In The Long Run, We Are All Dead

OUTSIDE THE BOX

By Alex Otti, alex.otti@thisdaylive.com

Economics has been described as a dismal science by those who don’t understand that the exactitude of the natural sciences does not apply in most cases in this social science subject. The reason is the behavioural dimension to the science of economics. President Harry S Truman had exclaimed a long time ago “please give me a one handed economist, all my economists say on the one hand…..and on the other”. I guess Truman must have been frustrated with the response of economists which tended to give alternative outcomes with alternative causes of action. Thus, you hear that “on the one hand, if you choose a particular course of action, you would get one set of results, while on the hand, if you choose a different course of action, you would get a different set of results. The reason is simply because we are dealing with human behaviour. The way one man behaves would be different from the way another man would behave. In the same vein, the way a man behaves in the morning may be different from how he would behave at noon which may also be different from how he would behave at night. This is correct even if you hold every condition constant.

Discussing macroeconomics becomes very interesting because this is an area that affects every nation. As a matter of fact, it is a major issue in most countries and determines whether leaders win or lose elections. As we approach November, those who have been following the US Presidential election campaigns will agree that the major debate between Hillary Clinton and Donald Trump have centered on the economy. All economies need some form of price and exchange rate stability, they want growth in output levels, they don’t want to see that the degree of change in price level is high, they want decrease in unemployment level, they want to see that production capacity is heading north, they want to see that the country is exporting more and importing less for balance of payment purposes. They also want to see that they don’t export anything to which they can add value locally, which means exporting jobs. They don’t want to import what they have capacity to produce locally, subject to efficiency considerations. They would only borrow if it is absolutely necessary. All these and more put together would underscore what some people will refer to as economic policies of a government. The economic policies of a party, define the ideology of that party and that makes the difference between one party and another, save for Nigeria where the jury is still out as to the extent to which economic policies define political party ideology.

One interesting fact about economics is that most of the variables are interconnected. To achieve one result, you may need to tweak or adjust one or two variables. That is the fundamental principle of the subject matter. If you want prices to come down, you must increase supply subject to demand not increasing. If you want prices to go up, then supply must go down in so far as demand remains constant. You may also achieve the same purposes if you tweak demand and hold supply constant. If wages are high, you need to increase labour supply to force down wages and vice versa. The problem with some of the theories is that in reality they may not work because of a lot of intervening variables. The most important is time. Given a long period of time, everything is possible. That is why we speak about the short run and the long run. Most of the theories should work in the long run and not in the short run. But like John Maynard Keynes said, “in the long run, we are all dead”.

It is important to understand what works and what doesn’t in an economy like ours more so, in an era of economic downturn. Exchange rate is the biggest issue for us for obvious reasons. We are an import-dependent country and given that oil prices had taken a nosedive, our foreign exchange earnings have also significantly dropped. Unless we are able to reduce our imports in the same proportion, we are bound to have difficulties meeting foreign exchange demand. Reduction of imports is a very viable option, given that import substitution is a policy that had worked elsewhere, but the question is, under what time frame? It is impossible in the short run, but in the long run, we are all dead. The first thing to do with exchange rate is to let the theory of demand and supply handle it. If we do not let the market determine the rate, what we will be creating will be a black market funded by round tripping. This was the situation until recently when an attempt was made to liberalise the foreign exchange market.

Unfortunately, because we did not completely deregulate the market, a wide gap between the official rate and the market rate has appeared again. The gap is over N100 per dollar at the moment and arbitrage has become attractive once again. We had argued in the past that deregulation where the CBN participates in the market at a rate determined by the market is the only way to go. The policy of intervening at rates determined by CBN may appear popular initially but is fraught with danger. Once there is an incentive to take advantage of a system, people will take the risk and reap the returns if they succeed. The truth is that CBN does not have enough dollars to go round those who want to buy and therefore is not in a position to fix price. We may choose to postpone the doomsday, but it comes with a price.

Closely related to exchange rate is interest rate. Interest rate works in such a way that when it is high, people will theoretically want to save and when it is low, people would rather spend. Businesses on the other hand will borrow when interest rates are low, subject to availability of demand for their goods and services. They will not borrow in a high interest rate regime.

So, what should we be doing with interest rate in an era of recession? The answer to that question is dependent on what we are targeting. If we determine that we want to manage exchange rates with interest rates, when interest rates go up and people save more, businesses would be discouraged from borrowing and therefore reduce the attack on the dollar, particularly those attacks that are speculative. But keep in mind that this kind of result can only be achieved in the long run. The other condition is that it depends on what the prognosis is for exchange rates going forward. If in the minds of speculators, the degree of depreciation of the currency will more than compensate for the high interest rates, they will continue to borrow to stockpile dollar no matter where you take interest rates to.

