October 16, 2014 | Commentary on Economy, Recession and Recovery, Economic Growth

Let's Fully Devalue the Devaluation Idea, Once and For All

Many bad ideas survive as urban legends. No field is immune, economics included.

The list goes on: Unions care more about consumers than about their own members. Minimum wage laws don’t raise the cost of hiring low-skilled workers. Keynesian stimulus policies have worked wonders in the past. And so on.

The latest bad idea that refuses to die is that countries should devalue their currencies to revive their economies. A new Wall Street Journal article notes:

“The world’s export engines are sputtering, putting new pressure on many nations to weaken their currencies to jump-start their economies.”

The timing of this article coincides with the annual meetings of the IMF and the World Bank, where “finance ministers and central bankers will spur each other to counter threats to growth.”

Skeptics may wonder why these policymakers didn’t think of this earlier, to prevent growth from sputtering in the first place. That bewilderment is more than a quibble.

There are many historical examples, stretching at least to the Great Depression, which show currency devaluations tend to go hand-in-hand with economic turmoil. (One NBER paper provides a list of 48 devaluations that took place during the Bretton Woods era; on balance, they were not wildly successful.)

We also have the recent devaluation efforts of the UK and Russia, neither of which has spurred economic growth. There are too many details on this issue to fit in one column, but interested readers can get additional information from one of several NBER papers.

Nonetheless, the main problem is that devaluation robs citizens of their purchasing power.

If the U.S. government devalued the dollar, for example, it would reduce the value of each and every dollar earned by U.S. workers and every dollar saved by U.S. retirees.

There’s more to this story, as noted above, but it’s generally not a good idea to make people poorer.

To see exactly how a devaluation might take place, it’s helpful to look at what happens to the relative value of currencies, or exchange rates.

Assume that a Venezuelan can use 4 units of that country’s currency, the bolívares, to get 1 U.S. dollar. Then, for whatever reason, the situation changes so that we have to use 6 bolívares to get $1.

In the language of international economics, the bolívares has gotten weaker. That is, Venezuelans need more of their currency to get U.S. dollars. The flip side is that the U.S. dollar has gotten stronger relative to the bolívares.

That is, U.S. citizens can now get more bolívares for their dollar. This fact means that exports from Venezuela to the U.S. are cheaper than they were before the exchange rate changed.

There’s nothing controversial here — it’s a basic change in value. If left alone, we can expect exchange rates to change in either direction for various reasons, such as supply and demand in any particular country.

But a policy of deliberately weakening a country’s currency — devaluation — greatly abuses the logic in this example. For starters, the idea that a country can boost exports through devaluation is utter folly because it leaves out the importers.

All 20 OECD countries, for example, could not possibly boost their exports at the same time, through devaluation or any other policy, because there would be nobody left to import all those goods. In this sense, the notion of boosting exports through devaluation is nothing more than the wrong-headed notion that exports are good, but imports are bad.

The truth is that trade is good, and barriers to trade are bad. We shouldn’t enact policies that hinder people from buying and selling goods and services as needed.

Another problem with the devaluation idea is that it ignores the possibility of retaliation. If countries buy into the devaluation logic, then they have no choice but to try to offset the moves of trading partners that devalue.

If China devalues 5 percent against the U.S., wouldn’t the U.S. simply devalue by 5 percent in return? Otherwise, based on this devaluation policy, the U.S. would suffer. This sort of tit-for-tat devaluation would be counterproductive, to say the least.

There are also some practical problems. First, only leaders of countries with fixed exchange rates can make the official rate whatever they want it to be. Countries such as Germany and the U.S., on the other hand, can’t simply switch to a new exchange rate because their currencies’ exchange rate is not fixed.

For countries with these floating, rather than fixed, exchange rates, the next best option is to intervene in currency markets and/or to “talk” their currencies down. The U.S. Treasury, for instance, might try to sell U.S. dollars and buy British pounds in an effort to devalue the dollar against the pound. They may also then publicly praise the weaker dollar.

Aside from adding to international diplomacy difficulties (the IMF charter prohibits manipulating exchange rates to gain an advantage over other members), it’s at least questionable whether one country could sustain such an intervention to have a meaningful impact on a global market.

Regardless, the entire premise is built upon making some people worse off at the expense of others. Foreign goods will cost more, so people’s standard of living will decline.

Recent events in Venezuela are just one example. The Economist noted in 2013:

“Venezuelans lined up to purchase airline tickets and TVs this weekend in a bid to protect themselves from price increases after ailing President Hugo Chavez devalued the bolivar for a fifth time in nine years.”

Under this sort of policy, people quickly realize that they have to purchase items sooner rather than later to avoid paying higher prices. Thus, a sort of inflationary spiral frequently takes hold — devaluation leads to high inflation, high inflation causes a country’s exports to become less competitive on world markets, the country further devalues to make exports more competitive, and so on.

A less dramatic example — China — suggests that devaluation policies simply cannot overtake global market forces. The dollar–Chinese yuan exchange rate was virtually unchanged from 1995 to 2005, but China’s exports to the U.S. increased six-fold during this period.

The value of currencies frequently changes when compared to other currencies, and those changes typically make some goods more or less attractive than others. But there’s no reason to think policymakers can exploit these facts to consistently improve their economies.

In fact, there’s good evidence that devaluation policies tend to turn out badly. A much better option would be for governments to eliminate tax, trade and regulatory burdens that make it harder for their citizens to compete internationally.

 - Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

Originally appeared in Forbes