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Don’t let big economic words daunt you

by Payal Kapadia

It’s never too early to get your facts straight about the economy. Many people, even the leaders of powerful countries, still get them mixed up. Using the wrong terms, like U.S. President George W. Bush did this week, can create a lot of confusion for everyone.

Bush made a huge snafu during his visit to Tokyo to meet Prime Minister Junichiro Koizumi. The two had just spoken behind closed doors about ways to rescue the Japanese economy, which is in the midst of a recession — in other words, the economy is shrinking instead of growing, with people losing jobs and spending less money, and companies suffering losses because their products don’t sell.

Bush told reporters that he had spoken to Koizumi about devaluation. Unfortunately, it seems he got it all wrong. What Bush meant to say was that he had spoken to the Japanese prime minister about deflation. But for a few chaotic hours, the market believed the president. Currency traders hit their panic buttons and started selling yen. Luckily, things didn’t get out of hand because some clever person asked the president’s aides for clarification. Without that, Bush’s mistake would have cost the market a lot of money.

What’s so special about devaluation and deflation? And what’s so bad about getting them mixed up? Deflation and devaluation are big economic ideas that affect everyone, even you and me. When leaders like Bush get muddled by them, we’re all in trouble.

Japan has a deflation problem, it’s something the newspapers write about a lot. Deflation happens when prices start to fall — from the clothes and food that we all buy to iron ore, cotton or other raw materials that manufacturers need to make their products. In a healthy economy, the prices of goods go up at a steady rate, not down. Producers can charge more for their products because consumers have more money to buy them. But in an economy that is slowing down, people are afraid for their jobs and their future, and they want to spend less. When there are few buyers, sellers have to lower the prices of their products in order to sell them — that’s deflation.

If prices in Japan keep falling, isn’t it a good thing? Won’t it be cheaper to buy video games or sports shoes? Yes, it will be, but in the long run, deflation is very bad for the economy. This is because companies will begin to close down if they don’t make any profit, and people will lose jobs.

Devaluation means something quite different. It’s when the value of a country’s currency goes down. Japan’s currency is the yen, and its value is equal to how much it can buy. You work this out by comparing the yen to the currencies of other countries, like the U.S. dollar or the British pound. This comparison is needed because countries buy and sell things from each other all the time. When the yen loses value, it becomes costlier for Japan to buy things from other countries, and it becomes cheaper for oher countries to buy things from Japan. This comparison is called the exchange rate.

The exchange rates for the world’s major currencies are published daily in the financial newspapers. At present, the yen’s exchange rate is about 132 yen to the dollar. This means that if you’re going on holiday to the United States and have 10,000 yen spending money, you’d have about $75 in your pocket to spend. But if the yen strengthened so that the new exchange rate was 66 yen to the dollar, you’d have about $150, double the spending money for the same 10,000 yen.

If this information is important to you, imagine how much it matters to currency traders, who buy and sell millions of yen, dollars and other currencies each day. Currency traders try to make a profit by buying and selling one currency for another. They have to guess how the exchange rate will change from day to day.

So, when Bush said that he had spoken to Koizumi about devaluation, currency traders who had large amounts of yen rushed to sell them, because they thought the value of their yen would fall. If you had 100 million yen and the exchange rate fell by just a single yen, you’d lose a fortune — almost $5,700 overnight!

If Bush’s aides hadn’t set the story straight, everyone would have been selling yen, and no one would want to buy it. This would have lowered the value of the yen even more — creating even more problems for Japan’s troubled economy.

If you can differentiate between devaluation and deflation without getting mixed up, you’re already a step ahead of Bush. It also helps to think before you speak, you might become president one day and you don’t want to get caught out like Bush did.