Competitive devaluation is not a free lunch

It's not often I disagree with David Glasner. Or, for that matter, with Ralph Hawtrey. But I fear I have to take issue with both of them over competitive devaluation. "Bring it on", says David. No, please don't. It's a terrible idea.

Hawtrey's pictorial explanation of why competitive devaluation is a good idea seems both charming and plausible:
This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . . .
The picture of an endless competition in currency depreciation is completely misleading. The race of depreciation is towards a definite goal; it is a competitive return to equilibrium. The situation is like that of a fishing fleet threatened with a storm; no harm is done if their return to a harbor of refuge is “competitive.” Let them race; the sooner they get there the better.
The highlight "in terms of gold" is mine, because it is the key to why Glasner is wrong. Hawtrey was right in his time, but his thinking does not apply now. We do not value today's currencies in terms of gold. We value them in terms of each other. And in such a system, competitive devaluation is by definition beggar-my-neighbour.

Let me explain. Hawtrey defines currency values in relation to gold, and advertises the benefit of devaluing in relation to gold. The fact that gold is the standard means there is no direct relationship between my currency and yours. I may devalue my currency relative to gold, but you do not have to: my currency will be worth less compared to yours, but if the medium of account is gold, this does not matter since yours will still be worth the same amount in terms of gold. Assuming that the world price of gold remains stable, devaluation therefore principally affects the DOMESTIC price level.  As Hawtrey says, there may additionally be some external competitive advantage, but this is not the principal effect and it does not really matter if other countries also devalue. It is adjusting the relationship of domestic wages and prices in terms of gold that matters, since this eventually forces down the price of finished goods and therefore supports domestic demand.

Conversely, in a floating fiat currency system such as we have now, if I devalue my currency relative to yours, your currency rises relative to mine. There may be a domestic inflationary effect due to import price rises, but we do not value domestic wages or the prices of finished goods in terms of other currencies, so there can be no relative adjustment of wages to prices such as Hawtrey envisages. Devaluing the currency DOES NOT support domestic demand in a floating fiat currency system. It only rebalances the external position by making imports relatively more expensive and exports relatively cheaper.

This difference is crucial. In a gold standard system, devaluing the currency is a monetary adjustment to support domestic demand. In a floating fiat currency system, it is an external adjustment to improve competitiveness relative to other countries.

But so what, you say? What is wrong with countries competing on terms of trade?

This graph, from Gavyn Davies in the FT, shows what happens to the "last fishing boat into harbour"(to use Hawtry's analogy):

(The 20% dollar appreciation has already happened, by the way: the US$ REER has risen that much in the last 18 months or so.)

Yes, that is a 1% deflationary shock and a 3% or more decline in the contribution of net exports to GDP. As Gavyn explains:
The negative impact of the rising dollar on the level of GDP, relative to the baseline, is surprisingly large and persistent, with a cumulative impact of around 3 percentage points after three years. About half of this effect arrives in the first four quarters after the dollar rise, with the rest coming later.
Importantly, the impact of the higher exchange rate does not reverse itself, at least in the time horizon of this simulation – it is a permanent hit to the level of GDP, assuming that monetary policy is not eased in the meantime. 
And he goes on to explain what the effect on (real) GDP would be:
According to the model, the annual growth rate should have dropped by about 0.5-1.0 per cent by now, and this effect should increase somewhat further by the end of this year. 
Doesn't sound much like a "free lunch" to me.

But of course this assumes that the US does not ease monetary policy further. Suppose that it does?

The hit to net exports shown on the above graph is caused by imports becoming relatively cheaper and exports relatively more expensive as other countries devalue. If the US eased monetary policy in order to devalue the dollar support nominal GDP, the relative prices of imports and exports would rebalance - to the detriment of those countries attempting to export to the US. They have three choices: they respond with further devaluation of their own currencies to support exports, they impose import tariffs to support their own balance of trade, or they accept the deflationary shock themselves. The first is the feared "competitive devaluation" - exporting deflation to other countries through manipulation of the currency; the second, if widely practised, results in a general contraction of global trade, to everyone's detriment; and you would think that no government would willingly accept the third. However, the Fed has permitted passive monetary tightening over the last eighteen months, and in December 2015 embarked on active monetary tightening in the form of interest rate rises. Davies questions the rationale for this, given the extraordinary rise in the dollar REER and the growing evidence that the US economy is weakening. I share his concern.

Hawtrey's "fishing fleet" analogy only applies when there is some kind of buffer that will absorb the deflationary shock. In his day, that was the gold price. These days, it is whichever country has the tightest monetary policy, which at the moment is the US. Though this could change once the Fed realises the world is once again casting the US in the role of consumer-of-last-resort - after all, this didn't end too well last time, did it? Central banks are passing deflation around the world like a hot potato.

Of course, if the world were to reintroduce some kind of common currency standard such as gold, we might be able to return to exchange rate targeting as a policy response. Alternatively, we could trade with Mars. But failing either of those, deliberately manipulating the exchange rate is destructive. In today's floating fiat currency system, there is no such thing as a "free lunch".

