Why currency devaluations don’t work

BRUSSELS:

The idea that devaluations make a country’s goods more “competitive” is pure gold for governments. Enhanced “competitiveness”, in turn, is believed to increase exports and reduce imports, thereby improving the country’s trade account, employment, balance of payments and domestic budget.

Governments also believe that the change in the value of their country’s currency will somehow go unnoticed internally and externally, and that market forces will somehow be blind to their monetary interventions. that they can change the trading terms at will. This theory is not true.

Devaluations as such lead to fully compensating price changes. The increase in the price level of the depreciating country’s currency minus the increase in the price level of the currencies of the countries against which the first currency was depreciated will exactly equal the depreciation. All devaluations will do is offset inflation.

The devalued country is immediately set into inflation as domestic prices rise rapidly to restore foreign goods after the devaluation. Depreciations are compensated everywhere and at all times by the same increase in the prices of goods as measured in the currency of the depreciated country against the prices in currencies against which the depreciation took place.

In policy as well as academic circles, it is widely believed that changes in exchange rates cause changes in trade balances. Devaluations are believed to lead to improved trade balances, while appreciations are assumed to lead to worsening trade balances.

Of course, the reason people are so concerned about improving the trade balance is because of the old Keynesian equation of economic output, that is, output = consumption + investment + government spending + net exports. According to this equation, any improvement in the trade balance leads directly to an increase in GDP.

However, things are not that simple in the real world. Realistically, an improvement in the trade balance usually does not correlate with a growing economy. Furthermore, devaluations simply lead to a fully compensating change in nominal prices and no change in the trade balance.

In other words, a devaluation country can expect no change in real output but will experience an increase in inflation.

But even within her own set of assumptions, the logic of devaluation does not hold. Certainly, it seems they would like to import less because imports are now more expensive and domestic import substitutes will become more competitive.

This, in turn, will prompt domestic producers to switch to import substitute production. But what about exports? Export goods, which are now relatively cheaper, become more attractive to consumers, both foreign and domestic, and less attractive to producers.

The higher price of import substitutes makes the production of these goods more profitable than the continued production of traditional export goods. Thus, supply shifts away from export goods at the same time as domestic demand for export goods increases, leaving fewer export goods available for export.

Therefore, exports should be reduced both by supply and demand. From the depreciating country’s perspective, logic would suggest fewer imports and fewer exports.

Devaluation is simply an attempt to change the prices of apples and other goods in one nation relative to another by changing the relationship between the criteria by which those prices happen to be measured.

If markets are efficient, the actual price of apples – relative to cars or labor hours or other things of value – will not be affected. Nor will this real price be different, other things being equal, in one nation or another.

Thus, if the criteria change, the values ​​measured by them should change in a way that preserves the original relationship of the actual values.

Or consider the same phenomenon from the perspective of a nation. If a country produces goods that it trades and consumes domestically, then the goods sold for domestic consumption will not differ in price from the goods sold for foreign consumption.

Similarly, foreign imports into any country should also be sold at the same price as domestically produced import substitutes – both before and after devaluation. If these prices were not adjusted in this way, speculators could make virtually unlimited profits by buying goods in one country and selling them in another.

In discussions about exchange rate intervention, it is often suspected that a good can sell at two different prices at the same time. The concept of undervalued and overvalued currencies can hardly mean much else. This implication is diametrically opposed to the concept of profit maximization.

To be sure, profit maximizers sell to the highest bidders and buy from the lowest sellers, regardless of nationality. Thus, if there are domestic and foreign sellers or buyers at the same time, in an efficient market goods, whether foreign made or destined for foreign markets, will sell at the same price as their domestic counterparts – both before and after exchange rate changes.

Given profit maximization, one would expect the sole effect of devaluation to fully offset inflation. The idea that somehow devaluation lowers the prices of all goods vis-à-vis foreigners and therefore leads to lower imports or greater exports is a thinly veiled resurrection of the discredited theory of absolute advantage.

If one extends such a bad theory to its extreme, one could even claim that if a country devalues ​​enough it will export everything and import nothing. It is hard to imagine that the end result of a currency devaluation is anything other than fully offsetting inflation. This alternative view of devaluation predicts that devaluations do not improve a country’s trade balance. Because nominal prices will adjust and real prices will remain unchanged, the depreciating country will not gain a competitive advantage.

With the available data on the effects of devaluation, in fact, one would be hard-pressed to find much of a relationship between exchange rate changes and trade balances.

Similarly, the alternative view predicts that an undervalued nation will experience rapid inflation relative to the rest of the world. Its nominal price levels would have to rise rapidly to restore the original relationship of real prices to real prices elsewhere in the world.

This result, of course, does not depend on the actual flow of goods from one nation to another. One can also observe the exact opposite price effects when a country appreciates.

While the price effects of exchange rate changes are more pronounced using wholesale prices, they are still quite evident using the less volatile consumer prices. Even over long periods of time, the relationship between exchange rate changes and relative inflation rates remains remarkably close.

A country is not a closed economy, nor is the economy of any other nation closed, it must be recognized. The only closed economy is the global economy itself. This is a lesson we would all do well to learn.

The author is a philanthropist and economist based in Belgium