#27 The never-ending dream
Currency depreciation to gain competitiveness. For the umpteenth time, it doesn’t work.
For another week the Euro has touched all time lows against the Dollar or the Swiss franc. These depreciations are normally welcomed by governments as an opportunity for local industries to become more competitive and grow. Once again, politicians do not want to see further than next elections apart. We are discussing today the impacts that currency depreciations and devaluations have in an economy, not looking only on the short term effects, but on the long term ones.
But first one off-topic. During the last 2 months, this newsletter has grown substantially at rates over 20% week over week. Even from the low levels we started, we have passed quite substantially the 1000 subscribers milestone. This was completely unexpected. My goal was, and is, to put my thoughts together. Nevertheless, happy to contribute with my two cents and thanks for being there.
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By A. Valverde
Devaluation and depreciation are two processes by which a currency loses value with respect to others. However, there is a fundamental difference between the two of them. Devaluation is defined as the deliberate reduction of a currency’s value, occurring when a country decides to lower its exchange rate in a fixed or semi-fixed exchange rate. Depreciation happens when there is a fall in the value of a currency in a floating exchange rate, as a consequence of the economic decisions made by the authorities in that economic area as well as in the competing ones.
In June 2021, over 1.2 US dollars were required to buy 1 euro. In July 2022, after an unsteady depreciation of the euro, parity was reached. Many advocate the benefits of this situation for the European economy, while others warn of the impoverishment this brings upon European citizens. Is there any truth to either of these statements?
The onset
After Richard Nixon effectively brought the Bretton Woods system to an end in 1971, national currencies lost their only remaining link, albeit indirect, to gold. Governments suddenly found themselves completely free to manipulate the value of their citizens’ money at will, always ready to take a fake shortcut to prosperity instead of enacting effective economic reforms. There are numerous examples throughout the globe in the last 50 years, like the successive devaluations the French franc, the Spanish peseta or the Italian lira underwent in the 80s and 90s, being unable to keep up with the Deutsche Mark. Every time these events took place, the media repeated unceasingly that the industry from the country with the devalued currency was now more competitive than before, whereas German products had lost appeal in international markets.
The goal was to compete on price by using a devalued currency. Although it can seem like a good idea, competing in quality eventually prevails. And so it happened that consumers everywhere continued purchasing expensive German cars (in DM) over their French or Spanish counterparts (in cheaper currencies), because their perceived quality was high enough to pay the price. In a similar fashion, Swiss products are highly demanded in spite of their price and the strong currency they have to be paid in.
For the better part of the 21st century, China has purposefully kept the value of its currency artificially low. Given its immense and ongoing trade surplus with the USA, the dollar should have gone down with respect to the renminbi. In spite of this, the Chinese administration went out of its way to prevent it from happening, the reason being they did not want to lose competitiveness and affect their growth by reducing exports.
It is a common misconception that when a nation’s currency loses value, be it by devaluation or depreciation, results are positive for its economy. It is said that, after happening, exports increase and imports decrease. On the one hand, exporters seem to see their situation improve overnight, since the currency they are being paid with is suddenly cheaper to the rest of the world. On the other hand, consumers suddenly find foreign goods more expensive, so they turn to local producers to buy what they used to import, therefore adding up to the development of the national industry. In both cases, unemployment tends to decrease and the economy moves forward. Simple, isn’t it? Rather simplistic.
In his masterpiece Economics in one lesson, Henry Hazlitt elaborates on how the art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy, as well as tracing the consequences of that policy not merely for one group but for all groups. The idea is based on Frédéric Bastiat's essay Ce qu'on voit et ce qu'on ne voit pas (That which is seen and that which is not seen). And looking at short- and long-term effects on every group is precisely what we are going to do.