Related reading

The trade effect of negative interest rates
Japan's negative rates: the China connection
Let's all play QE - Pieria

Image is of Craster Harbour in Northumberland, UK. Photographed by me in April 2015.


  1. IEA November electricity data out.
    A 5.5 % reduction in USofA electricity production.(vs Nov 2014)
    A 5.3 % reduction of Canadian production.

    These are massive numbers.
    Its as if Australia and New Zealand shut off all electricity production / consumption in that month.
    A milder early winter but this affects home heating oil consumption rather then the relatively static electricity market.

  2. The OECD energy data makes the dynamic very clear.
    Europe deflated up to 2014.
    It began to inflate chiefly via the use of consumer car credit in 2015.
    North America is in a inverse relationship.
    The UK is at the fulcrum .

    The core of the problem is the very nature of the consumption patterns.

  3. France's, would not it be better to substitute gold for level prices? Obviously, there is no free lunch in economy, never, but there are limits. Country A devalue its money, and country B do the same for not to loose GDP en net export. The limit to the free lunch Es the rise of price level above the monetary objective.
    I'd prefer cooperation between central bankers, at least to reduce de volatility of the markets, and some sensible control of capital movements. But I do see a limit in price level, and more human than gold.

    1. I see absolutely no benefit in returning to a gold standard, or to any managed exchange rate system. Some countries do better with a pegged or managed exchange rate, but that is a local decision. But many do better with a free float: for example, the Russian central bank has given a textbook demonstration of the benefits of abandoning a fixed peg for a free float, which others should learn from. I think there might be some value in having an international medium of account (similar to Keynes's bancor), but it should be a floating rate system.

    2. When I talk about cooperation, I don't suggest some type of fixed exchange rate. I'd rather for free exchange rate, but in that case, movements of capital must be regulated. I've no confidence in financial markets, I don't believe in EMH, the epicenter of the problems of today.
      More freedom in financial market, less exchange rate respond to real variable.

    3. What benifits did Rusia receive?

  4. how do you have a devaluation ,competitive or otherwise, when you have floating exchange rates?

    1. In a floating-rate system, monetary policy influences exchange rates. For example, the Bank of England devalued sterling by 25% in 2008 by cutting the base rate to 50 bps and doing QE.

    2. This example shows why, in current conditions of recessionary risks, there might be benefits from competitive depreciation, even though it is not a free lunch. If the ECB responds to Japanese attempts to push down the yen by expanding QE and the Fed does so by delaying its next rate rise, then the overall effect would be useful global monetary expansion.

      It would though be preferable if such expansion were internationally coordinated and better still if it were combined with investment-led fiscal loosening.

  5. In simple Corkish.
    The policy of the Bank is to always inflate prices.
    The serfs plainly cannot afford current production.
    They cannot consume useful stuff.
    So a option is to inflate a useless item rather then a useful good or asset .(unaffordable abundant houses in Ireland is a very example)

    Of course in a social credit world the rock is not needed as the objective is not inflation / concentration.
    A social creditor would be happy to see prices deflate into a universal and independent (from the banks) income.

    As always the problem is economics is always the same.
    Nothing complex.
    How do you (if you wish) close the production / consumption loop.

  6. The disinflation effect appears to reduce rapidly (importers returning prices to historic levels?) Whereas exports permanently reduced.

  7. @Chris
    Net exports to sovereign countries within the EU28 is infactaly increasing.
    Look on the internal trade of the EU 28 as a sort of mini global me.

    The UK and Denmark for example are absorbing massive surplus production from mercantile Europe.

    Denmarks electricity production / consumption dynamics are simply incredible.
    It's national production of electricity declined by over 10% (Jan - Nov 2015) yet it's consumption increased slightly.

    Imports from Germany are surging but the net effect throughout the EU is rapidly declining Production / consumption.

    The lack of national and sub national production / consumption is striking.

    The EU is not I repeat not a free trade area.
    It is a forced trade
    Trade as currently organised is subtracting from basic consumption.

  8. This comment has been removed by the author.

  9. Competitive devaluation is like trying to make smoked kippers from gannets. Well, you did feature Craster, lovely place. First try had a bad typo' sorry!

  10. Competitive devaluation is like trying to make smoked kippers from gannets. Well, you did feature Craster, lovely place. First try had a bad typo' sorry!

  11. This comment has been removed by the author.

  12. Witnessed the little social dividend talk in Brussels
    Needless to say I disagreed with the overall tone and substance of the debate.

    Using social credit policies to save the EU monster is the most diabolical tactic ever considered.
    Only national credit issued with the objective of it used in sub national production / consumption should be the goal.
    Not to aid such a internationalist abomination.

    In any case asking CBs to print and distribute money so as to reduce capitalist friction would be like getting Randy Newman to sing The Kingfish at a bankers wedding......

    Not going to happen.

  13. How real politics works .....
    The big question is who got into the gutter first.
    Huey Long or Standard oil like interests.

    This is a very balanced documentary .
    Tom Wickers observations at 1.07 is striking given his New York times background.

