- Currency Devaluation and Economic Growth / Artikel mises.org - - Elli -, 03.10.2003, 15:19
Currency Devaluation and Economic Growth / Artikel mises.org
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<font face="Verdana" size="2"><font color="#002864" size="5"><strong>Currency Devaluation and Economic Growth</strong></font>
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<font face="Verdana, Helvetica" size="4">By Frank Shostak</font>
<font face="Verdana, Helvetica" size="2">[Posted October 3, 2003]</font>
<font face="Verdana, Helvetica" size="2">A September 21 announcement by the
G-7 finance ministers endorsed less intervention in the foreign exchange
market, and triggered a large sell-off of the US dollar. On the day of the
announcement, in relation to the end of August, the US currency fell by 4.8%
against the Euro and 4.1% against the Yen.</font>
<font face="Verdana, Helvetica" size="2">Many economists have suggested
that the weakening in the US dollar could actually be good for the
economy—since a weaker dollar will boost manufacturing production, which in
turn will lift employment and all this will set in motion economic growth. It
follows then that the US dollar devaluation is exactly what is needed to keep
the US economy going.</font>
<p align="center"><font face="Verdana, Helvetica" size="2"><img alt src="http://www.mises.org/images3/NYOTB.gif" border="0" width="469" height="317"></font>
<strong><font face="Verdana, Helvetica" size="2">The popular way of
thinking</font></strong>
<font face="Verdana, Helvetica" size="2">According to popular thinking the
key to economic growth is demand for goods and services. It is held that
increases in demand for goods and services gives rise to economic growth by
triggering the production of goods and services. Increases or decreases in
demand for goods and services are behind rises and declines in the economy's
production of goods. Hence in order to keep the economy going economic
policies must pay close attention to overall demand.</font>
<font face="Verdana, Helvetica" size="2">Now, part of the demand for
domestic products emanates from overseas. The accommodation of this demand is
labeled exports. Likewise, local residents exercise demand for goods and
services produced overseas, which is labeled imports. Note that while an
increase in exports gives rise to overall demand for domestic output, an
increase in imports weakens demand. Hence exports, according to this way of
thinking, are a factor that contributes to economic growth while imports are a
factor that detracts from the growth of the economy.</font>
<font face="Verdana, Helvetica" size="2">Because overseas demand for a
country's goods and services is an important ingredient in setting the pace of
economic growth, it makes sense to make locally produced goods and services
attractive to foreigners. One of the ways to make domestically produced goods
more in demand by foreigners is by making the prices of these goods more
attractive.</font>
<font face="Verdana, Helvetica" size="2">For instance, the price of an
identical bag of potatoes in the US is $10 and 10 Euros in Europe. Also, the
exchange rate between the US dollar and the Euro is 1:1 i.e. one-to-one.
At the exchange rate of 1 Euro to $1 a European can get for his 10 Euro one
American bag of potatoes.</font>
<font face="Verdana, Helvetica" size="2">One of the ways of boosting their
competitiveness is for Americans to depreciate the US dollar against the
Euro. Let us assume that in response to a Fed announcement that it will
drastically loosen its monetary stance, the rate of exchange falls to 0.5 Euro
per $1. Consequently, this will mean that $10 is now worth 5 Euro, which in
turn implies that an American bag of potatoes in Europe is offered for 5 Euro.
Consequently, a European can now purchase for 10 Euro two American bags of
potatoes instead of one before the depreciation of the US dollar. In other
words, the purchasing power of Europeans with respect to American potatoes has
doubled.</font>
<font face="Verdana, Helvetica" size="2">If we were to apply the potatoes
example to all goods and services, one can reach the conclusion that as a
result of currency depreciation, all other things being equal, the overall
demand for domestically produced goods is likely to increase. This in turn
will give rise to a better balance of payments and in turn to stronger
economic growth. Observe that to lift foreigners' demand, Americans are now
effectively offering two bags of potatoes for one European bag of potatoes.
This also means that the price of the European bag of potatoes in the US is
now twice what it was before the depreciation of the US dollar.
This most likely will lower American's demand for European potatoes. What we
have here, as far as the US is concerned, is more exports and fewer imports,
which according to mainstream thinking is great news for economic growth.</font>
<font face="Verdana, Helvetica" size="2">Equally, at the original exchange
rate of 1:1 a reduction in the domestic price of US potatoes from $10 to $5
would also enable a European to exchange his 10 Euro for two bags of potatoes.
