Money illusion is the tendency to think in terms of nominal rather than real monetary values – one key difference being that nominal values do not take inflation into account. For example, when the money deposited in a savings account accrues 8% annual interest rate, my nominal return at the end of the year is 8%. My real return, though, depends on inflation and can turn negative if inflation rises above 8%. The interest might look attractive, but after one year, my purchasing power has actually eroded as prices of goods and services increased faster than my wealth during the period. This means I can afford to buy less. As the money illusion illustrates, obsessing over nominal values is irrational as what we care about is how much we can afford. However, it is prevalent in the world of psychology and economics.
₦ 1 = $1 = Best Economy
Nigeria’s obsession with the nominal exchange rate cannot be overstated. Sites that regularly display parallel market exchange rates have become extremely popular in the country. And as the naira depreciates, you can hear the groans of despair across the country.
During the election campaign, it was reported that President Buhari had promised to make ₦1 = $1. The story was quickly debunked, and several commenters publicly questioned the feasibility of the suggestion. Nevertheless, the story stuck, telling us quite a bit about what the media and politicians think the electorate want to hear. While it is hard to tell if this story had any effect on his election success, it has become a stick to beat the current administration with as the naira has lost over a third of its official value since then.
The older generation is never hesitant to reminisce over the days when ₦1 = $1, a supposed indicator of how Nigeria was once a great country. However, rarely mentioned is the problem with that exchange rate. Nigeria’s agricultural sector was once a bright spot – from the 1950s to the mid-1960s, Nigeria was the world’s largest producer of palm oil. But after the civil war and the sudden petroleum boom, agriculture suffered. Nigeria’s crude oil exports soared, leading to an inflow of dollars. The higher dollar supply allowed Nigeria acquire its beloved overvalued naira (₦1 = $0.53 in 1980), which this UN paper outlined as a leading cause of the decline of agricultural goods in the 1970s. Crucially, as the naira strengthened, Nigeria’s agricultural exports became more expensive, so demand fell. Meanwhile, cheaper imports encouraged Nigerians to buy foreign goods, eventually leading to the fallout of Dutch Disease that currently plagues us.
When countries attempt to boost production and increase exports, they tend to devalue their currencies to make exports more competitive. China, for example, has often been accused of maintaining an undervalued currency. Even Germany, the economic behemoth of Europe, was recently targeted by Peter Navarro, the head of President Trump’s National Trade Council, for exploiting a ‘grossly undervalued’ Euro. As Nigeria tries to boost exports, there is a case for a weaker currency. To be fair, this must be weighed against the higher cost of imported raw materials in the short run; at least until the local content drive bears fruit.
Central Bank Credibility
The fetishisation of the nominal exchange rate also spreads to the Central Bank of Nigeria (CBN). This partly explains its acquiescence in recent foreign exchange policy, despite knowing better. This is an important point. You would assume that the CBN does not suffer from the money illusion, after all, central banks are the magicians that attempt to use inflation to moderate the rise in real wages and public debt.
So the fixation with the nominal exchange rate likely stems from the belief that it is the best route to stabilising inflation. Currency depreciation will feed through to inflation, so this argument has some credence. However, by maintaining an artificial rate, resultant dollar shortages and the high black market premium may cause even greater economic harm.
Two things must be clarified. Firstly, the nominal exchange rate is not entirely irrelevant though the real one matters more. Secondly, currency depreciation is painful in most parts of the world. And as one of the culprits increasing traffic to Abokifx, I like to know that my naira can be exchanged for more dollars. But when prices change in Nigeria or the US, this nominal rate says little about how many goods my naira can buy abroad. Therefore, it is not worth protecting this nominal rate at the expense of real variables in the economy. This is one criticism of the current exchange rate policy – preserving the nominal exchange rate at 305 has likely hit business profitability and deepened the economic recession.
The campaign to defend the naira – “Buy Naija to grow the Naira” – distracts from other goals such as poverty alleviation and reducing inequality. Even our attempt at reducing poverty with the ₦5000 cash transfer program suffers from money illusion. ₦5000 promised in 2015 doesn’t buy the same amount of food at the market today because inflation has risen sharply since then (average of 15.6% in 2016).
Nigeria isn’t the only country that has a bias towards nominal variables at the expense of life changing welfare. The economic world is guilty of fetishising GDP and similar aggregate data, regardless of how poorly they translate to actual life improvements. Nigeria, though, deserves special mention. After all, which other countries have prominent pastors prophesying over the value of the exchange rate?
Source : Stears Business