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Exchange Rate Afflictions


Exchange Rate Afflictions

Yes, it is a fact that the recent appreciation of the real against the dollar -- that is here to stay -- is detrimental to the export sector, although it is great for imports. However, the overall problem is not in the high relative value of the real, nor in the Chinese imports. The whole problem lies in the economic arrangement of the country.

It is not yet the case, but if some obstacles created by the Brazilian government are not removed and the dollar continues its free fall, the country will face a real danger of deindustrialization (whether this is necessarily bad or not will also be analyzed below). But this will be only an extreme situation -- something still very far away.

The most flustered, including some self-proclaimed liberals, are already clamoring for intervention in the foreign exchange rate. Any exchange rate policy aimed at preventing the devaluation of the dollar will not only fail to achieve its intent, but may also generate even more disastrous consequences, something that will be explained later in this article. Besides, whenever the exchange rate is altered in order to promote an industry, several other sectors will be inevitably impaired -- which means that, in the end, the sectors that have greater political influence will win. It is doubtful that such an arrangement, entirely based on the power of lobbying, will be the best in economic terms.

Another solution always considered with great care -- primarily by mercantilist businessmen -- and that has already been implemented to benefit the steel industry, is protectionism - which consists in increasing import tariffs (read "confiscation of your money for the benefit of the inefficient"). The pernicious effects of such measure have already been explained in detail here. We will return to them as the article unfolds. But first, a few clarifying points.

The theory for beginners

Before we enter the discussion, some technical clarifications on the exchange rate should be made.

We live in a world where every country (mere territorial extensions whose outer limits are politically delineated) has its own little piece of colored paper serving as a means of exchange. All these little pieces of paper fluctuate against each other in international financial markets, and through the supply and demand mechanism the price of one is determined relatively to the other. This price is the exchange rate.

(Just an addendum: liberal economists, especially those associated with the Chicago School, say that a floating exchange rate is a synonym of a free market. How can that be? Even if there was absolutely no government intervention in the currency market, the mere existence of floating rates between different geographical areas already indicates interventionism. After all, a genuine free market monetary system -- the gold standard -- wouldn't have these fluctuations based on national borders).

Once you determine the exchange rate, the concept of strong and weak currency becomes very important. For example, a year ago, on October 15, 2008, one dollar cost R$ 2.15. Yesterday, October 14, 2009, one dollar cost R$1.70 (check the daily rate here). During this period, the real appreciated against the dollar, which means the real has strengthened against the dollar -- or, similarly, the dollar weakened against the real. But still, it is said that the dollar is stronger than the real, because with one dollar you purchase R$1.70, while with one real you buy $0.59.

Important: the concept of strong and weak refers to the exchange rate of one currency against another, and not the domestic purchasing power of currency.

When considering international trade, strong and weak currencies can be good or bad. For example, on the one hand, a strong currency is good for consumers in their country of origin, because it makes imports and foreign travel cheaper. Strength means it is able to buy more units of the currency of another country. For example, a product that costs $ 100.00 cost R$ 215.00 last October and now costs R$ 170.00. The real has strengthened against the dollar.

On the other hand, a strong currency is bad for companies that export, because it makes their products more expensive abroad. For example, a product that costs R$ 100.00 cost $ 46.00 last October and today it costs $ 59.00. Thus, if the exporter wants to keep the same price of $ 46.00, he will receive only R$ 78.20 at the current exchange rate. In both cases -- fewer sales or lower prices -- exporters will have fewer revenues.

The reasoning is exactly the opposite for a weak currency.

Consequently, a weak currency does not necessarily mean a moribund currency. It may be weak in relation to another one, while maintaining a high and stable purchasing power within its own country - the Chilean case is a good example.

Having explained the very basics, let me give an Austrian interpretation of the exchange rate.

What does really determine the exchange rate?

Ask an economist the question above and chances are he'll respond by saying it is the balance of transactions in the country that determines the exchange rate.

Let me explain: efficient economies export what they produce and import that which they don't. Under ideal conditions, the total balance of transactions in all countries (exports minus imports) should be zero. However, at any given time, one country will present a trade deficit or surplus, depending on the relationship between imports and exports (if the imports are greater than exports, there will be a trade deficit; if exports are greater than imports, a surplus). This, along with other factors -- such as political and economic stability of the country, the interest paid on public debt and foreign investment made in the country -- contribute to the relationship of supply and demand between the currencies.

This is the conventional explanation for the determination of the exchange rate: the result of the balance of payments (trade balance and services plus the inflow or outflow of capital).

Nevertheless, this explanation only addresses one side of the equation. For the determination mechanism of the exchange rate to be properly understood, we must also look at the other side of the equation: the supply and demand of currencies.

