Dear bigben1,
Much economic activity is governed by psychological considerations, but
there is a good technical reason why borrowing money does not produce
the same inflationary pressures as printing money. To understand why this
is so, let us briefly consider the nature and the causes of inflation.
Inflation is a rise in the price of goods and services within a given
nation's economy, which is equivalent to a depreciation in the value of
one unit of the national currency.
"INFLATION: Rising prices, across the board. Inflation means less
bang for your buck, as it erodes the purchasing power of a unit of
currency. Inflation usually refers to consumer prices, but it can also
be applied to other prices (wholesale goods, wages, assets, and so
on). It is usually expressed as an annual percentage rate of change on
an index number."
The Economist: Economics A-Z: Inflation
http://www.economist.com/research/Economics/searchactionterms.cfm
"What the value of money actually is (i.e. what units of the standard
will buy, in general) depends on 1) how much money there is, 2) how much
money is held out of circulation, and 3) how many exchanges circulating
money is used to cover. This is the "quantity theory of money" and can be
expressed in a famous equation by the American astronomer and economist
Simon Newcomb: MV = PT. "M" signifies the actual quantity of money; "V"
signifies the "velocity," which is the rate at which money circulates
or how long money is held out of circulation; "T" is the number of
transactions, or exchanges; and "P" is the level of prices. This equation
easily illuminates most questions about inflation or deflation, which
is how money becomes less or more valuable over time. [...] Inflation
is where the aggregate level of prices goes up and deflation where the
aggregate level of prices goes down."
friesian.com: Money, Value, and Monetary History
http://www.friesian.com/money.htm
Such a rise in prices can be caused by heated economic activity in
prosperous times, but the major influence on the value of a currency
unit is the amount of that currency in circulation.
"Inflation will occur if V and T remain constant but M goes up, i.e. the
supply of money increases without any other changes. Inflation can also
occur if V goes up (people spend money more quickly) or T declines (the
economy shrinks), as the other variables are constant. Most inflations,
however, occur because of independent increases in the money supply."
friesian.com: Money, Value, and Monetary History
http://www.friesian.com/money.htm
"This is unrealistically simple (remember, we're doing theory now!) but
suppose the government were to replace every dollar with two new dollars,
marked so we can tell the difference between old and new dollars. Then
you'd expect, I think, that prices in terms of new dollars would be
twice as high. In short, changes in the money supply executed in this way
will be associated with proportionate changes in prices, with no effect
on output or employment. [...] Extremely high rates of inflation are
generally associated with high rates of money growth, often the result
of financing large fiscal deficits by printing money."
Stern School of Business: Nouriel Roubini and David Backus: Lectures in
Macroeconomics: Money and Inflation
http://pages.stern.nyu.edu/~nroubini/NOTES/CHAP6.HTM
"Supply problems have had far more dramatic inflationary
effects. Throughout history, governments have tried to solve financial
problems by simply printing more money. This can drive the value of
money drastically downward, especially in modern markets where money
is not backed by gold. Twice as many dollars in an economy makes those
dollars worth half as much."
HowStuffWorks: How Currency Works
http://money.howstuffworks.com/currency9.htm
When a government borrows money or receives aid from another government
or from an international agency, it is not increasing the supply of
its national currency. Consider the case of an aid agency that pays the
government in its own currency: in this case, money is being transferred
from one body to another, but the total amount in circulation stays the
same. If money is imported from abroad, as it were, then the government
receives its aid or its loan in a foreign currency, which again has
no effect on the amount of its national currency in circulation. A
government's foreign reserves are then spent on imported goods and
services, or exchanged for funds in the national currency.
The effect of an international loan should not be confused with that
of a bank loan within a country, which does indeed increase the money
supply. However, the inflationary effects of loans are weak to nil because
the increase in circulation is offset by the risk of loan defaults.