Analysis of the facts
First of all, let us focus on consumers. They are without a shadow of a doubt worse off after the currency depreciation. If we look at their savings in cash, today they are worth less than yesterday, and the lost value is not coming back. If we focus on their consumption expenditure, it is suddenly not enough to satisfy their needs to the same degree as before. They now have to lower their consumer standards one way or another. Either they consume the same goods in smaller quantities or they consume alternative goods they value less. On every front they are worse off. Having said that, the situation with producers is not as clear as with consumers. As we have seen, it might look like currency depreciation only poses advantages, but this is not true. If anything, it benefits uncompetitive producers and damages the rest.
Producers can be divided into those who sell inside their country (local sellers) and those who sell abroad (exporters). First and foremost, regardless of where they sell, producers act in most cases as importers as well. They need inputs from abroad (raw material, components, energy, etc.). In the rare case they purchase everything within the borders of their country, their suppliers will likely get at least a share of their inputs from abroad. If some link in the supply chain sees the prices of its inputs increase, every output from there on will also see its price increase. And this increase will eventually reach the exporter that buys everything locally. This way, currency depreciation results in higher prices not only for foreign goods, but also for local ones. It turns out local products are not as cheap as it was expected, despite the reduction in the currency’s value. Local sellers see their costs increase without the purchasing power of their customers having done the same, which means their businesses are negatively affected.
We have just seen how currency depreciation harms some producers, specifically those who do not export. Then again, we might think exporters are better off with it. If the price hike in their inputs is lower than the rise in revenue after the depreciation, they will be happy about it, right? In the short term, yes, they might earn more without having had to adjust. In a nutshell, they will be stealing value from the rest of the society for their sole benefit, given that consumers would not provide them this value willingly. In the long term, however, they might be worse off. Maintaining the value of the currency means they have to find out better ways to become competitive. A reduction in the currency’s value, whatever form it takes, acts like a drug that hinders this process. Competitiveness can be improved via lower prices/costs, or via higher productivity. By resorting to devaluation/depreciation, I may look more competitive with respect to my foreign peers, since I am cheaper now, but I won’t be one bit more productive.
We must not lose sight of the issue here: these exporters cannot compete in a free-market environment. Others produce more efficiently, and so their products can be offered at a higher quality-price ratio. Consumers tend to prefer these producers, regardless of where they are established (in their country or abroad). Inefficient producers, for their part, will prefer depreciation to undergoing a business restructuring to improve their productivity.
Government groping the currency
Let us picture two imaginary countries, called Mediterranean Land and Teutonic Land, whose currencies are subject to a fixed exchange rate. The government in Mediterranean Land is addicted to devaluation, whereas the central bank in Teutonic Land does everything it can to keep the value of its currency stable. Given these circumstances, companies in Teutonic Land have incentives to be more productive than those in Mediterranean Land, because their authorities do not alter the value of the currency regardless of the state of the economy. In a balanced situation, consumers in both countries tend to buy more goods from Teutonic Land, since the quality-price ratio of their products is higher, and therefore purchasers are able to get more/better goods for the same price, or the same goods at a lower price.
If no monetary intervention ever took place, companies in Mediterranean Land would sooner or later have to adapt their manufacturing methods and/or improve their processes to increase their productivity and eventually match that of their peers in Teutonic Land. Nonetheless, as we know, governments are short-sighted, so as soon as the leaders from Mediterranean Land see disappointing metrics, they will act devaluing their currency. For the sake of the example, let us say they implement a 50% devaluation. Over the weekend, the currency of Mediterranean Land will come to be worth half of what it used to. Suddenly, consumers in Teutonic Land are able to buy twice as many goods from Mediterranean Land as before (for simplicity reasons, we ignore other influences on prices). Conversely, consumers in Mediterranean Land can only get from Teutonic Land half of what they used to with the same money. This will shift consumption in both countries towards goods from Mediterranean Land, whose producers are comparatively inefficient, and will harm the profit-and-loss accounts of the more efficient producers in Teutonic Land.
