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EconTalk

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No. 1 -- < An Occasional Column on Ethiopian Economy> -- 1994


EDITOR'S NOTE: This is the inaugural issue of an occasional column on economic issues affecting Ethiopia. It is intended for a general audience at Cleo/EEDN; economics jargon will be kept to the minimum, and current issues of debate will have priority. Guest columns and questions are welcome as are suggestions and replies.

They are to be sent off-line to the editor.

-- Berhanu Abegaz (bxabeg@MALTHUS.MORTON.WM.EDU )

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ON ENABLING ENVIRONMENT AND THE FOUR D'S

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The theme of this commentary was prompted in part by a question from Theodros Kidane who, upon hearing that EconTalk was about to enter the information superhighway on a mule-back, suggested that the first posting be devoted to the economics of devaluation. I thought it would be a good idea to discuss devaluation briefly in the broader context of structural adjustment programs (SAPs).

It is a truism that sustained economic development is preconditioned on high rates of productive investment in human resources and physical capital. Since investment entails risk and long-term commitment, a stable and conducive policy environment is required by both private and public enterprises in their (hopefully) competitive search for profitable opportunities.

An 'enabling' environment (who wants a disabling one, anyway?) must, therefore, be created by dismantling institutions and policies that have outlived their usefulness, and by enacting positive measures to encourage productive activities. In other words, negative incentives must be replaced by positive ones.

For laggards like Ethiopia, the advice emanating from the multilateral institutions (such as the World Bank Group and the IMF) and most professional economists can be summed up as follows: cure thy chronic ailments by taking the "four D's" as prescribed. Some kind of economic medicine, you might wonder. Yes, a heavy dose of Devaluation, Disinflation, Deregulation, and Denationalization. If the body economic has been isolated from civilization (i.e., the world market) for too long, or contaminated by socialismiasis, or run by Neanderthals, the dosage will have to be administered carefully and with an adequate supply of nourishment (adjustment assistance).

In the standard jargon, the first two fall under the rubric of IMF- mandated Stabilization (read, resuscitation) designed to restrain spending (i.e., reduce the budget and trade deficits to sustainable levels). The second two focus on rehabilitation or Structural Adjustment, under the purview of the World Bank. It takes two know-it-all economic doctors and a large army of expensive short-term consultants to save the patient from itself (or from its misguided children, as many say). Do you ever wonder why regime after regime in Ethiopia or country after country in the Horn keeps making the same mistakes despite patently disastrous results?

Any way, the two sister institutions, which are presently celebrating their 50th anniversary, have encroached on each other's territories. The Volker Commission has just called on the IMF to concentrate on macroeconomic stabilization, and the World Bank Group focus on structural adjustment needed to facilitate medium-term growth. Bilateral institutions such as USAID and EU, important sources of economic aid for Ethiopia, generally follow the latest fad of the Brettonwoods institutions and, most importantly, the political leanings of the White House and the European Parliament, respectively.

DEVALUATION

Devaluation may be nominal or real (adjusted for inflation using the price indices of imports and exports). Devaluation of the nominal exchange rate of the Ethiopian Birr (Birr per US$) refers to the increase in the number of Birr one US$ can purchase. That is, holders of Birr will have to give up more Birr to obtain one US$ following a devaluation. The prices of dollar-denominated assets or goods would inevitably go up "in terms of Birr".

When the Birr was devalued from 2.07 per US$ to 5.00 per US$ in October 1992, it is as if the cost of American-made goods rose a whopping 250% for Ethiopians (assuming that U.S. exporters did not

raise prices) in terms of dollars! All other things being the same, this would discourage imports form the US and Ethiopian exports to the US as intended by the reformers. This would also discourage capital outflows from Ethiopia and encourage inflows from America, again all other things being the same. If it is so dandy, who would oppose devaluation or support an overvalued Birr? Well, consumers/users of imported goods lose out and exporters gain. In the absence of exchange control, those who wish to keep dollar accounts lose, too. When you make something that is desirable (US$) artificially cheap, there will be excess demand for it and draconian exchange controls will have to be instituted. And, if the losers from devaluation have political clout (however few they may be), or if policy makers who count subscribe to a different theory, then an overvalued exchange rate may last longer than it should.

Under free market conditions, exchange rates are driven more by speculation (capital flows) than by trade flows. Hence, they tend to get too erratic and create enormous uncertainty. That is one of the reasons developing countries try to keep their nominal exchange rates stable (say by pegging them the US$ or the French franc). But they are powerless to control the real exchange rate-- Ethiopia's real exchange rate fluctuated a lot despite the stability of the nominal rate.

How do we know the 'optimal' exchange rate of the Birr, any way? When Ethiopian economists (Dr. Befekadu Deguefe comes to mind) rant and rave about the devastating impact of the recent devaluations on the cost of living and the cost of critical imports, aren't they suggesting that the old rate was somehow better than the new? Great questions. Humility dictates that we admit that we do not quite know the right exchange rate of the Birr. In order to determine the 'optimal' exchange rate for a given state of the Ethiopian economy, one will have to build a computable general-equilibrium model ... Oh, Sorry, I got carried away. There is a damn good rule-of-thumb, though. That is, the average exchange rate (say, Birr 7 per US$) in the parallel market (never say, black market, please) gives us a ceiling that would prevail under free market conditions. An official nominal exchange rate of 5-6 Birr would, therefore, be a good approximation of the equilibrium rate. If you have a better answer, let me know.

What about the economic and social consequences of devaluation? Well, the big debate centers around this issue. Several considerations come into play. First, the effects of devaluation must be seen in conjunction with other reforms (remember the other three D's?).

Secondly, the time horizon is important. The good effects materialize tomorrow (it take coffee growers some time to expand coffee production) but the bad effects are felt today (the prices of imported oil in terms of birr will rise immediately). Assuming that a certain level of devaluation is the right policy and it is implemented with appropriate speed, then the real question should center on whether steps will be taken to shield the poor from its adverse effects. Besides, exchange system reform provides a necessary but not sufficient condition for growth.

I have rambled long enough. The bottom line is that

(a) exchange rate flexibility is one of many economy-wide policy instruments;

(b) international competitiveness ultimately depends on the productivity of the Ethiopian labor force;

(c) the right policy is one that addresses the problem at its root; and

(d) economic reform produces losers and gainers, and fairness in the sharing of the burden/benefits of reform may be frustrated by unscrupulous politicians as witnessed by the ongoing debates in Ethiopia. As you occupy you minds with talk of high finance, please never forget that the mind of the average Ethiopian is occupied with thoughts of food for much of the day.

To end on a lighter note, Lord Keynes, in emphasizing that macroeconomic policies must focus on short-run problems, once quipped: "in the long-run, we are all dead." I am also tempted to retort, invoking the folk wisdom in this part of Virginia: Everybody wants to go to Heaven, but no one likes the dying it would take to get there!

I will discuss the other D's in the near future. In the meantime, may you have a devalued ego and revalued income.

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EconTalk Factoids (1992, billions of US$):

World GDP ......................$23,060 (was $2,808 in 1970)

High-income economies........ $18,312

Middle-income economies ..... $ 3,549

Low-income economies ........ $ 1,146

ETHIOPIA .................... $ 6

SUGGESTED READINGS:

Eshetu Chole, "A Preliminary Appraisal of Ethiopia's Economic Reform,1991-93" , H. Marcus, ed, New Trends in Ethiopian Studies (Red Sea Press,1994).

Berhanu Abegaz, "Ethiopian Economic Reform", in B. Abegaz, ed, Essays on Ethiopian Economic Development (Avebury Press, 1994).