We may also determine to target inflation, which means increase in general price level in the economy. Recall that inflation has been on the increase in the recent months. According to figures released by the National Bureau of Statistics (NBS), inflation increased from 16.5% in June to 17.1% in July and to 17.6% in August 2016. Acceptable inflation figures under normal circumstances are between 2 and 3% per annum. To tame inflation therefore, we need to manipulate interest rates to cut down expenditure and increase savings. This is true if the inflationary situation is a standalone occurrence. Theoretically, when inflation is controlled, the economy will rebound. But on the other hand, when you tame inflation you may end up with unemployment because as savings increase with higher interest rates, businesses will reduce borrowing and reduce output given that demand would go down and businesses will cut down output and lay off workers. Layoffs will reduce the disposable income available to the hitherto employed workers who have now lost their jobs. The net effect is that aggregate demand would go down which will lead to further reduction in capacity and further shutdowns. We are, therefore, dealing with a very delicate balance.

There is another situation where inflation occurs simultaneously with increase in unemployment level, reduction in output, and stagnant or negative economic growth. Seems familiar, right? Economists refer to this situation as Stagflation. Prior to the 1970s the term Stagflation did not exist because economists never believed that it was possible for inflation and stagnation to occur together. Inflation was understood to be a fallout of economic growth. From the foregoing, it is clear that what we face in Nigeria today is Stagflation. When you find yourself in this kind of hole, you just have to stop digging. How do you do that? One, you must realise that your lifestyle has to change. Leadership doesn’t seem to get it. It still behaves as if oil is still selling for $100 per barrel. The National Assembly still enjoys huge allowances, the number of aircrafts in the Presidential fleet has not reduced. Governors are still drawing the same amount and in some cases, more in security votes even when their states are technically insolvent.

In terms of solutions, there are two that readily come to mind: the austerity measure and the fiscal stimulus packages and both of them work. But they work differently. Austerity measure is normally very painful and can take a lot of time for recovery to happen. By the way, it is instructive to state that stagflation does not just go away overnight. While we may choose to exercise our “bragging rights” by making optimistic comments about our imminent recovery, this kind of downturn takes between 3 to 4 years to contain, if proper discipline and the right policies are implemented. It can last much longer if the right things are not done.

Our recommended approach to recovery will be the implementation of a stimulus package. What we expect is that the government will pump money into job-creating sections of the economy. By so doing, the government will also be rolling out the much desired infrastructure for the country. Monies should be spent to build roads, bridges, rails, airports, seaports, power, water, parks, and modern educational and health facilities. These would create jobs and push up demand in the economy. I had extensively dealt with this in my column of May 23, 2016 which I would recommend to interested readers. While pumping money into critical sectors of the economy, we must simultaneously cut down non job-creating expenditures. Cost of governance must go down. Allowances and perks must be cut to the barest minimum and financial discipline must be implemented across board.

The next thing that we should be doing is not to increase interest rates. MPC in its July meeting increased monetary policy rate from 12% to 14% and maintained that in the September meeting. That policy pushed treasury bills rates to about 19% p.a. If risk free rate is 19% p.a., it means borrowing rates will be no less than 25%. That is too high for most businesses and from the earlier argument, they would be forced to scale down and lay off workers. When this happens, demand will go further down and force more closures. This is like digging when one is already in a hole. Another danger of maintaining very high risk free rate is that it is a disincentive for lending. Look at it this way, if a bank can earn almost 20% p.a. by investing in government securities which carries zero risk, why would the bank lend to business at 25% with so many risks, including the risk of 100% loss of the money? If we were targeting inflation only or exchange rate only, increase in rates would have worked. But we have a bigger elephant in the room to deal with.

Our approach should rather be to reduce rates, discourage banks from keeping their money in high yielding government instruments and get them to lend to businesses at reasonable rates and stimulate production which would increase employment and also stimulate aggregate demand. What we are doing will not scratch inflation, will not create jobs, will also not reduce demand for dollar as speculators still see huge incentives to demand more dollars and certainly will not help us get out of the economic crisis. We need not reinvent the wheel. It was Ronald Reagan who summarised what he has learnt about the economy thus “Government’s view of the economy could be summed up in a few short phrases: if it moves, tax it, if it continues moving, regulate it and if it stops moving, subsidise it”. It couldn’t have been said more succinctly.