"A bank receives money on deposit, holds part of it as a cash reserve,
and loans out the rest. In effect this increases the supply of money
since both the loaned cash and the credited deposit at the bank function
as money. The result could be inflationary, but the system tends to be
self-balancing because bank loans, especially commercial loans which are
used to create or expand businesses, multiply transactions. A loan is
also a kind of deposit, as a bank credits itself with the money it has
loaned. A bad loan, to an unsuccessful person or business, cannot be paid
off and so at some point must be written off as a loss by the bank. Thus
the bank's "deposit" is simply lost, and the money supply thereby
decreases by that amount. Banking therefore can stimulate the growth
of an economy through loans but usually will not produce an inflation,
as bad loans balance the transactions created by the good loans."
friesian.com: Money, Value, and Monetary History
http://www.friesian.com/money.htm
Finally, consider that money borrowed from abroad, while it does
not contribute to inflation, is not to be considered free money. The
problem of foreign debt is especially acute in the former Yugoslavia,
where the government policy of tempering inflation by refraining from
issuing money, in conjunction with the requisite loans from abroad, has
resulted in crippling national debt. It is no solution at this point to
print new money, since that will only devalue the national currency and
make it more difficult to pay back the loans.
"Nevertheless, in the course of six years, inflation has remained
low. Prices have gone up by only 2 to 3.5 per cent a year, and only in
August this year the increase of prices reached 5 per cent. What made this
possible? The fact that excessive expenditure was not settled by money
issue but by foreign loans. During five years, from 1994 until 1998,
Croatia's foreign debt increased from 2.5 to 9 billion dollars."
Aim Press: Inflation on the Threshold
http://www.aimpress.ch/dyn/trae/archive/data/199902/90218-002-trae-zag.htm
To recapitulate, inflation is a devaluation of the national currency
dependent on an increase in the amount of currency in circulation. Loans
and disbursements from abroad do not in themselves increase circulation,
because they are either paid in foreign currency or they constitute a
transfer of funds in the national currency.
If you feel that my answer is incomplete or inaccurate in any way, please
post a Clarification Request so that I have a chance to meet your needs
before you assign a rating.
Regards,
leapinglizard
Search Queries:
inflation printing money
://www.google.com/search?hl=en&lr=&c2coff=1&q=inflation+printing+money
foreign loans cause inflation
://www.google.com/search?hl=en&lr=&c2coff=1&q=foreign+loans+cause+inflation |
Request for Answer Clarification by
bigben1-ga
on
19 Oct 2004 15:59 PDT
Dear Leapinglizard-ga
Thanks for your answer and your invitation to let you know if your
answer was incomplete or inacurate in anyway.
Let's start with the following quotes from your response and my
comments on them (I started making them in capital letters but later
forgot, so please don't attach any importance to the size of the
letters).
QUOTE 1 "...in this case, money is being transferred from one body to
another, but the total amount in circulation stays the same." DON'T
UNDERSTAND THIS SENTENCE.
QUOTE 2A "If money is imported from abroad, as it were, then the
government receives its aid or its loan in a foreign currency, which
again has no effect on the amount of its national currency in
circulation. A government's foreign reserves are then spent on
imported goods and services,
YOUR REPLY MISSED THE IMPORTANCE OF THE SENTENCE BETWEEN BRACKETS IN
THIS PART OF MY QUESTION: "...why a developing country would prefer
borrowing or getting aid (assuming a project doesn't require inputs
from abroad that require hard currency)..."
QUOTE 2B "...or exchanged for funds in the national currency." I DON'T
THINK COUNTRIES BORROW FOREIGN CURRENCY OR RECEIVE AID TO THE EXTENT
THAT THEY HAVE LOCAL CURRENCY TO EXCHANGE IT FOR. WHAT WOULD BE THE
POINT? I GUESS THIS IS THE SAME ARGUMENT BEING MADE IN QUOTE 1.
I don't think your answer proves yet that such loans from abroad,
which would have to be transformed into local currency to be of any
use, are any better against inflation than increasing the money supply
through loans made available by banks (even if the deposits in those
banks came from money printed by the government). In fact the sentence
about bank loans in the following section of your response "...The
result could be inflationary, but the system tends to be
self-balancing because bank loans, especially commercial loans which
are used to create or expand businesses, multiply transactions." seems
to lend credence to the assumption in the following section of my
question "...he ensured that the printed money would turn into a
source of wealth. Isn't this more important than having 'backing' for
printed money?" Yet, leapinglizard, countries say: "I have no money"
or "I need to borrow money" or "I need to wait for someone to give me
aid" in order to undertake development. The question is what is the
ECONOMIC reason?
