Friday, April 9, 2010

Fallacies of Simple Conclusions - I

Every day, in almost every aspect of life, we come across "laws" based on simple conclusions. These are more prevalent in economics than any field because of the very nature of the science. These simple conclusions which become codified into "laws" can prove to be extremely harmful, especially when fed as pre-digested wisdom to powerful people who fail to grasp the multi-faceted nature of economic decisions.

Many of these "laws" have been haunting India through policy makers who believe them to be true. Many times, there's no disputing their truth. What is harmful, is the fact that there is more than one effect of any economic decision, and the rest of the impact is completely ignored in favour of that one "dominant" truth. Let's take a look at one of these today...

Fallacy 1) A strong rupee hurts exporters, and is therefore bad for the economy: This is actually two simple conclusions bundled into one. The first is "a strong rupee hurts exports". The second is "what is bad for exports is bad for the economy".

Looking at the first, well yes, a strong rupee can hurt exports. But only if that's the only advantage offered by our products. The Price. Its been close to 40 years now that India's followed a weak currency policy, engaging in competitive devaluation with most countries in Asia and some on the other side of the world. If after all this time, all we can compete on is price, then our export industry hasn't really done enough to deserve any of the advantages that it gets. Like Tax exemptions and a weak currency. Having said that, however, let's look at the "law" without judging it's beneficiaries. A strong currency can hurt exports, that part can be held as true. But other effects of a strong currency include cheaper imports, increased domestic purchasing power, low inflation and enhanced faith in the currency. A strong currency reduces the price of all imported products and also those where the price is dependent on international prices. So fuel prices, metal prices, imported fruits and through some adjustment mechanisms, foodgrains all become cheaper when the rupee strengthens. This increased domestic purchasing power benefits the domestic portion of India's economy, which is incidentally, more than 4 times the export oriented part. But no one says this when thay say "a strong currency hurts exports".

The second "law" is "what is bad for exports is bad for the economy". Once again, a statement that taken by itself sounds intuitively true. But fails to address a basic question. What are exports good for? Why does the country need to export? There are questions that I have answered in detail in my earlier notes, The Purpose of Exports. To summarize, a country needs to export just to earn the foreign exchange needed to pay for imports. Of course, a country can gain access to other markets through exports, markets which are larger and have have more purchasing power. But the primary aim of any economic policy should be to increase domestic purchasing power, not sacrifice it to gain access to external purchasing power. Exports are a means to an end, not an end in themselves. When The "law" tries to tie export growth to economic growth, it does not warn against export oriented strategies that damage domestic growth. Or the ability to import.

Looking at the "law" now, we can see how false it's premise is. A strong currency hurts exports, but benefits the doemstic economy. It makes exports more expensive for foreigners but makes imports cheaper for our citizens. It can reduce inflation, increase domestic purchasing power and support growth in the domestic economy, which is many times the size of our exports.

But no one will ever tell you that.

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