There are times when economics is just the way that accountants show they have a sense of humour. Those calculations that climate change, or not climate change, will lead to 5% off the economy in 2070, or 3% on it, they're really just jokes. There are so many things that are going to affect economic growth over the next 50 years that any forecast to less than a 100% margin is a guess. Or that demonstration of having a giggle.
On the other hand there are things that economics really does get right. Not because they are calculations of what should happen, nor because people are silly enough to try to predict to within 5% over half a century. But there really are things that economics does get right simply because at one level we're just talking definitions. Definitions do end up coming true even if the path might wander a little in getting there.
Take, for example, two pieces of information from this newspaper. One is that the inflation rate was 9.49% in December in Bangladesh. The other is that the foreign exchange reserves are falling, now apparently down to $16 billion. The one other number we need here is the US inflation rate -- 3.2% on an annual basis in October.
As we've talked about here before the central bank tries to control the Tk/$ exchange rate -- tries to keep it high, that is, fewer taka to buy $1. This is what causes the shortage of foreign currency. Everyone thinks that one dollar is worth more taka than the central bank does. Therefore they don't sell them. This is why the FX reserves are shrinking. Well, we've said that before -- you can’t have a shortage of foreign currency when you've a free market, floating exchange rate.
Over the long run exchange rates change according to relative inflation. If inflation in the US is less than that in Bangladesh, then the taka will decline against the dollar. The reason this is how it works, goes all the way back to David Ricardo -- who published in 1817 which should be enough time for people to catch up.
Things that can be traded will cost the same amount in different places. If they're cheaper in one place then people will buy them there to sell in the more expensive places. Enough people do this and the price difference will go away. This is why Shell (or BP, or any large company) are priced the same in HK, NY and London. Because there are enough people willing to buy in one, sell in another, if prices diverge. The global gold price is the global gold price. The same is true of the currencies that we use to buy and sell these very things.
Switzerland has had lower inflation than the UK and US for the past 80 years, the Swiss Franc has risen in value against the pound and dollar. The US has had less than the UK this past century and a half, the dollar has risen against the pound.
Now, in the short to medium term these can indeed get out of line by the next “pip” move. In the medium term it can remain out of line. Interest rates, government action to limit price moves, restrictions on trade, these can mean that exchange values can get out of line with market ones. When they do then we find one half of the would be transaction -- those wanting to buy dollars with taka perhaps -- find themselves just unable to do so at the official price. Central banks find the FX reserves vanishing maybe.
But in the long term exchange rates will move to balance those differential inflation rates. That's just what they do. There is also no policy that will prevent this. Delay perhaps, cause problems by doing so certainly, but prevent? Nope.
At which point, why not accept reality and just have the free market exchange rate so that there aren't any of those problems -- like the vanishing foreign exchange reserves at the central bank?
Tim Worstall is a senior fellow at the Adam Smith Institute in London.