QUOTE 3: Somewhere you say "...the inflationary effects of loans are
weak to nil because the increase in circulation is offset by the risk
of loan defaults." Does this mean that people are careful not to loose
money borrowed because they would loose whatever guarantee they gave
for the loan? This is a psychological reason. A fear of greater loss
is placed on the borrower to act as deterrent against loosing what he
borrowed. If the government was confident that it can carry out
development--like FDR was--couldn't it just print money and forget
their problems? Is there a reason not to do it that is not
PSYCHOLOGICAL?
QUOTE 4 "Nevertheless, in the course of six years, inflation has remained
low. Prices have gone up by only 2 to 3.5 per cent a year, and only in
August this year the increase of prices reached 5 per cent. What made this
possible? The fact that excessive expenditure was not settled by money
issue but by foreign loans. THIS ONE IS INTRIGUING. THE QUESTION IS
WHY? If "EXCESSIVE EXPENDITURE" was in imported goods and services, it
wouldn't be relevant to my question.
|
Clarification of Answer by
leapinglizard-ga
on
19 Oct 2004 16:57 PDT
Let me address your questions in order, using your own numbering.
1.
The basic idea is that inflation is caused by an increase in the money
supply. What is the money supply, you ask? It is the total value of
bank notes of a country's currency in circulation.
Now consider the two ways in which foreign aid can be disbursed. The
first possibility is that the foreign aid agency transfers funds to
the government in the domestic currency of the latter. Such a transfer
does not imply an increase in the money supply. It only means that the
national currency is being circulated, as it was meant to do. This is
the case to which the passage of mine from which you are quoting makes
reference. Some amount of money is passing from one body to another,
but the total value of the money supply remains unchanged.
The other possibility is that the foreign aid agency makes a payment
in a hard currency such as American dollars, pounds sterling, or
euros. In such a case, there is patently no increase in the domestic
money supply. Even if the hard currency is exchanged for the local
currency, this does not increase the money supply. In either case, the
foreign aid does not in itself contribute to the money supply, nor,
hence, to the essential cause of inflation.
2a.
Again, consider the two ways in which foreign aid can be administered.
It is paid either in hard currency or in soft. In either case, the
money supply is unaffected. Hence, there is no additional impetus for
inflation. The argument applies regardless of whether the foreign
government desires hard currency or soft, and whether it is paid hard
or soft.
2b.
Indeed, most governments that are in a position to demand foreign aid
don't have a strong enough currency to warrant payment in domestic
funds. In any case, foreign aid agencies habitually maintain their
funds in a hard currency. In the typical case, an aid-recipient
government is given a hard-currency disbursement which it then spends
without exchange.
I only brought up the marginal questions of domestic-currency payment
and domestic-currency exchange in order to make sure I covered every
possible scenario. The outcome, however, is the same from an
inflationary viewpoint. As the example of Croatia attests, foreign aid
does not contribute to inflation, because it does not increase the
domestic money supply of the recipient nation.
The question of money-supply increases brought about by domestic bank
loans is related, but it does not bear directly on the connection
between foreign aid and inflation. I only wanted to point out with
that quotation that even an increase in the money supply needn't lead
to inflation, as long as it is balanced by some kind of withholding.
However, foreign aid does not contribute to the money supply.
The economic reason that you are looking for, then, is this. A
government that is short of cash and can't or won't raise further
money from its populace by taxation has two choices. The first is to
print money, which increases the money supply and causes inflation,
hence a devaluation of the currency. The other option is to borrow
money from a foreign entity, which, although it increases the national
debt, does not increase the money supply, and therefore does not
contribute to inflation. This is why foreign aid is preferred to
printing money.
3.