In short, changes in the exchange rate or changes in prices in respective
countries will determine so-called international competitiveness, which is
also labeled as the real exchange rate. This can be summarized as:</font>
<p align="center"><em><strong><font face="Verdana, Helvetica" size="2">Real
exchange rate = (domestic prices/foreign prices)*exchange rate</font></strong></em>
<font face="Verdana, Helvetica" size="2">The <em>exchange rate</em> is the
number of foreign currency per unit of local currency.</font>
<font face="Verdana, Helvetica" size="2">According to this expression, a
fall in the real exchange rate implies growing competitiveness and a rise
means falling international competitiveness. Hence, following this expression,
currency depreciation (a fall in the number of foreign currency exchanged per
local currency) will lead to a fall in the real exchange rate and thus to an
increase in international competitiveness.</font>
<font face="Verdana, Helvetica" size="2">A fall in foreign prices, however,
will lift the real exchange rate and therefore reduce competitiveness. In this
way of thinking, it is quite clear that currency depreciation—all other
things being equal—is beneficial for economic growth.</font>
<font face="Verdana, Helvetica" size="2">For instance, in their research
study of the Mexican economy, Dornbusch and Werner have concluded that:"If
the currency is not devalued, growth will not keep pace with the growth of the
labor force; the divisions in Mexican society will widen; and national
stability will be threatened."</font><a id="_ftnref1" href="http://www.mises.org/fullstory.asp?control=1345#_ftn1" name="_ftnref1"><font face="Verdana, Helvetica" size="2">[1]</font></a>
<font face="Verdana, Helvetica" size="2">Furthermore, according to
Dornbusch and Werner,"…recent major devaluations in Finland, Sweden,
Italy, Spain and the United Kingdom did not lead to inflation—in fact, it
has come down, as have interest rates. Devaluation was a boon to these
countries."</font><a id="_ftnref2" href="http://www.mises.org/fullstory.asp?control=1345#_ftn2" name="_ftnref2"><font face="Verdana, Helvetica" size="2">[2]</font></a>
<font face="Verdana, Helvetica" size="2">It seems that the message conveyed
by the real exchange rate equation tends to confirm the experience in the US.
Thus since 1999 US competitiveness viz. Japan has been steadily falling. The
real exchange rate, which stood at 138 in November 1999 jumped to 176 in
August 2003. The fall in competitiveness during this period was associated
with a sluggish economy. In short, the data seems to support the view that a
rising real exchange rate may be an important contributing factor to currently
subdued economic growth.</font>
<font face="Verdana, Helvetica" size="2">Moreover, our statistical analysis
indicates that the lagged growth momentum of the real exchange rate displays
good visual inverse correlation with the growth momentum of industrial
production. An increase in the growth momentum of the real exchange rate (deterioration
in US competitiveness) is followed by a fall in the growth momentum of
industrial production. A fall in the growth momentum of the real exchange rate
(improvement in US competitiveness) is followed by an increase in the growth
momentum of industrial production.</font>
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<font face="Verdana, Helvetica" size="2">It seems, therefore, that it makes
a lot of sense to depreciate the US dollar in order to revive the economy.</font>
<strong><font face="Verdana, Helvetica" size="2">Why boost in exports due
to currency depreciation cannot grow the economy</font></strong>
<font face="Verdana, Helvetica" size="2">When a central bank announces a
loosening in its monetary stance, this leads to a quick response by the
participants in the foreign exchange market through selling the domestic
currency in favor of other currencies, thereby leading to domestic currency
depreciation. In response to this, various producers now find it more
attractive to boost their exports. In order to fund the increase in production,
producers approach commercial banks, which on account of a rise in central
bank monetary pumping are happy to expand their credit at lower interest rates.</font>
<font face="Verdana, Helvetica" size="2">By means of new credit producers
can now secure resources required to expand their production of goods in order
to accommodate growing overseas demand. In other words, by means of newly
created credit producers divert real resources from other activities. As long
as domestic prices remain intact, exporters will record an increase in profits.</font>
<font face="Verdana, Helvetica" size="2">However, the so-called improved
competitiveness on account of currency depreciation means that the citizens of
a country are now getting less real imports for a given amount of real exports.