    Why cannot we get such honest debates in Europe ?
    Its very clear we are dealing with corruption all the way down.
    Given that Central Bankers have installed the mechanisms of scarcity (making corruption mandatory ) with such demonic precision - why must they be portrayed as alter boys by your good self ?
    They have of course constructed both the foundations and apex leaving their minions to fill in the spaces.

  14. The Louisana revolt of the 1920s and 1930s was the last time when a Us state with a distinct culture reacted forcefully against Washington and New York capitalistic concentration.

    Now that the Us of A is now a failed state why must Europe repeat that journey?
    Why is failure so imperative?

    Why must we follow Brussels and Londons instructions.... Leading certainly into the abyss?

    The Irish guy on the panel seemed capable but not very wise.
    His identification with Europe was perhaps sincere but shallow.

    I imagine his Europe is either one airport lounge or another.
    A capsule experience.
    Very sad.
    Of course another Irish girl in the audience wanted more carbon taxes.
    Where do these people come from?

    Do they not realize pre treaty of Westphalia Europe was a very loose assortment of different baggage.
    This arrangement gave it a cultural dynamism.
    But the bedrock of civilization always rested on the village.

    Europe continues to implode as it absorbs the materialistic evangelists of the American FDR programme.
    Again to repeat America is now sunk.
    Europe is sunk.
    Both have lost redundancy in the short term interests of capitalistic efficency.

  15. Orson Welles classic 1955 interview of Lael Tucker.

    Its clear from this interview the elite were very aware of the problems building within the post war consumer war society .

    Why do people such as yourself want to "Save Europe" when it has no foundation .....

    What is there to save ?
    Why engage in such gross centralization ?
    What is London and Brussels trying to aggregate ?
    The gaff has been scoured .

  16. The irony of Orson Welles journey to 1955 Basque country was......

    The main earner locally was smuggling.
    When the border was opened up over the following decades the value of trade was captured by rent seekers located in the financial cities.

    The aspiration of free trade espoused in that film meet the present reality of its capture and current forced nature so as to feed the mega cities of today.

    Spain is feeding London and its growing population with fruit from its garden while its present resident population is declining.
    The banks response is predictable.
    Flood the continent with unencumbered human assets so as to replace the debt laden residents.
    Keeping the illusion of capit
    alistic movement and its gross urbanization

    1. Stop now, please, Dork. You've had your say, and you are once again far off topic.

  17. Is there an assumption here that competitive devaluation is at all distinguishable from "domestic" loose monetary policy? (under a floating rate regime)

    Whatever the intent or PR, what both policies require is making currency "easier to get" which should have approximately the same end effect whatever pipe is used to inject extra currency in the system. In the presence of a clogged up banking pipe, a CB flogging fresh prints on the forex market may work a little bit quicker.

    1. That's absolutely right. You cannot disconnect exchange rate of interest rate, save the case you have capital controls, but including that case, it is iimposibke to lean against the wind. Sooner or later, you have to admit the devaluation.

  18. So you would say that if the world was a country and it would conduct monetary easing, the effect would be zero? Because if the world consists of countries that simultaneously conduct monetary easing of the same magnitude, the world should behave the same as the aforementioned country.
    I think the effects would be to push growth and inflation a little higher everywhere.

    1. No, I am saying the precise opposite. If the entire world simultaneously did monetary easing, it would indeed lift all boats. But if countries individually manipulate their currencies in order to steal demand frm each other, the result is a destructive race to the bottom.

  19. Hmmm, I' m sorry, but how is this a consistent view? I mean the intention does not matter for the result unless one specifically assumes distinct political repercussions.
    Say half the world engages in easing, this would essentially force the rest of the world into some kind of easing to offset the deflationary impact of a rising currency. Would that be enough? It seems like you have to assume some sort of a tipping point, as to when we have comptetive easing and when we have global easing.
    I think this is wrong and would assume that if say 30% of the world eases, we will have 30% of the benefits of worldwide easing. Additionally the devaluing countries might take more benefits from the other countries so that these would be worse off while the world wide effect is still the same.

    1. Why are you assuming that devaluation in order to seize export advantage and monetary easing are the same thing?

    2. Because the instruments used to achieve one or the other are the same (QE, lowering interest rates). Even if countries would specifically buy foreign exchange (which they don t even do now), done globally that would be offset to just QE.

  20. if country A make QE and devalue, that has collateral effects in B. If B is in the same cyclical moment than A the effect is good: it can spand its money, just at the point exchange rate return to the old parity.
    If B is in a boom, with inflation, it can profit of the anti inflationary effect of its exchange rate rise.
    The problem is for some group of interest that profited of an advantageous interest & exchange rate, but That n not a macro economy problem.
    It could be possible that a good macro policy is not a free lunch, but perhaps is a problems of particular interest.
    We know the force that such a group may deploy in the media to defend its vested interest.

  21. An other thing not often mentioned about the cost of depreciation of currencies is that every one{s real monetary income decreases until possible renegociation.

    This is probably not lost on accountants and payers of wages.


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