As I mention above, the question of bank loans does not bear directly
on the matter of foreign aid. The offset mentioned in the document is
indeed a psychological consideration. However, the reason why foreign
aid does not contribute to inflation is not psychological. It is
technical. The reason is that foreign aid does not increase the money
supply. If the money supply is constant, there is no significant
inflation.
4.
The reason why Croatia's foreign aid did not contribute to its
inflation is that the foreign aid did not increase the money supply.
This has nothing to do with how the Croatian government spent its
money, whether on foreign goods or on domestic goods. As it happens,
the Croation government spent much of its loan money to pay foreign
creditors, to fund infrastructure improvements, and to service its
payroll.
leapinglizard
|
Request for Answer Clarification by
bigben1-ga
on
20 Oct 2004 07:28 PDT
Thanks very much for your efforts, but I'm still not satisfied.
MAYBE MY QUESTION HAS TO DO WITH LARGE SCALE DEVELOPMENT AND YOUR
ANSWER WITH SMALL SCALE. Take a country like Democratic Republic of
Congo. The total value of their economy is 5.4 billion dollars per
year or 110 income per capita. Suppose they would like to double that.
Suppose that another 5.4 billion can come from cultivating 10 million
hectares (that is less than one tenth of the unused land with
agricultural potential in that country by the way). Suppose that they
need 1,000 dollars per hectare in local currency as start up cost = 10
billion dollars. Ignore for the sake of this example any inputs
(tractors, etc) they may need from abroad and assume it can all be
done locally. IF SOMEONE WAS WILLING TO DONATE OR LEND THEM 10 BILLION
DOLLARS, I DON'T UNDERSTAND HOW THEY COULD PUT THEM IN CIRCULATION
WITHOUT PRINTING ANY MORE MONEY (CAN THEY?)--and if they can't why
wouldn't it be better to just print it themselves?
Maybe we are talking about different scales? Maybe the economic wisdom
is that you can't have fast development without inflation? Maybe there
are some parameters of how much you can absorb as loans or gifts in
relation to what you have in circulation (if they were to be converted
to local currency) or as a percentage of the GNP? I now remember I
once heard that in Venezuela there was inflation when they poured
dollars earned from oil into domestic development. I don't know
whether that money was turned into real wealth. That is why I think
the question for a country should be "should I mind the risk of
inflation while I turn fresh money in circulation into wealth?",
rather than the statement "I can't develop because I have no money,
therefore I should borrow some or beg for some," because (if we are
indeed talking of different scales) the last statement seems to hide
the fact that they can only borrow or be gifted a little and otherwise
the risk of inflation will be there anyway.
So what I'm trying to confirm is my understanding that what they are
REALLY doing by saying I cannot print money is choosing between no
risk of inflation and no significant development. At the same time
your earlier answer seems to indicate the risk of inflation, which
does exist in circulating money through loans, is generally offset by
the increased number of transactions that it generates. Suppose I was
to say to DRC: "RATHER THAN STAYING POOR AND DEVELOP VERY GRADUALLY BY
WAITING FOR GIFTS OR LOANS, DEVELOP QUICKLY THROUGH YOUR OWN PRINTED
MONEY AND OFFSET THE RISK OF INFLATION BY THE GREATER NUMBER OF
TRANSACTIONS YOU WILL CREATE--MAKE SURE PRINTED MONEY IS TRANSFORMED
INTO WEALTH QUICKLY THROUGH THE INCENTIVE OF GIVING PEOPLE A JOB,
WHICH IS EQUIVALENT TO PEOPLE HAVING TO PROVIDE A GUARANTEE FOR A
LOAN." If this statement would be technically wrong, I would
appreciate if you can tell me why--by rephrasing and consolidating
your answer in response to this rephrased question. Thank you.
|
Clarification of Answer by
leapinglizard-ga
on
20 Oct 2004 08:19 PDT
No, my answer has to do with large-scale loans such as those tendered
to former Yugoslavian countries in the 1990's.
