rich and not have a strengthening currency.  A strong currency is a GOOD THING! 

Grant takes aim at the constant voices calling for a devaluation of the rand at its most fundamental point and asks, Is the rand really even strong? 

During the past year, the rand has risen against the dollar, the euro, and a trade-weighted basket of currencies. But the exchange rate with gold remains volatile and, though the five-year uptrend in the rand-gold price seems to be slowing, it is too soon to declare the rand “strong” by that measure. 

The dollar, the euro, and all the other fiat currencies are, by definition, man-made currencies. This characteristic, which they share with the rand, makes them all susceptible to inflationary bias, especially during a recession. 

As a standard by which to judge the rand’s performance, they are a slow heat. The commodity money — gold — shows them up. 

Part of the volatility in the gold price, worldwide, is due to fears of future price inflation in many countries. This makes it difficult to be sure what the rand’s gold exchange rate is saying about current rand strength. 

Let’s take Shakespeare’s standard: “To thine own self be true.” What is the judgment of South Africans, as revealed by their actions when trading rands for goods and services each day? 

To them, the rand has been weak. The consumer price index (CPI) has spent more than two years well above the 3%-6% range that is targeted by the Reserve Bank. It has only recently re- entered the range, with a reading of 5,8% for November. 

That is a great improvement, but even 3% is not a very ambitious target. If that is the bottom of the range, it suggests official weakness. 

Indeed.  Human Action has pointed out before that the 3-6% “inflation” target band requires perpetual inflationary monetary policies that can only over time weaken the rand versus goods and services and, if offshore price increases are subdued, will weaken against foreign paper currencies as well.  We have been banging the strong rand in 2010 drum a lot lately, but only because of weak offshore currencies and a flat money supply which will temporarily drag down consumer price increases and see the rand gain. 

The best news for the rand is the low growth rate of the monetary base (M0) over the past year. For much of the past five years, the M0 growth rate has often been as high as 20% a year. 

That is why price inflation has been so high, and why the rand was so obviously weak from late 2007 to early last year. 

But for the past year, the M0 growth rate has been falling steadily and is now around 5%. 

This explains the current relative strength of the rand and suggests that price inflation will continue to fall. 

Quite.  Unfortunately there is a real danger that this stable money supply environment is seen as bad by the ignorant powers-that-be and that by 2011 SA is again cranking up the printing press like it has been so fond of doing since the mid-1980’s.  As Grant ominously points out, 

The danger lies in politics. There are always those who believe that currency depreciation should be used as a tool to subsidise exporters. 

The problem with a push for a more “competitive currency” is that no government or central bank can make their money more or less ‘competitive’.  People and companies are the crux of competitiveness, not currency.  The transitory gains to some from a weaker exchange rate are always eventually offset by more important factors.  Grant correctly points to the fact that currency is simply a medium of exchange and unit of account, meaning that inflationary devaluation policies “separate…business planning from economic reality”.  Devaluation policies require lower interest rates than the market would deem appropriate, making long term investment decisions falsely attractive and resulting in mal-investments, poor capital allocation, and ultimately recession. 

Perhaps Grant’s best and most important insight is the fact that deliberately weakening the currency imposes a tax on foreign capital inflows.  It effectively says to foreigners that SA has enough capital and skills and wants to slow inbound investment flows. 

SA has a major deficiency of capital and skills, evidenced by lingering poverty and low average incomes.  More capital accumulation is needed to increase employment and real wealth and devaluing the rand is NOT the way to get there.

Next time you hear a hot-shot from Investec saying that the rand is too strong and that a weaker rand is the key to lifting South Africa out of the economic mire, add them to your “they-don’t-get-it” list.