TWI and growth

Roger J Kerr at the Rates Blog uses the following graph to state that GDP growth will recover sharply over the coming year.

Source (Rates Blog)

Although it is a pretty picture – it only tells us part of the story. And it does not imply that we will see a sharp rise in economic activity.

How does an exchange rate fall “stimulate activity”

A weaker New Zealand dollar does not suddenly imply that our economy is in better shape. Although a weaker dollar makes our exports more competitive, it also makes imports relatively more expensive.

The mechanism by which a lower exchange rate can lead to higher GDP is through this very change in prices. By making imports more expensive, people substitute for domestically made goods – by making exports more competitive we are now able to buy more domestically made goods with the proceeds from these sales. However, anything we need to import, or anything we want to import, would have now risen in price.

As a result, even though a increase in the exchange rate should increase production – it is not necessarily going to increase the happiness of society. Anyway, I am floating away from the issue, so:

Other factors matter

Looking at the exchange rate and economic growth is only a small part of a very big story. Although Roger appears to think that economists have forgotten about the “stimulatory” impact of a low exchange rate this is not the case – our focus lies more strongly on the drastic fall in the terms of trade that appears to be on the horizon.

A lower terms of trade implies that we need to sell more exports to buy our current level of imports – effectively, the relative price of exports to imports is falling. The exchange rate decline has helped to protect exporters (by increasing their ability to buy domestic goods) – but it also implies that importers (including consumers) will have to face large price increases than would have been the case.

Furthermore, if the credit market is gunked up then it is likely that investment and building will fall back sharply – as it currently is.

The 4% result

However, Roger states that GDP growth should rebound to 4%! Seemingly ignoring the other factors that he mentioned when stating why the graph doesn’t look so good over other periods of time.

Doing a little simple statistics, an OLS regression tells us that we “should” get 4% growth in September 2010 – not in 2009 (when growth “should” be a little over 1%pa). However, the error band is so large that it says that the “model” is 95% confident average annual growth will be between 0.2% and 8% over the year to September 2010 – a huge range (BTW the adjusted R2 on such a regression is only 0.24 – implying that it only explains 24% of the variance of GDP).

Furthermore, these numbers are subject to all sorts of errors – correcting for one of them (heteroskedasticity) allows us to keep the 4% growth rate but the error bands become ridiculous!

Ultimately, trying to predict activity solely on the basis of the exchange rate is folly. Economists haven’t forgotten about the stimulatory impact of the exchange rate – we just realise that there are a bunch of other issues that have to be weighed up before making a forecast.