You say that you do not understand how the DRC, in your hypothetical
scenario, could accept a loan of 10 billion dollars without printing
money. Let me explain how this is indeed possible. By the way, the GDP
of the Democratic Republic of the Congo is $40 billion, and it is
unrealistic that a single loan disbursement would be a quarter that
size. A more typical loan package would run into the hundreds of
millions.
In any case, suppose the DRC is to receive a loan of some large number
of dollars. Now, the currency of the DRC is the Congolese franc. This
currency is subject to instability as a result of weak industry,
rampant corruption, rebel insurgencies, and the ever-threatening
prospect of civil war. Thus, the Congolese franc is a soft currency.
Developed countries do not trade in it, and a foreign aid agency would
not use it.
When the foreign aid agency makes its payment to the DRC, it does so
in a hard currency such as dollars or euros. Relative to a soft
currency such as the Congolese france, dollars and euros are like
gold. They are not actually gold, but they are very stable relative to
the Congolese franc. Fluctuations in the value of the dollar or of the
euro are nothing like fluctuations in a soft currency. Thus, the DRC
government receives its aid and spends its aid in the hard currency.
The money supply of its national currency, the Congolese franc, is not
affected. Since the money supply of the Congolese franc does not grow
as a result of the foreign aid, this aid has no effect on inflation.
Inflation is made possible by growth in the money supply. The foreign
aid does not increase the money supply. Hence, there is no inflation.
Be careful not to confuse dollars with Congolese francs. The hard
currency does not affect the money supply of the DRC. Only an increase
in the number of Congolese francs would affect the money supply of the
DRC. Dollars are not the same as Congolese francs. The circulation of
dollars does not contribute to the total value of Congolese francs in
circulation. Therefore, inflation is not possible, not by the mere
fact of disbursing foreign aid in a hard currency.
So no, we are not talking about different scales. We are both talking
about a very large scale, the scale of international loans.
International loans do not in themselves cause inflation.
A surefire method of bringing about inflation is to print money.
Printing money directly increases the total value of the national
currency in circulation, resulting in a proportional decrease in the
value of each currency unit. There is indeed a technical flaw in your
later statement. Let me quote it.
RATHER THAN STAYING POOR AND DEVELOP VERY GRADUALLY BY
WAITING FOR GIFTS OR LOANS, DEVELOP QUICKLY THROUGH YOUR OWN PRINTED
MONEY AND OFFSET THE RISK OF INFLATION BY THE GREATER NUMBER OF
TRANSACTIONS YOU WILL CREATE--MAKE SURE PRINTED MONEY IS TRANSFORMED
INTO WEALTH QUICKLY THROUGH THE INCENTIVE OF GIVING PEOPLE A JOB,
WHICH IS EQUIVALENT TO PEOPLE HAVING TO PROVIDE A GUARANTEE FOR A
LOAN.
The "greater number of transactions" that results from printing money
is in fact an increase in the total value of the transactions. In
other words, the government is increasing its money supply, which is
the value of all its currency notes in circulation, by printing more
money. Printing more money doesn't make more economic value. It just
debases the currency. Making a $100 payment into a $200 payment by
using double the notes doesn't offset anything. It makes each note
worth half as much.
Suppose the government has a number of workers who are underpaid, and
has a great deal of debt that it must service. If it says, hey, let's
print some money to pay our workers and service our debt, then it puts
more money into circulation. All of a sudden, everyone has more money.
Now everyone has a greater salary, but everything costs more. If the
government says, hey, let's hire more workers and pay them with
printed money, then the situation is even worse, because the workers
who were already being paid are now getting their salary in a debased
currency. If the government doubles the number of payments by printing
money, then the real value of every previously existing payment is
halved.
It is not true that giving people a job is equivalent to making them
guarantee a loan. A loan guarantee is backed by capital value. If I
use my house to take out a mortgage, then I cannot sell my house at
the same time. The value of the loan I receive is offset by the value
of the house that I put up for security. The net effect on inflation
is zero.
This is not to say that printing money is all bad. Indeed, one branch
of the Keynesian theory says that it is good. As you point out,
printing money lets the government hire workers to make something.