The changes in the money supply of a particular currency influence its exchange rate. For example, by comparing over time between the rate of growth of the money supply in a country and the rate of growth of economic activity in that country (and knowing that the higher the growth of economic activity, the greater the demand for money), we have what the Austrians call "growth rate of excess money supply." To put it more popularly, if within one year the money supply grew in Brazil, say, 15%, and economic activity grew by 5%, then the growth rate of excess money was 10%. This rate is an important indicator in predicting the probable direction of the exchange rate of that currency.

Comparing the growth rate of excess money from one country to another, we have a forecast of the trend of the exchange rate. The currency of the country whose excess money supply is growing faster will weaken over time. Conversely, the currency of the country whose excess money supply is growing at a slower rate will appreciate against the currency of the other country. This is exactly what is happening with the real against the dollar.  Over the past 12 months, the money supply (M1) in the U.S. grew at an average of 15%, while economic activity was in -2%. In Brazil, during the same period, M1 grew by 7%, while economic activity grew by 1.3%. The excess money supply in the U.S. grew at a much higher rate than in Brazil.

Therefore, according to the Austrian school, the exchange rate of a currency, as the price of any other good, is determined by their relative scarcity in relation to its demand -- which, in turn, is influenced by the level of economy activity.

As with any other good, it is supply and demand that determines the price -- or the exchange rate -- of a currency.

Therefore -- and here's the secret -- the exchange rate between two currencies will tend to be equal to the ratio between the purchasing power of each one. In other words, it is the relative purchasing power of each currency that will determine the rate of exchange between them.

The purchasing power of the dollar is still greater than that of the real, the dollar remains stronger than the real. But as it seems that the "growth rate of excess money supply" will remain higher for the dollar than to the real, the trend is that the real will continue to appreciate against the dollar.

Where is the limit?

The impossibility of the foreign exchange policy

If the Austrian theory is correct, the dollar will, inevitably, continue to weaken (to the dismay of exporters). Of course, there may be occasional moments when the dollar rises again, but the overall trend is of a falling American currency.

Only three things can reverse this tendency: (1) a tough sheriff taking office as the new chairman of the Fed and raising interest rates to double digits -- something unlikely, (2) the U.S. economy recovering sharply -- something impossible, or (3) the Central Bank of Brazil going crazy and starting to print money insanely -- even though this is the most plausible of the three, it is also highly unlikely.

Therefore, the scenario is indeed of a further devaluation of the U.S. dollar and appreciation of the real. And as the Fed shows no signs it will stop printing money any time soon (see the frightening chart of the monetary base), exporters should get accustomed to this reality.

Obviously, there are always those who sustain that the Central Bank should intervene in the exchange rate to artificially raise the dollar (always for the benefit of exporters). Theoretically, the Brazilian Central Bank could do one of the two options below.

In the first scenario, it would print reals and buy dollars with these reals. This withdrawal of dollars from the market (lower supply) would theoretically push its price up and the exporters would smile again. The problem is that this very device has been adopted for years (as shown here), and the dollar continued to fall -- which was not a surprise for Austrian theory adherents; after all, as we saw, what determines the exchange rate is not solely the supply of dollars.

In the second scenario, the Brazilian Central Bank would sell bonds in exchange for reals and use these to buy dollars, causing the same process above. The only difference from this method to the former is non-inflationary nature, although it increases the public debt. And, once again, neither one succeeds in its intention to appreciate the dollar.

Alexandre Schwartsman suggested an interesting third possibility: let the government raise its primary surplus. The reasoning is that a larger primary surplus would allow a greater reduction of domestic debt, leading to a fall in interest rates, which would, in turn, discourage the inflow of dollars.

The problem is that this idea -- based on the Mundell-Fleming model -- does not hold. From January to August, the SELIC rate has fallen by five hundred basis points -- and the dollar fell more than 28%. Recent data show the dollar influx is directed to the stock market and to investments and not to the purchase of government bonds -- which means that the interest rate differential is not having a decisive role.

Therefore, the current exchange rate isn't abnormal or configures "artificial appreciation". The dollar is in fact doomed. Our media commentators should simply be more humble and read and listen to Peter Schiff and Jim Rogers more attentively.

Finally, it is worth repeating, deliberately influencing the exchange rate means favoring one group (only the exporters) to the detriment of the rest of the population. It is impossible that such an action is beneficial to all. This is indeed the logic of any intervention: promoting a small group -- one that is electorally profitable -- at the expense of all others.

For instance, even though the dollar could be artificially appreciated, it would be bad for the import of capital goods, which are essential for economic growth, for they represent investment. The whole country would lose.