In short, while the country is getting rich in terms of foreign currency, it
is getting poor in terms of real wealth, i.e., in terms of the goods and
services required for maintaining peoples' life and well-beings. As time goes
by however, the effects of loose monetary policy filters through a broad
spectrum of prices of goods and services and ultimately undermine exporters
profits. In short, a rise in prices puts to an end the illusory attempt to
create economic prosperity out of thin air. According to</font> <font face="Verdana, Helvetica" size="2">Ludwig
von Mises</font><font face="Verdana, Helvetica" size="2">,</font>
<font face="Verdana, Helvetica" size="2">The much talked about advantages
which devaluation secures in foreign trade and tourism, are entirely due to
the fact that the adjustment of domestic prices and wage rates to the state
of affairs created by devaluation requires some time. As long as this
adjustment process is not yet completed, exporting is encouraged and
importing is discouraged. However, this merely means that in this interval
the citizens of the devaluating country are getting less for what they are
selling abroad and paying more for what they are buying abroad;
concomitantly they must restrict their consumption. This effect may appear
as a boon in the opinion of those for whom the balance of trade is the
yardstick of a nation's welfare. In plain language it is to be described in
this way: The British citizen must export more British goods in order to buy
that quantity of tea which he received before the devaluation for a smaller
quantity of exported British goods.</font>
<font face="Verdana, Helvetica" size="2">Contrast the policy of currency
depreciation with a conservative policy where money is not expanding. Under
these conditions, when the pool of real wealth is expanding, the purchasing
power of money will follow suit. This, all other things being equal, will lead
to currency appreciation. With the expansion in the production of goods and
services and falling prices and thus production costs, local producers can
improve their competitiveness and profitability in overseas markets while the
currency is actually appreciating. Within the framework of loose monetary
policy exporters' temporary gains are at the expense of other activities in
the economy, within the framework of a tight monetary stance gains are not at
any one's expense but just the manifestation of real wealth generation.</font>
<strong><font face="Verdana, Helvetica" size="2">Can currency depreciation
take place in a free market?</font></strong>
<font face="Verdana, Helvetica" size="2">The entire issue of the alleged
benefits of currency depreciation is only of relevance in a hampered market
where paper money is enforced by the government through its central bank. In a
free-market economy, there cannot be such a thing as currency depreciation,
which supposedly can grow the economy.</font>
<font face="Verdana, Helvetica" size="2">Within the free market, there
cannot be currency depreciation as such. Since in a true free-market economy
money is gold, there cannot be an independent entity such as a"dollar."
Prior to 1933, the name"dollar" was used to refer to a unit of gold
that had a weight of 23.22 grains. Since there are 480 grains in one ounce,
this means that the name dollar also stood for 0.048 ounce of gold. This in
turn, means that <em>one ounce of gold</em> referred to <em>$20.67</em>. Now, <em>$20.67</em>
is not the price of one ounce of gold in terms of dollars as popular thinking
has it, for there is no such entity as a dollar. <em>Dollar</em> was just a
name for 0.048 ounce of gold. On this Rothbard wrote,"No one prints
dollars on the purely free market because there are, in fact, no dollars;
there are only commodities, such as wheat, cars, and gold.</font><a id="_ftnref3" href="http://www.mises.org/fullstory.asp?control=1345#_ftn3" name="_ftnref3"><font face="Verdana, Helvetica" size="2">[3]</font></a>
<font face="Verdana, Helvetica" size="2">Likewise, the names of other
currencies stood for a fixed amount of gold. The habit of regarding these
names as a separate entity from gold emerged with the enforcement of the paper
standard. Over time, as paper money assumed a life of its own, it became
acceptable to set the price of gold in terms of dollars, francs, pounds, etc.
The absurdity of all this reached new heights with the introduction of the
floating-currency system.</font>
<font face="Verdana, Helvetica" size="2">In a free market, currencies do
not float against each other. They are exchanged in accordance with a fixed
definition. If the British pound stands for 0.25 of an ounce of gold and the
dollar stands for 0.05 ounce of gold, then one British pound will be exchanged
for five dollars. This exchange stems from the fact that 0.25 of an ounce is
five times larger than 0.05 of an ounce, and this is what the exchange of
5-to-1 means.</font>
<font face="Verdana, Helvetica" size="2">In other words, the exchange rate
between the two is fixed at their proportionate gold weight, i.e., one British
pound = five US dollars. The absurdity of a floating currency system is no
different from the idea of having a fluctuating market price for dollars in
terms of cents. How many cents equal one dollar is not something that is
subject to fluctuations. It is fixed forever by definition.</font> <a id="_ftnref4" href="http://www.mises.org/fullstory.asp?control=1345#_ftn4" name="_ftnref4"><font face="Verdana, Helvetica" size="2">[4]</font></a>
<font face="Verdana, Helvetica" size="2">The present floating exchange rate
system is a byproduct of the previously discredited Bretton Woods system of
fixed currency rates of exchange, which was in operation between 1944 to 1971.