Even if the value of everyone's banking account is reduced a little
bit, the capital value resulting from the workers' effort may be a
great boon to the economy that only improves it in the medium- to
long-term. This is why FDR's Keynesian efforts were a great success.
His administration allocated the printed money wisely and ensured that
the great projects were run efficiently.
The trouble is that a Third World country usually cannot be depended
upon to allocate its printed money wisely or to manage anything
efficiently. That is what makes it a Third World country. Printed
money is frittered away on useless projects and lost to corruption.
That is why the country needs foreign aid, and why the aid comes with
strict conditions attached, requiring that the government impose
stronger financial regulations and implement more transparent markets.
If poor countries could implement Keynesian policy efficiently, they
wouldn't need our help, at least not after a few decades. For success
stories, look at Japan and Korea. For stories of failure, look at
Brazil and Zimbabwe. Brazil and Zimbabwe just keep printing money and
debasing their currency in a vicious cycle. Japan and Korea received
foreign aid, implemented international standards of finance and
industry, and are now leading First World nations. These are examples
on a very large scale.
Printing money has only worked so far as a method of economic recovery
in advanced, industrialized nations that can absorb the negative
effects of inflation and in which the government spends the printed
money wisely. Impoverished governments do not have such governments.
To avoid increasing their money supply and thereby causing inflation,
they should not print money. They should borrow money from abroad,
which will not increase their own money supply. No new money is being
printed in the case of foreign aid. The supply of national currency
does not change. There is therefore no inflation.
leapinglizard
|
Request for Answer Clarification by
bigben1-ga
on
20 Oct 2004 11:11 PDT
Hi. Thanks for the answer.
I have understood how dollars don't create inflation if they are kept
as dollars. I have also understood that in the case of DRC aid is
disbursed in Dollars. I thank you for pointing out that there's a
technical difference between mortgaging a house and getting a job.
That answers my main question.
You didn't address the question of how a large loan can be absorbed
without printing money if the country WANTED to use it in local
currency, except by pointing out in the case of DRC and Yugoslavia
that they don't want to, and by pointing out that loans aren't usually
that big--so the question maybe irrelevant, I guess. By the way in DRC
the GDP calculated through the Purchasing Power Parity method is
$40.05 billion (2003 est. CIA world fact book); so it looks like
things are about 8 times cheaper than in the US. Actual dollar value
according to the Financial Times World Desk Reference of 2002 = 5.4
billion. But my case is still hypothetical, I agree.
Your answer seems to be that's not the actuality, so why insist on it.
Just because that reality is not fixed in stone. It is up to the
policy makers to make policy. It seems to me from your explanations
that they can make a policy where their economy is basically
dollarised by receiving large loans or aid in dollars with certain
consequences (one of which is not inflation I now understand), or they
can go slow, or they can print money and bear the consequences. You
didn't address the limiting development that might result from not
being able to convert large loans into local currency without printing
money (assuming printing money is not acceptable)--but that may go
beyond the scope of my original question.
You did give me the basis for IMF's insistence that money not be printed:
"Printing money has only worked so far as a method of economic
recovery in advanced, industrialized nations that can absorb the
negative
effects of inflation and in which the government spends the printed
money wisely. Impoverished governments do not have such governments.
To avoid increasing their money supply and thereby causing inflation,
they should not print money."
A country may disagree with this assesment of themselves as being
incapable because they are impoverished. The proof of whether they are
right or wrong would be seen after some time. Such assesment of them
as incompetent is after all an opinion and or a generalisation. Not a
hard and fast technical reality.
As I said before, you have answered my basic question: borrowed money,
if it remains as dollars or is exchanged for the already circulating
local currency does not cause inflation. I still have the sub
question: is it possible to exchange a LARGE amount of hard currency
without printing money? And the other one: Is there a limit to the
amount of development that a country can carry out through loans or
aid that will remain as dollars or that can be exchanged for local
currency without increasing the money supply?
If you feel some of this is beyond the scope of my original question I
will understand, although I feel the my parenthetic statement
"(assuming a project doesn't require inputs from abroad that require
hard currency)" is still not fully answered. Maybe you would say: "as
long as those local inputs are paid with dollars, no matter where the
inputs come from, inflation will not be created." But wouldn't those
dollars (assume 5 billion in DRC), force printing of local currency
when people try to exchange them to buy something in local currency?
