From the exchange rate to economic growth - Part II

David Wong, Contributor

The most important race for Jamaica today is not any of those being run by its great athletes, but that between its income and its planned expenditures. For some time now, total planned expenditures have been winning the race, and this is the root cause of much woe in Jamaica, including that over the secular decline in its exchange rate since the 1970s.

As I've said before, the fundamental cause of the unstable Jamaica dollar-US dollar exchange rate is the persistent and growing gap between planned Jamaican expenditures and Jamaican income in US dollars. Therefore, the only sustainable way to stabilise Jamaica's exchange rate is for Jamaica's national income to grow faster than its planned expenditures, not to adopt a hard peg for the Jamaica dollar to the US dollar, as some influential people in Jamaica have suggested.

In order for Jamaica's national income to grow faster than its planned expenditures, the Government should adopt appropriate strategies, such as those presented in Part I of this series (Gleaner, December 5), to integrate Jamaica's economy more fully into the global economy as a competitive entity, and reduce the rate of growth of government expenditures and raise taxes in such a way so as not put impediments in the way of income growth.

A natural starting point for validating the above proposition is to conduct a close examination of the fundamental relationship between the following three balances: the international trade balance, the private domestic saving (Saving) and private domestic investment (Investment) balance, and the government's budget balance (Budget Balance). Part II of the series will analyse the relationship between these three balances from the standpoints of accounting and economics.

A fundamental macroeconomic accounting identity is the following:

Net Exports are always equal to Saving minus Investment plus government tax revenues minus government spending.

Government-tax revenues minus government spending is the Budget Balance. When the Budget Balance is negative, government is spending more than it is collecting in taxes and, therefore, its budget is in deficit. This is currently the case, and has been the situation in Jamaica for some time now. When the Budget Balance is positive, government is spending less than it is collecting in taxes and its budget is in surplus. This is a rare event in Jamaica.

Saving-Investment Balance

Saving minus Investment is called the Saving-Investment Balance. When Saving exceeds Investment (additions to plant and equipment, and other long-lived durable capital goods such as houses and other structures), the Saving-Investment Balance is positive and Saving is more than sufficient for financing planned Investments. When the Saving-Investment Balance is negative, Saving is less than the planned Investment and Saving is insufficient for financing planned Investment.

An obvious implication of the above relationship is that the Budget Balance is a component of Jamaica's Net Exports, which is roughly equivalent to what is called its international trade balance or its current account balance. The bigger the budget deficit, other things being equal, the bigger will be the trade deficit and the greater will be the pressure on the Jamaica dollar to depreciate. However, if the Saving-Investment Balance is simultaneously positive, this will soften the impact of the budget deficit on the trade deficit. Such appears to be the case in Jamaica at present because Jamaican private 'investors' (savers or those who manage people's savings) appear to be significant buyers of foreign-denominated government debt. However, notice that if the government's budget were to be balanced, there could still be a trade deficit if Saving falls short of planned Investment.

While the above identity is useful for summarising the necessary relationship between concepts such as the trade deficit, the government-budget deficit, and the balance between Saving and Investment, it can be quite misleading if the underlying economics are ignored.

The preceding discussion of the relationship between the three balances presents only an accounting view and does not say anything about the economic decisions that underlie the accounting identity, which records only the necessary outcome.

Shifting from accounting to economics, we must recognise that: (1) Saving depends positively upon national income, i.e., an increase in national income increases Saving and (2) Government-tax revenues depend positively upon national income. From the accounting relationship, an implication of these two economic facts is that raising national income is the only sustainable way of reducing the trade deficit and stabilising the value of the Jamaican dollar for when national income increases, both Saving and government-tax Revenues rise, and Net Exports necessarily fall unless either Investment or government spending rises in an offsetting way. In general, however, neither Investment nor government spending is directly related to the current level of national income. Investment depends on the expected profitability of investment projects and government spending depends on social and political considerations. In summary, if the trade deficit is to be brought under control and the pressure on the Jamaican dollar to lose value, relative to the US dollar, is to be relieved, planned expenditures cannot be allowed to win the growth race with national income.

The discussion, so far, clearly indicates policies such as reducing the budget deficit and promoting a positive Saving-Investment Balance through income growth for stabilising the exchange rate. Policy details depend on the process of income growth and the scope for increasing taxes and reducing expenditures.

To this point, the exchange rate has played no role in the discussion of the macroeconomic relationship. I've made reference only to how a widening trade deficit may pressure the Jamaica dollar to depreciate. So where does the exchange rate enter? The preceding discussion was all about the so-called real (non-monetary) side of the economy. The rest of the formal economy consists of the money (loan) market, the stock and bond markets, and the foreign-exchange market which constitute the financial side of the overall economy. Interest rates, bond and share prices, and the exchange rate are determined on the financial side of the economy. There is, naturally, a mutual-feedback relationship between the real and financial sides of the economy since the economy is a single entity.

Real investment decisions

Interest rates and bond and share prices, along with the state of business expectations or the animal spirits of the entrepreneurs and the capitalists, to use Keynes' term, ultimately feed into the real investment decisions that determine total Investment. But the fundamental driver of capitalist investment decisions is the expected profitability of investment projects. The rate of growth of Investment, the speed of real capital accumulation, in turn, is the main driver of national income growth. Interest rates and bond prices affect the cost of undertaking investment projects, but if there is no expectation of sufficient returns to deliver a sufficiently high profit, then capitalists will not invest, even if it is very cheap to do so.

Who would borrow today, even at zero interest rate, to produce for tomorrow if there is a firm expectation that the Second Coming of the Christ is tomorrow and it will be Judgment Day for one and all? Clearly, no one with an ounce of sense would do so, and capitalists are usually not stupid when it comes to calculating profits. As Milton Friedman and George Stigler, two founding fathers of the conservative Chicago school of economics, would say, if there were such capitalists, you wouldn't come across them because they would have been eliminated by capitalist competition a long time ago.

Net Exports is Exports minus Imports. Net Exports are negatively affected by the rate of growth of national income because imports depend positively on national income. Exports depend positively on foreign income, not on Jamaica's own national income. In fact, the strong dependence of Exports on global (foreign) income is one of the main channels through which a recession in the global economy, such as the present great recession, is transmitted to Jamaica's economy. This discussion of the factors that determine Net Exports implies that Net Exports are negatively affected by a recession-induced fall in global income. The global recession-induced fall in Jamaica's Net Exports reduces Jamaica's national income because Net Exports are one of the four components of national income. The other three components of national income are: consumption, investment, and government spending.

Both exports and imports and, therefore, Net Exports, depend on the exchange rate, which is usually expressed as the Jamaican dollar price of a US dollar, through the competitiveness index of Jamaican industries. The competitiveness index is measured as the relative price of commodities produced by Jamaica-based industries to the Jamaican-equivalent price of similar commodities, produced by foreign-based industries. The exchange rate is the conversion factor for foreign prices to Jamaican-equivalent prices.

In Part III of the series, I'll discuss the important relationship between the exchange rate, labour productivity and competitiveness, and between labour productivity, economic growth, and improvement in Jamaica's living standards.

David Wong (dwong@fullerton.edu) is a professor of economics at California State University, Fullerton and a participant in the Caribbean Dialogues forum moderated by Trevor Campbell.