Within the Bretton Woods system the US dollar served as the international
reserve currency upon which all other currencies could pyramid their money and
credit. The dollar in turn was linked to gold at $35 per ounce. Despite this
supposed link to gold, only foreign governments and central banks could redeem
their dollars for gold.</font>
<font face="Verdana, Helvetica" size="2">A major catalyst behind the
collapse of the Bretton Woods system was the loose monetary policies of the US
central bank which pushed the price of gold in the gold market above the
official $35 per ounce. The price, which stood at $35/oz in January 1970
jumped to $43/oz by August 1971 - an increase of almost 23%. The growing
margin between the market price of gold and the official $35 per ounce (see
chart) created enormous profit opportunity, which some European central banks
decided to exercise by demanding the US central bank redeem dollars for gold.</font>
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<font face="Verdana, Helvetica" size="2">Since Americans didn't have enough
gold to back up all the printed dollars, they had to announce effective
bankruptcy and cut off any link between dollar and gold as of August 1971. In
order to save the bankrupt system policymakers have adopted the prescription
of Milton Friedman to allow a freely floating standard.</font>
<font face="Verdana, Helvetica" size="2">While in the framework of the
Bretton Woods system the dollar had some link to the gold and all the other
currencies were based on the dollar, all that has now gone. In the floating
framework there are no more limitations on money printing. According to</font>
<font face="Verdana, Helvetica" size="2">Murray
Rothbard</font><font face="Verdana, Helvetica" size="2">:</font>
<font face="Verdana, Helvetica" size="2">One virtue of fixed rates,
especially under gold, but even to some extent under paper, is that they
keep a check on national inflation by central banks. The virtue of
fluctuating rates—that they prevent sudden monetary crises due to
arbitrarily valued currencies—is a mixed blessing, because at least those
crises provided a much-needed restraint on domestic inflation.</font>
<font face="Verdana, Helvetica" size="2">Through policies of coordination,
central banks maintain synchronized monetary pumping so as to keep the
fluctuations in the rate of exchanges as stable as possible. Obviously, in the
process such policies set in motion, a persistent process of impoverishment
through consumption is not backed up by production of real wealth.</font>
<font face="Verdana, Helvetica" size="2">Furthermore, within this framework,
if a country tries to take advantage and depreciate its currency by means of a
relatively looser monetary stance this runs the risk that other countries will
do the same. Consequently, the emergence of competitive devaluations is the
surest way of destroying the market economy and plunging the world into a
period of crisis.</font>
<font face="Verdana, Helvetica" size="2">On this </font> <font face="Verdana, Helvetica" size="2">Mises
wrote</font><font face="Verdana, Helvetica" size="2">,"A general
acceptance of the principles of the flexible standard must therefore result in
a race between the nations to outbid one another. At the end of this
competition is the complete destruction of all nations' monetary
systems."</font>
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<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Frank Shostak is
an adjunct scholar of the Mises Institute and a frequent contributor to
Mises.org. Send him </font> <font face="Verdana, Helvetica" size="2">MAIL</font><font face="Verdana, Helvetica" size="2"> and
see his outstanding Mises.org</font> <font face="Verdana, Helvetica" size="2">Daily
Articles Archive</font><font face="Verdana, Helvetica" size="2">. Special
thanks to Michael Ryan for his comments.</font>
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<a id="_ftn1" href="http://www.mises.org/fullstory.asp?control=1345#_ftnref1" name="_ftn1"><font face="Verdana, Helvetica" size="2">[1]</font></a><font face="Verdana, Helvetica" size="2"> Dornbusch
R. and Werner A. 1994."Mexico, stabilization. Reform and no
growth," Brookings Papers on Economic Activity, Vol 1, pp, 253-315.</font>
<a id="_ftn2" href="http://www.mises.org/fullstory.asp?control=1345#_ftnref2" name="_ftn2"><font face="Verdana, Helvetica" size="2">[2]</font></a><font face="Verdana, Helvetica" size="2"> Ibid.</font>
<a id="_ftn3" href="http://www.mises.org/fullstory.asp?control=1345#_ftnref3" name="_ftn3"><font face="Verdana, Helvetica" size="2">[3]</font></a><font face="Verdana, Helvetica" size="2"> Murray
N. Rothbard."The Case for a Genuine Gold Dollar," in Llewellyn H.
Rockwell, Jr., <em>The Gold Standard: An Austrian Perspective</em> (Lexington,
Mass: D.C. Heath, 1985), pp. 1-17.</font>
<a id="_ftn4" href="http://www.mises.org/fullstory.asp?control=1345#_ftnref4" name="_ftn4"><font face="Verdana, Helvetica" size="2">[4]</font></a><font face="Verdana, Helvetica" size="2"> Ibid.
</font></font>
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