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Straight talk on the exchange rate debate

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Straight talk on the exchange rate debate

10th December 2010

By: Seeraj Mohamed

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We have had much discussion about the exchange rate over the past few years. This discussion has had trade unions and certain manufacturers on one side and representatives of financial institutions on the other side.

 

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There have been conflicting messages from within government but it seems that those most responsible for economic policies that could affect the exchange rate do not want those policies. Instead, they continue to point to the ineffective and expensive route of using foreign exchange reserves to influence the exchange rate. They also warn us that one cannot maintain an undervalued exchange rate for long. One of the main problems with this debate – in addition to the opportunism of those who benefit from a volatile and overvalued exchange rate – is that the economic and financial perspectives of those engaging in the debate are so different. Therefore, it is worth providing a quick discussion on the different views.

 

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There are those who think that the value of a currency is an outcome of an equilibrium process and that the currency represents the economic fundamentals in a country. I suggest that you think about what the term ‘fiat’ currency means and think about how currencies are valued today. This would have you explore how global currency markets work and also think about different financial instruments used for trading currencies. Even a fairly quick investigation would have you realise why there is so much new thinking in behavioural economics, particularly regarding the psychology of economic agents such as currency traders.

 

If you want to argue that a country cannot overvalue its currency for long because arbitrage in financial markets will cause the currency to revert to its ‘true value’, then you are seriously misguided. Trying to pin down an actual value for a currency is like searching for a pot of gold at the end of the rainbow. It does not exist. The daily spot prices we see quoted in the media are the result of the psychology of currency traders, thousands of over-the-counter (and probably shadow banking) derivatives deals (some of which would have been made months ago). Of course, the manipulations by many different central banks and many other factors add to the confusion.

 

Much of what we hear from commentators are subjective views. For example, traders may realise that the US is acting to weaken its currency, but that does not mean that they actually know what the value of the dollar should be. Most of them are trying to make money on marginal changes in currencies. There- fore, arbitrage does not bring us to the ‘true’ value of a currency – it is just another factor that influences exchange rates. Therefore, to believe that arbitrage makes the manipulation of currencies difficult or impossible is naive. It is based on an idea that you have the ability to pin down what a currency is actually worth and then to further assume that you can predict the future.

 

To most financial market commentators and many government economics officials, I suggest that it may be worth your while to look at other perspectives on economics and financial markets. Look at perspectives not based on an ideological agenda supporting free markets or trying to argue that any State regulation is tantamount to central planning. Instead, try to understand how different capitalist economies work. Try to understand how global markets work. They can work with more or less planning and can work with more or less global coordination. However, they cannot work without a major role for the State. As we have seen, the via- bility of most Western economy financial institutions and the future of global finance depend on an active role (or intervention, as some like to call it) by the State.

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