Self-fulfilling prophecies

Oct 08 2013, 02:50 IST
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SummaryMost experts know little about what makes a currency strong, or weak for that matter

With the rupee stabilising after a strong rebound, and a semblance of confidence having returned, it is time to look back and take stock of what really happened in July and August, when it seemed as if no level of the rupee was low enough.

The value of a currency is whatever everyone believes it should be. Over the medium term, economic forces do get currencies closer to where fair value should be, but unfortunately, there is no simple method to arrive at a universally agreed future fair value. This uncertainty is enough to drive cycles of greed and fear, exacerbated by expert economists who at the drop of a hat switch from growth differentials will make the rupee appreciate steadily to inflation differentials will make the rupee depreciate steadily. Policymakers trying to explain the fall inadvertently added fuel to the fire by justifying the currencys weakness through overly simplistic statements.

If you see a spark and cry fire in a crowded theatre, the chances are more people will get hurt in the stampede to escape than the fire. Experts who grimly predicted a steady depreciation of the rupee in public forums, acted no differently, though their self-image was probably more benign.

There is nothing wrong with discussing possible causes, but incorrectly justifying the fall publicly (and worse, giving sensationally pessimistic forecasts) spreads fear. Not surprisingly, the supply of dollars from exporters had dried up: they were holding up as much as they could. Importers on the other hand were effectively buying dollars for several years worth of imports. As excessive demand for the dollar forced the rupee down further, further waves of speculation were triggered. Contrary to the popular belief that evil hedge funds on foreign shores were big sellers of the rupee, almost US$13-15 billion of flows happened in July and August due to corporates panicking about the currency.

Any one-line explanation for the currencys continued weakness is like a quack over-simplifying a complex illness, and in the process hurting the patient. No less a person than Nobel-laureate Paul Krugman wrote in his book Peddling Prosperity that economics is a primitive sciencenot far from where medicine was a hundred years back. By then we had figured out how the human body works, but didnt know enough to cure diseases: life expectancy hadnt changed much for 2000 years. Then something clicked, and cures started coming through: life expectancy surged. That such definite ideas

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