The issue of deindustrialization

A controversial issue: is it necessary for a country to have several industries, which produce various items, for it to have a sustainable development?

Certainly, it needs to sell things abroad in order to be able to import. No country is self-sufficient in everything. It will always depend on some imports to survive. To import, it must produce something and export it.

The only exception would be in the case of a country that had an infinite reserve of an international currency of exchange. For example, imagine a country having an abundant stock of gold. It could use gold to import all the goods it needed. In this odd case, it would be unnecessary to have any industrial base. It could acquire everything from abroad. That is, until the day its gold stock ended...

A very similar situation is happening to America. Since the Bretton Woods agreement in 1944, the country was awarded the privilege of issuing the international currency of exchange. The U.S. central bank printed dollars and sent them abroad, and in turn these countries shipped to the U.S. products of all kinds. This apparently worked. Dollars sent abroad returned in the form of investment in U.S. government bonds, and the cycle would restart -- something that looked like perpetual motion. But, unobserved, the American industrial base was disappearing. After all, it didn't make sense to produce things in the country if it could buy them from abroad more easily.

This erosion of the American industrial base, historically robust and known for its good wages, also had other causes: aggressive unions demanding increasing privileges, increase in government regulations, increasing tax burden, aging plants and equipment, the culture of "bigger is better" -- which generated waste and did not encourage conservation and discipline -- and a disregard for the quality and design of its products -- where the Japanese had a feast.

Now that the dollar is increasingly discredited, the tendency is that foreigners, especially from China, cease to invest in U.S. government bonds -- after all, nobody wants to have revenues in a currency that is worth less each day. When this disbelief in dollar takes hold, the U.S. will have enormous difficulties in importing goods, since the country has lost its industrial base. In fact, they will have problems even to stock their shelves (that's the prediction of Gerald Celente).  And while the service sector is apparently robust, it is impossible to earn enough foreign currency only by exporting movies and information technology.

All this digression is simply to say that, yes, the industrialization of a country is important. Brazil, for example, is not known for exporting information technology to other countries. Industrial products account for 59% of our exports, and the rest consists of bananas, oranges, soybeans and meat. Therefore, the industrial sector is indeed a vital sector to the economy. The more goods we produce, the richer we will be.

(Some say that in an entirely service-oriented economy, services may be acceptable substitutes for goods, since both generate money. In this case, the basic distinction between money and wealth is ignored. Money is the means of exchange. Wealth is what is received in exchange.)

Thus, although the economic schools agree on the importance of the industrial sector, they quarrel over how to reinforce it.

There are those who believe that adopting protective tariffs is necessary to protect and improve the efficiency of industries. Paradoxical as it is, they believe the best way to bring efficiency to an industry is protecting them from competition.  Leaving aside the immorality involved in stealing from some to give to others, as well as in believing to have the right to prevent people's freedom to choose, the following questions remain unanswered: How big a tariff? Why this amount? Why not a larger or smaller amount? How long should such a tariff last? Why not for a longer or shorter period of time? Which sector should be protected? Why one sector rather than another and, finally, why is shielding from competition the secret to efficiency?

There are those who support direct subsidies through Brazil's National Bank for Economic and Social Development (BNDES). The above questions still apply. After all, how can someone think that pouring subsidies into companies will make them become more productive?

The only measure that stimulates productivity and inventiveness is called competition. Any policy that protects a particular industry from competition will only perpetuate its inefficiency.

What to do then?

Since the dollar's fall is here to stay, industries should shape up. Let them seize the opportunity and import machinery and inputs more cheaply, allowing for an increase in their productivity.

In turn, the government can do a lot. It can reduce the enormous tax burden borne by the industry and deregulate, creating strong competition at home and attracting foreign companies. Leaving all the current regulation and tax apparatus unchanged and (trying to) manipulate the exchange rate is a guarantee of failure and more inefficiency. If the government signals it will influence the exchange rate, it is sending misleading signals to the industry: "Don't do anything yet, I'll fix the situation!" It is impossible to imagine that, in this scenario, industries would be encouraged to increase their efficiency.

Privatization of ports and airports would expedite the process of shipping goods and reduce operating costs, such as storage costs.

Finally, given that the dollar is doomed, and considering that the dollar is the problem, Brazil should trade in other currencies.  In May 2009, Peter Schiff praised Brazil and China for their announced intention to abandon the dollar and trade between one another in Real and Yuan. The greater the monetary freedom to trade, the better (see the video, this part begins around 8:30).

Having a naturally strong currency is a good thing for everyone. Trying to prevent this process will benefit only the usual suspects.

Sobre o autor

Leandro Roque

Leandro Roque é editor e tradutor do site do Instituto Ludwig von Mises Brasil.

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