Posted by: michaeldavidpower | November 19, 2009

Devaluation – No silver arrow!

I focus heavily on devaluation as a cure for South Africa’s economic ills because I know – in the quiver of arrows that will be necessary for Treasury to use so as to hit its growth and employment targets – it is always the one arrow that the Already Haves are most unwilling to see used. Yet in my opinion, it is by far the most important arrow we have; indeed, were we to fight the war on poverty in South Africa without it, I am convinced we would lose.

That said, it is by no means the only arrow we must carry in our macroeconomic quiver – indeed were it the only one, I suspect we would also lose the war.

This piece highlights the next two most important arrows we must use: one which limits the exercise of monopolistic behaviour by capital and the other which does the same for labour.

Remember, the object of any devaluation is to realign the relative price structures prevailing in a country so as to suppress certain undesirable features – such as domestic demand for imported goods – whilst stimulating other more favourable responses – foreign demand for domestic goods, for instance. And when a country is devaluing rather than revaluing its currency, this means within that country prices will tend to rise in its aftermath, with some much more than others.  As horrifying as it may seem, the object of devaluation is precisely to generate inflation. The ‘aha’ aspect of this provocative claim however is that one tries to generate more inflation in ‘bad’ products than in ‘good’ ones – imported Italian shoes become more expensive so persuading domestic consumers to switch to Made-In-South-Africa takkies.  Some ‘good’ products will also unavoidably increase in price – oil perhaps – but this is a price we have to pay for all the other more beneficial consequences of devaluation.

The flip-side to this story which we do not immediately see but which should be to our advantage over the medium term is the deflation of South African goods and services prices to foreigners and, yes, the fall in South African wages as measured in US Dollars to levels that are more competitive globally. Some goods – gold for example – have their prices set internationally and whose dollar price will not fall . Others – South African wine, forestry products  and tourism for example – will likely fall in price to the foreign buyer. This should lead to increased demand and so to a positive supply side response domestically.

Devaluations succeed if and when, over time, their gains exceed their losses. They do not succeed – and here critics of a devaluation strategy in South Africa’s case are 100% right to be wary – when the short to medium term advantages are  frittered away over the long-term.

This again leads me those other two arrows we must carry. If, in the aftermath of a devaluation, a supplier to the domestic market operating out of a heavily concentrated industry then uses their pricing power to force through price rises that essentially cancel out the gains and only result in higher profits to that supplier, a problem arises. The solution – and some quarters of South African business will not like this – is aggressive use of windfall taxes or strong intervention by the anti-trust authorities or both.

But just as Government should penalize any monopolistic behaviour by capital after a devaluation, so too – and here’s the rub – should they do so were labour to behave likewise, being equally aggressive towards both unionized and ununionized labour in South Africa.

These two arrows must be used without fear or favour on all those parties in South Africa that would try and undo the benefits flowing from devaluation. Invariably, there will be some slippage – we would want to see export-oriented sectors prosper in the aftermath of a devaluation, for instance, so stimulating new investment and job creation – but all in all the success of a devaluation is ultimately measured by minimizing that slippage.

If however all the advantages accruing from a devaluation were to be given back in its aftermath, then I have enormous sympathy with those cynical carpers who chant from the side-lines “Don’t do it at all”.  Rather wait until a crisis finally breaks the currency – as it surely will – and then rebuild from the other side, having learned from our national mistakes. That is, after all, the essence of what happened in East Asia beginning with the crisis in Thailand in July 1997. Asia learned that overvalued exchange rates, accompanying current account deficits and overdependency on foreign capital flows will eventually end in tears.

South Africa should learn from Asia’s fall and subsequent rise. Unless we can find the courage to fire the arrow of devaluation – and to do so with a full quiver of ready-to-use secondary arrows – that arrow will end up firing us.

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