INSIGHTS: BAD IDEA DEVALUING CURRENCY TO HELP EXPORTERS
By Guest Columnist Frank Hollenbeck:
A finance and economics professor at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and an Associate Director of a Swiss private bank.(Reprinted with permission from the Mises Institute)
The European Central Bank’s (ECB) decision to shortly print over 1 trillion euros has reignited concerns over currency wars. The euro has dropped almost 20 percent over the last six months after endless hints from the ECB.
We are in a currency war, and have been since 2008. Our current global monetary system is deeply flawed in spite of the International Monetary Fund (IMF), which was supposedly created to foster monetary cooperation and financial stability. Yet, the IMF has been eerily silent lately, which has not gone unnoticed by those who butter the IMF’s bread.
The current unwritten rule on exchange rate policy is that direct intervention is frowned upon, but indirect intervention is acceptable if the exchange rate was not the initial objective of policy. The thinking here is similar to that used when dropping a thousand pound bomb on a terrorist, wiping out a preschool, and then saying “it’s no problem since our primary target was the terrorist.”
It is simply irresponsible to look only at the direct and not indirect effects of economic policies. The US’s quantitative easing over the last six years has forced emerging market countries to impose capital controls and other currency restrictions, and ramp up their own printing presses. Current Japanese monetary policy, which is driving down the yen, is causing serious consternation to its Chinese and Korean neighbors. The People’s Bank of China recently lowered reserve requirements and is planning to widen the trading band on its currency. Let’s call this what it really is — retaliation and escalation of worldwide currency wars.
Does Devaluing Currency Really Help Exporters?
Of course, these actions are based on another popular misconception promulgated by economists: that a depreciating currency will allow exporters to reduce their prices overseas, helping them capture market share, thus boosting profits with positive ramifications for the domestic economy. The mistake in this logic is that it looks at the direct effects while totally ignoring other direct and indirect effects.
A simple example will make this clear. Suppose the exchange rate is one dollar for one euro. The European exporter is selling his product for $100 in the US which he converts into 100 euros to cover his production cost of 80 euros. Now suppose the euro depreciates so that it takes 1.5 euros to get 1 dollar. The exporter can now lower his price to $66.66 since this will bring in the same number of euros as before the depreciation. He has gained a competitive advantage over his foreign rivals, with benefits to the domestic economy.
The first problem with this story is that with new financial instruments such as swaps and financial futures, many exporters can hedge their foreign exchange risk long term, and may have already committed themselves to the rate they swap dollars for euros.
The second problem with this story is that many exporters today import many of their inputs. A BMW has parts coming from all over the world. Its engines may come from the UK. The leather seats may come from China and the steel may come from Brazil. If the depreciation causes input prices to rise from 80 euros to 120 euros, the exporter will be unable to lower his dollar prices, and, therefore will not gain in competitiveness. Of course, not all costs are imported inputs. This, however, highlights how depreciations really help exporters.
Workers Don’t Benefit from Devaluation
If domestic cost, mostly labor, does not adjust to the higher import prices resulting from the depreciation, exporters will gain, but this gain comes from reducing the real incomes of domestic workers. If these workers ultimately negotiate an increase in nominal wages to bring their real wages back up to before the depreciation, the gain to exporters will disappear. The depreciation has created only a temporary gain.
Few journalists seem to understand that a policy to reduce the foreign exchange value of a currency is, in reality, a policy to transfer wealth from workers — the middle class and the poor — to the wealthier owners of export industries. It is another example of the central bank acting as a reverse Robin Hood, taking from the have-nots to give to the haves.
Furthermore, there are many other indirect effects that make depreciating your currency a very bad policy objective. Mises explained that standard balance-of-payment accounting cannot be used when the unit of account is being distorted. Even if exporters are more profitable, this is not something to cheer if a higher nominal profit means lower real profit.
Of course, other economic actors are also hurt by a beggar-thy-neighbor policy. Consumers will bear the brunt of higher prices on foreign products. Domestic firms who import their inputs and sell on the domestic market will also likely be hurt.