Or are we assuming that they will go unexchanged indefinitely and once
introduced in the economy there will always be dollars circulating
side by side with the local currency--or that the local currency would
be abandoned?
|
Clarification of Answer by
leapinglizard-ga
on
20 Oct 2004 12:48 PDT
Your second subquestion is very difficult to answer in precise terms.
My education gives me a sufficient background to address it generally
-- I took a concentration in Economics for my International
Baccalaureate diploma -- but I have not been able to find a numerical
formula or even a set of specific guidelines that lets one calculate
how much development can be carried out in the hard currency delivered
in an international aid package.
If there is such a limit, I am not aware that any foreign-aid
recipient country has reached it. The fact is that in a country that
stands in dire need of large foreign inputs, the citizenry always
prefer hard currency to their own national currency. This reasoning
also addresses your first subquestion. In the event that a government
feels it must exchange foreign-aid funds from hard currency to soft,
there will surely be citizens prepared to sell their local notes for
dollars, pounds, or euros. There is far greater security in foreign
bills, after all, than in the currency of a failing or failed economy.
So the answer is yes, it is certainly possible for a Third World
government to exchange large sums of hard currency without printing
money. The source of the local currency will be the public at large.
It is invariably the case that the currency of a poor economy is very
soft, implying that there are large numbers of its bills in
circulation. It is not clear, however, that it would benefit the
government to do so. As long as a hard currency can be freely
exchanged, it can just as easily be spent directly on development
projects. There is no great advantage in exchanging first, then
spending.
The one positive effect of such a transaction would be to increase
confidence in the local currency. This is the kind of action known as
"propping up" the national currency. The national banks of developed
economies, including Britain and the United States, will often engage
in such large-scale transactions in order to stabilize their currency.
In a developing nation, however, the emphasis would be on encouraging
economic activity rather than propping up the currency.
In fact, part of the Keynesian strategy, which I mentioned earlier,
says that a devaluation of the national currency, whether by means
artificial or natural, can help to jump-start an economy by making its
exported goods cheaper and therefore more competitive in the
international marketplace, encouraging increased production. Whether
this is a sound strategy is a hotly debated question, and I would
prefer not to take sides. If you are interested in the arguments for
and against, you might like to read the following articles. The last
of the four is a general commentary on truth in economics.
Friedman vs. The Austrians, Part II
http://www.libertyhaven.com/thinkers/miltonfriedman/inflationary.html
Ludwig von Mises Institute: Garrison versus Keynes
http://www.mises.org/fullstory.aspx?control=679&id=73
Auburn University: Roger Garrison: Is Milton Friedman a Keynesian?
http://www.auburn.edu/~garriro/fm2friedman.htm
looksmart: "The Manichaean character of economics" by Charles Kindleberger
http://www.findarticles.com/p/articles/mi_m1093/is_5_42/ai_56057294
As to whether a large input of hard currency can indefinitely remain
in circulation, the answer is yes. Those funds that do not leave the
country will remain within the country, passing from citizen to
citizen. In much of Central Asia, including Afghanistan and former
Soviet republics such as Kazakhstan and Uzbekistan, dollars are the
preferred currency, and for good reason. A dollar can always be spent
abroad, but an afghani or a tenge cannot. Thus, hard-currency units
are widespread within developing countries and are recognized as the
only medium for serious transactions involving heavy machinery,
automobiles, or freight-sized quantities of goods. This is true in
much of Africa and in parts of South America. If you travel to
Bolivia, Mongolia, Nigeria, or even Russia, no one will refuse
dollars. For some transactions, the locals will insist on hard
currency.
