ERPZ Stop Mugging. Start Learning.

Balance of Currencies

Reading Dr Goh Keng Swee's Wealth of East Asian Nations helped me see the realities of many economic theories. While Dr Goh is a really intellectual academic, he is deeply practical and makes policy decisions based on his observations of the real world. The most interesting piece of information I picked up from the book so far is how the real world deviates from the theory that connects Balance of Payments equilibrium to the Floating exchange rate system.

We learnt in A Levels Economics and basic Macroeconomic modules that Floating exchange rate system is supposed to provide a self-correcting mechanism for the Balance of Payments (BOP) through the appreciation or depreciation of currencies in accordance to export and import figures. The typical explanation goes like this: When a country exports heavily and starts accumulating surpluses for BOP, the demand for their goods would drive up the demand for their currency and that translates to appreciation of their currency. From the perspective of the consumers, the appreciation will make the goods more expensive and thus reduce their demand for them. Eventually the exports will reduce to a level that eliminates the surplus. The opposite case is expected of a country experiencing trade deficit since depreciation of their currency would make their exports more competitive.

Unfortunately the real world doesn't work that beautifully. And it has all to do with the individual countries efforts to manage their currency. In other words the theory did not expect the individual countries to respond in the way they do in reality. In countries like Japan and Germany, the appreciation of their currencies leads their exporters to find more cost savings and achieve greater efficiencies in order to offer the same goods at the same or just slightly higher price for their consumers in countries experiencing depreciating currency. This means that the surpluses stays with them. On the other hand, the countries experiencing deficits like the US attempts to hold its currency value by attracting capital investment into their country so that they can continue to import goods at roughly the same prices even when the countries they import from are supposedly having appreciating currencies.

At the end of the day the Balance of Payment worsens with countries like Japan accumulating more surpluses and US sinking deeper into deficits. The issue is not even about a comparison of whether free float currencies works better than managed float, it is about the spirit of the entire economy and their reaction towards movements in currency values. The deep desire of Japanese companies to export is matched by the deep desire of American consumers to import and the result is obvious in the world we live.

Macroeconomics is still a long way from being mastered by us all.