Distorting Prices Hurts an Economy
A depreciating currency reflects a country’s central bank printing money faster than its neighbors. Yet, this printing hurts all firms, including exporters. Printing money alters absolute and relative prices. It interferes with the critical signals that prices send across time about what and how society wants goods and services to be produced.
What Europe needs is not a weaker euro, but significant structural reform. Europe should learn from Latvia’s experience with reform. In 2009–2010, Latvia cut government spending from 44 percent of GDP to 36 percent. It fired 30 percent of the civil servants, closed half the state agencies, and reduced the average public salary by 26 percent in one year. Government ministers took personal wage cuts of 35 percent. The Latvian economy initially dropped 24 percent, but rebounded sharply with yearly real growth of nearly 5 percent over the last three years. Yet, Latvia did this without using currency as a weapon since it kept its former currency, the lats, fixed against the euro.
ON THE ECONOMY: MY BEAUTIFUL BALLOON
Would you like to ride in my beautiful balloon? Would you like to glide in my beautiful balloon? We could flow among the stars, together you and I, for we can fly, up, up and away (for we can fly) in my beautiful, my beautiful balloon. The world’s a nicer place in my beautiful balloon. It wears a nicer face in my beautiful balloon. We can sing a song and sail along the silver sky, for we can fly, up, up and away (for we can fly) in my beautiful, my beautiful balloon. When the 5th Dimension sung this Jimmy Webb song in 1967, it soared to number 10 on the charts. That year, the rate of inflation in the United States was 4.19 percent, more than double last year’s rate of 1.6 percent.
As someone who grew up in the 1970s, inflation in the United States was reaching levels that had not been experienced since the Second World War. In fact, the 1970s represented the height of inflation sparked, in part, by the Vietnam War and mirrored spikes that occurred during other periods of conflict. The chart (gratefully stolen from Oregon State University) shows estimated inflation in the US going back to Revolutionary times.
As the chart shows, there have been periods of hyperinflation in America, as well as long stretches of what today might be called “deflation.” In fact, the post war period is the only time in U.S. history that the country has experienced sustained inflation over the long term.
Today, it seems that policy makers are more concerned about deflation, or falling prices than they are about inflation. This concern stems mainly from the fact that virtually all economists today are mired in Keynesian economic theory that – in a nutshell – suggests that all that matters in an economy is spending. This differs from the more classical understanding about economics where production drives economic activity.
The effect of this doctrinal approach to economic theory is that economic policies have been designed to encourage consumption over production, and as always when demand outstrips supply, prices rise. In other words, there is inflation.
Historically, as the chart shows, periods of inflation have been matched by periods of falling prices as the economy goes through its normal cycles of ebb and flow. The Federal Reserve (and for that matter other central banks) has helped create steady-stream nominal (or monetary) inflation through a steady debasing of the currency. In other words, through what is now styled as Quantitative Easing, or by printing more dollars, the Federal Reserve pulls down the price of currency through the process of supply and demand.
In general, monetary inflation does not really matter in an economy since all prices will rise in concert with each other. Keynes himself was basically indifferent to the idea of inflation. He concluded that the economy was driven by consumption, mild inflation would encourage borrowing – and therefore consumption – since lenders would be paid back with less valuable dollars in the future.
American fiscal, tax and monetary policy has been designed to encourage debt, and today, after an extended period of constant inflation, we are awash in it. And the government itself is one of the largest debtors. As inflation rises, the value of the dollars used to pay the debt back fall and debtors benefit at the expense of creditors. Currently, the Federal government owes about 55 percent of the nation’s overall debt so there is good reason why the government wants to see higher inflation. If “deflation” were to occur, the national debt in real terms will grow significantly, limiting the government’s ability to borrow and spend.
In terms of the real economy, where people produce something, earn wages and then spend those wages on goods and services, deflation is generally meaningless. Wages have been falling in real terms for years, and were they to fall in nominal terms along with falling prices, there would be no impact on what people could buy and how they live. Debtors would be impacted, and as the cost of debt rises, they would have less to spend on other things, but lenders would benefit since they would be paid back in more valuable dollars.
More often than not, public policy is about deciding who will be winners and who will be losers. When politicians can disguise these decisions with beautiful balloons then that is exactly what they will do.
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