So the answer is that a parallel system of hard-currency transactions
does tend to develop in aid-recipient countries, although the local
currency is not abandoned completely. Rural folk who do not travel
frequently to cities will still rely on national notes, and the
government will still use it to service its payroll. Thus, agriculture
and the civil service remain a means of circulating the soft currency
while much of the private marketplace is committed to the hard.
leapinglizard
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Request for Answer Clarification by
bigben1-ga
on
20 Oct 2004 15:51 PDT
OK, I thank you. As you can see I'm trying to find out if there's some
kind of limit to the inflation-free development that can be done
through foreign aid or loans; or if there's some reason why if a
country is responsible it shouldn't print money. Or why, as in the
case of Venezuela that I mentioned (in which I think they must have
had to print fresh local currency to exchangea a huge amount of
dollars that they were getting from oil), significant development may
cause some inflation anyway in the short term and a country should not
be so afraid of it, because by rejecting the risk of inflation they
are rejecting development. If you come accross something in that
direction, can you let me know? Shall I hold for a day before closing
the file? The rest of it is clear. I'm impressed with your scholarly
style--and had fun looking at some other things you have researched
that show you are creative (good teak furniture company names),
scientific oriented and a computer expert, amongst other things.
Congratulations. I hope this job is a good one for you and I'm sure it
will lead to many good things.
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Clarification of Answer by
leapinglizard-ga
on
20 Oct 2004 17:09 PDT
Economic policy makers know that it is no simple matter to strike a
balance between development and inflation. The two often go hand in
hand, as you speculate. Moderate inflation is consistent with a
growing economy, while deflation is a sure sign of depression. These
effects are broadly acknowledged, but the mechanism responsible for
them is the subject of furious debate between different schools of
thought. The aim of achieving economic expansion without high
inflation is something like a holy grail of economics.
The following article gives a good overview of the two main
interpretations of inflation, namely the Keynesian and the monetarist.
Monetarists, the disciples of Milton Friedman, argue for the tightest
possible control over the money supply, for fear of devaluing the
currency. Keynesians, who are people like FDR and perhaps like you,
say that printing money to make productive investments in the economy
can act as a spur to growth.
"A small amount of inflation is often viewed as having a positive
effect on the economy. One reason for this is that it is difficult to
renegotiate some prices, and particularly wages, downwards, so that
with generally increasing prices it is easier for relative prices to
adjust. Many prices are "sticky downward" and tend to creep upward, so
that efforts to attain a zero inflation rate (a constant price level)
punish other sectors with falling prices, profits, and employment.
Thus, some business executives see mild inflation as 'greasing the
wheels of commerce.' Efforts to attain complete price stability can
also lead to deflation (steadily falling prices), which can be very
destructive, encouraging bankruptcy and recession (or even
depression).
"Many in the financial community regard the "hidden risk" of inflation
as an essential incentive to invest, rather than simply save,
accumulated wealth."
Wikipedia: Inflation: The role of inflation in the economy
http://en.wikipedia.org/wiki/Inflation#The_role_of_inflation_in_the_economy
The Venezuelan government did not have to print any money to exchange
the dollars it received. Like all governments, it keeps hard currency
reserves with which to service its foreign debt. If only it received
such an influx of hard currency that it could pay off all its debt! It
would then be a pleasant dilemma to consider what to do with the
remainder. This is not to say that Venezuela spends all its oil income
on debt payments. In fact, it has spent much of it in recent years to
buy quantities of its national currency, the bolivar, from its
citizens in order to prop it up against devaluation caused by foreign
investors' fears of an economic collapse. The value of a particular
currency can change independently of inflation, you see. It is enough
that holders of the currency sell it off at a high rate, which need
not be attended by a rise in domestic prices.
BBC News: February 8, 2002: Fears grow for Venezuelan currency
http://news.bbc.co.uk/1/hi/business/1809628.stm
BradyNet Forum: January 10, 2003: Fitch Dwngrs Venezuela's Foreign
Currency Sovereign Rtg to 'CCC+'
http://www.bradynet.com/bbs/venezuela/100046-0.html
Forbes: August 25, 2004: Venezuela Official Comments on Currency
http://www.forbes.com/business/commerce/feeds/ap/2004/08/25/ap1518713.html
Thank you for words of praise. I have enjoyed working on this question
of yours, and it is good to know that one's work is appreciated
leapinglizard
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