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Devaluation: a fool’s errand

Devaluation/inflation When a country devalues its currency it sets into motion a series of events that can ...
Published May 10, 2022
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When a country devalues its currency it sets into motion a series of events that can literally last for decades. Holders of the newly devalued currency quickly lose faith in the willingness of Government to hold firm on the new currency value and start to move money holding out of the devalued currency. This substitution of monies in demand is called “hot money” or “currency flight”.

The devaluing country is instantaneously set upon by inflation as domestic prices quickly rise to restore balance with foreign products following the devaluation. Devaluations per se are everywhere and at all times offset by an identical rise in the prices of goods as measured in the devaluing country’s currency vis-à-vis prices in currencies against which the devaluation took place.

The resultant inflation has a number of nasty fiscal effects that greatly impede output, employment and production. Progressive tax codes in nominal income mean that inflation pushes businesses and individuals into higher tax brackets with higher marginal tax rates. Illusory capital gains resulting from inflation are taxed. Pricing procedures become unfathomable. Price controls and subsidized government pricing throw commerce into disarray. Unexpected inflation throws the debt market out of whack as well and causes credit contraction of enormous proportions and lastly, high and erratic inflation causes widespread withdrawal from all financial markets as risk aversion in the face of ignorance takes control of everyday business dealings. Expenses for conserving cash becomes significant. In the extreme, domestic money loses its “moniness” and the economy reverts to barter.

Devaluation/trade balance

Devaluations simply lead to a full offsetting change in nominal prices and no change in the trade balance. In other words, a devaluing country can expect no changes in real output but will experience an increase in inflation. The idea that devaluations make a country’s goods more “competitive” is pure gold to heads of states. 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. All that is missing for this panacea is a generalized cure for all disease. Governments have also believed that changing the value of their country’s currency will, in some way, go unnoticed internally and externally and that the forces of the market will somehow be blind to their currency interventions; they believe, in essence, that they can, change the terms of trade at will. It is truly astonishing that highly educated people consigned with their nations trust can assume that they have the power to change a market price without shifting either demand or supply. But, the assumptions go even deeper than relating currency changes with changing the terms- of-trade. Once the new terms-of-trade have been set, there is a universal presumption that markets will respond accordingly, and that the devaluing country’s exports will increase, imports will decline, and that total employment in the devaluing country will rise.

Devaluations per se lead to fully offsetting price changes. The increase in price level of the devaluing country’s currency less the increase in the price level of the currencies against which the first currency was devalued will exactly equal the devaluation. All that devaluations will cause is offsetting inflation.

This alternative view of devaluations predicts that devaluations do not improve a country’s trade balance. Because normal prices will adjust and real prices will remain unchanged. The devaluing nation will not gain a competitive advantage. With the available data on the effects of devaluations, in fact, one would be hard pressed to find much of a relationship at all between exchange rate changes and trade balance.

Similarly, the alternative view predicts that a devaluing nation will suffer rapid inflation relative to the rest of the world. Its nominal price levels will have to increase rapidly to restore the original relationship of real prices with real prices elsewhere in the world. This effect, of course, does not depend on the actual flow of goods from one nation to another. One can also notice the precise opposite price effects when a country revalues. While the price effects of exchange rate changes are more distinct using wholesale prices, they are still quite evident using the less volatile consumer prices even over long period of time, the relationship between exchange rate changes and relative rates of inflation remains remarkably close.

The trade balance, like many other economic indicators, responds both predictably and in a logical way to the overall economic environment.

Using gimmicks to alter the trade balance is to a large extent futile, and perhaps even mischievous.

Copyright Business Recorder, 2022

Arthur B Laffer

The writer is the founder and chairman of Laffer Associates, an economic research firm that has provided global investment —research services since 1979. His economic acumen and influence in triggering a worldwide tax cutting movement in the 1980s have earned him the distinction in many publications as “The Father of Supply-Side Economics”


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