In this situation, what incentive is there to produce more with fewer resources? The miracle of free-market capitalism is it establishes a framework that fosters innovation and increases the productivity of all agents. We have shown how it affects companies. However, individuals also benefit from it. Being able to spend less and less money over time effectively implies not only that people have higher purchasing power, but also higher saving power and investing power, which generates more wealth for the whole society in the long term. As savings increase throughout society, more money is ready to be used by established companies and newborn entrepreneurs, and so the steering wheel turns in the right direction. Currency depreciation, be it naturally occurring or actively sought, halts this process and sends the message that being competitive is not needed to survive. If consumers don’t choose me on their own accord, competition will be wiped out by making it artificially expensive, and so consumers will have no choice but me.
Time for a History lesson
This is precisely what has been happening in the Western Hemisphere since Nixon closed the gold window. As we have previously mentioned, during the last quarter of the 20th century, countries like France, Spain or Italy could not compete with Germany and, instead of letting their respective industries undergo actual reforms, they systematically devalued their currencies in a vain attempt to boost their turnover. However, after an initial mirage, things went back to where they were. Governments, as if dealing with shampoo, simply lathered, rinsed and repeated. And every time they did, their citizens lost another chunk of their savings.
Deliberate devaluation of the currency is not something new. Those who issue the coin have been stealing from their people since the dawn of man. Athens emerged as leader of the poleis in Ancient Greece because of its sound currency, in a time when other rulers quickly gave in to the temptation of coin debasement. Similarly, Rome experienced successive devaluations, especially during its imperial phase.
After massive economic disruptions caused by an inflationary crisis during the 3rd century, emperor Diocletian enacted in 301 AD his infamous Edictum De Pretiis Rerum Venalium (Edict concerning the sale price of goods), literally a price control policy. As we know, its results were the opposite of what Diocletian had expected, scarcity rampaged throughout the empire and black-market prices soared enormously. With the idea of restoring stability, Constantine’s reform was enacted in the year 310. The existing currency, called aurelus, was removed. A new one, the solidus, was issued. The Roman currency had just lost 15% of its value.
After the fall of the Roman Empire, every major king, prince or tyrant, from East to West, has inexorably resorted to coin debasement. The prospect of devaluing their currency is simply too appealing to rulers. Wars and social services are expensive, taxes are unpopular, and debasing the currency is a straightforward way, not easily noticeable to the general public. Indeed, Father Juan de Mariana showed over 400 years ago in his Tratado y discurso sobre la moneda de vellón (Treaty and discourse on the fleece coin) how the House of Habsburg repeatedly reduced the content of noble metals in the coins in order to increase the revenue of the state.
Back to the present day, most of the countries in the European Union share a common currency. Neighboring countries with their own currency tend to keep a stable exchange rate with the euro. This is only logical, since an individual economy does not have the size to compete with the eurozone. Nevertheless, there is a noteworthy exception to the rule: Switzerland prides itself in having a solid currency. Despite its relatively small GDP and important trading relations with the EU, in the past years they have refused to follow the downward spiral of the euro. Instead of gaining competitiveness by means of price reduction, they strive for competitiveness by means of quality. Every central bank should follow their lead, instead of going back to the same old tactics under some flashy rebranding like Modern Monetary Theory.
Conclusions
Now we have a general understanding of currency depreciation and its repercussions. Long-term, healthy growth will never be achieved that way. It might generate an artificial boost at first, but sooner rather than later reality knocks at the door. Complex problems, such as lack of competitiveness in the global markets, require complex solutions. The only outcome of devaluation and depreciation is massive robbery of every currency holder. If we believe this time will be better, we will once again find ourselves several steps backwards, having given away our wealth and the control of our money to bureaucrats. There are no shortcuts to prosperity.
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This was a very interesting read. Thank you!
Great take as always, thank you! Deval is indeed rather just a short term thing like pulling the dust under the rug ... but used extensively to extend/mitigate 'political/career' gain/risk and dressed up as a 'solution' ;)).
It reminds me the half joke half truth in terms of ECB and monetary policy transmission: 'Draghi walks into a bar. Bartender asks "Why did you need another TLTRO?". Draghi says "because the first one didn't work". My own 2019 'extension' with the MRO included:
https://twitter.com/Maverick_Equity/status/1088756505388744705
Have a great weekend!