Seems like the favorite past time nowadays is to bash economists. More recently the fate of the naira since the alleged float has been to….you guessed it…bash economists for getting it wrong. I’m not here to indulge you. But I do think its important, even you are not an economist, to learn. Or at least try to learn more about how economies work. Or at least how we think economies work. So here are two things which are important in understanding Nigeria’s troubles today and the path to getting out of those troubles.
- Pains from unsustainable policy
Can you remember that game we all played with rubber-bands when we were kids? The one where you get a rubber-band and latch on a folded of paper. And then try to shoot people with it by using the rubber-band as some type of missile launcher? It was a fun game. Sometimes it actually worked and you hit the target. Most times though you just ended up with pain on your fingers.
Think about the mechanics of pulling the rubber-band. Once you start pulling you have to let go at some point. The longer you pull, the more stress you impose on the rubber-band. The longer you pull the more painful it will be on your fingers when you let go. But you know you have to let go at some point. If you don’t the rubber-band will break and the pain will be even more.
Unsustainable policy kind of works in that way. You have a policy that you know can’t go on forever. The policy needs to end. The longer you hang on to the policy and the longer the policy distances itself from reality, the bigger the pain will be when you eventually let go. The pain is worst when the policy ends by force.
We have seen many of such policies in Nigeria. The most notable is the fuel subsidy fiasco. A policy that went on for so long and at such huge cost to the country. And a policy that was forced to end due to the collapse of oil prices and government revenue. Cue the pain from sharp increases in fuel prices.
More recently we have had the fixed naira policy. A policy that was unsustainable and a policy which sooner or later had to end. We held on for 18 months with the subsequent strain on the economy. It has ended and the pain is here with the sharp adjustment of the currency on official markets.
The morale of the story? Don’t start unsustainable policy. Don’t even start. If you started by some kind of accident then let go as soon as possible. Because the longer you wait the bigger the pain will be when you do let go, by choice or by force. Also do not use the pain from letting go as an excuse to start unsustainable policy again. That only means future pain.
- The transmission mechanism.
Say you have a plant that you are responsible for. Your orders are to water the plant once a day. And for the most part you do it diligently. But then you forgot about it. You didn’t water the plant on Monday. The plant isn’t going to die. It’ll probably be fine. But then you forget on Tuesday, Wednesday, and Thursday. By Friday the plant is on its death bed.
The point of this story is that it takes time for your actions (or inaction’s) to become visible in the plant. If you implement a policy of not watering the plant on Monday, the plant won’t immediately die that same Monday. It will take a while before the plant dies.
The same happens in reverse. You wake up on Friday screaming “Oh my God i forgot to water the plant”. You go ahead and water it. The plant is not going to miraculously regain its verve. It will take a while from when you start watering the plant again to when the plant regains its verve.
Policy, especially monetary policy, works just like the watering plant example. We call it the transmission mechanism. If you implement a policy today, good or bad, it takes a while for the effects of that policy to show up in the economy.
For example, if you implement a bad policy like trying to fix your exchange rates when you are faced with external shocks, it takes a while for that bad policy to cause a recession. You will not have a case where a policy is implemented on Monday and the effects on the economy show up on Tuesday. Economies don’t work that way. The exact amount of time is uncertain and probably depends on the country and specifics. For example, some studies argue that it takes about 18 months for interest rate changes in the United States to affect inflation.
Similarly, if you implement a good policy, like abandoning your currency peg and floating the currency, it takes a while before the effects of the policy manifest on the economy. If you float the currency today, you are not going to see an improvement tomorrow. It will probably take months. And even that depends on the other policies you implement.
The morale of these two lessons is that we have had bad and unsustainable currency policy for the last 18 months, and bad fuel pricing policy for more than 18 years. And now we have let go. There will be pain during the adjustment. It is inevitable. And the pain will be proportional to the amount of time we hung on, so it will be a lot. We should not expect the positives of the abandonment of bad policy to show up immediately. It will take a while. But once the adjustments end then we should be on a more sustainable growth path. Conditional on other policies being reasonable of course. We shouldn’t attempt to go back though. That just means we are pulling the unsustainable rubber-band again, with the pain that comes when we inevitably have to let go, again.