Tuesday, 27 September 2016

On Currency Devaluation (Deliberate and Otherwise)

It is an unstated central bank policy in many parts of the world to reduce the value of their currency to below its fair value. The reason for doing so is 'competitiveness'. A weaker currency means lower global prices for your goods and hence increases your exports, while at the same time reducing imports. Since a fundamental equation of economics says that GDP = C+I+G+X, or consumption plus investment plus government expenditure plus net exports; it would appear self evident that an increase in net exports would increase GDP.

This is, unfortunately, completely wrong. There are two ways that it is wrong, both pretty fundamental:

  1. As a recent Bloomberg report discusses, a reduction in currency does not necessarily increase net exports.  
  2. Any increase in net exports comes at the expense of an offsetting decline in domestic consumption/investment (C+I+G). Thus giving no net economic growth.

In this previous post, I give empirical evidence that there appears to be no benefit to running a current account surplus in terms of GDP growth, or even any benefit regarding private and public sector debt build-up. In this post, I really just want to show how theoretically false the whole paradigm is.

This post will be divided into 5 short sections. The first discusses how a sovereign government already has all the tools it needs to run an economy at capacity. Section 2 will discuss the circumstances in which a reduction in currency will or won't increase net exports. Section 3 discusses how an increase in net exports reduces domestic demand. Section 4 discusses reasons for running a surplus/deficit, then 5 discusses what to do if a deficit is forced upon you.

1. The Capacity of an Economy

The capacity of an economy is how much it can produce if everyone is employed in their most productive roles. For example if an economy consists of a shoe factory that has space for 1000 workers, each of whom can produce 1000 shoes; the capacity of the economy is 1,000,000 shoes and there are jobs available for 1,000 workers.

The factory can run under capacity by employing only 800 workers and producing only 800,000 shoes. On the other hand, capacity can be increased by investing in new machinery that enables workers to produce 1200 shoes per worker. 

Next, we can look at the role of demand. If people want to buy 1m shoes, for the price they cost to make plus a markup, the factory will be able to employ all 1,000 workers. If there is only demand for 800,000 shoes it must lay off workers and run below capacity. If there is demand for 1.2m shoes then initially the price will go up (inflation) but eventually investment will be made to increase supply capacity.

The role of demand here is extremely simple and very obvious. Demand must be high enough for the factory to run at capacity. If demand is higher than supply we get inflation but also an increase in supply in the future.

Unfortunately much of the discussion about a productivity slow-down seems to focus on supply issues rather than the obvious demand issues. And still the lack of demand goes unaddressed.

If a government (which has control of its own currency) wants to increase demand so that an economy runs at capacity and invests in increasing capacity, what does it need to do? It needs to make sure that the government deficit is high enough to get enough money flowing through the system to keep inflation at its target (note that inflation in this context means inflation of prices of domestic goods and services, not inflation imported because of falling exchange rate etc).

This is a complex subject, but I discuss it more in a blog post here and in my paper on the subject here. Using monetary policy is a terrible idea as I discuss here (with simulations). Fiscal policy is the only way to do this without creating bubbles, exacerbating inequality and damaging future growth.

So there is a very simple way for the government to ensure full employment and an economy running at capacity. It involves investment to increase capacity and enough deficit spending to keep demand high enough to fill the capacity. There is no reason to try to take demand from abroad.

This does not stop countries trying it though.

2. Does an fall in currency increase net exports?

To answer this question, we need to differentiate between different types of devaluations of currency. In order to do so, we need to look at a simple identity that a current account surplus is equal to your capital account deficit; the only way to run a current account surplus is to net invest your savings in another country (this subject is very well described by Michael Pettis). Likewise the only way to have a current account deficit is if people in other countries invest their savings in your economy.

This means that in the absence of any saving in foreign economies, the current account balance (which in the absence of any previous investments is equal to the trade balance) must be zero. The only change to net exports (ignoring exchange of foreign investment income) will come if there is a change in the net amount of capital invested in the country.

So, to give an example quoted in the Bloomberg piece, Pound Sterling fell by 19% against the US dollar in the two years to 2009. What was the reason for this change? The productivity, and expectation of future productivity, of the UK economy fell vs that of the US economy. Was the exchange rate in 2009 artificially low? No. Was there more money being taken out of the UK than put in as investment? No. In fact, there was still money coming into the UK from countries pursuing policies that lowered their own exchange rate. So should there be an increase in net exports? No,

Regarding the fall in GBP caused by Brexit, what are the causes? If it is a withdrawal of investment from the UK, or if it is caused by speculative bets against the Pound, then we would expect to see the trade deficit narrowing. I don't believe that this will prove to be the case, as the surplus countries still need somewhere to put their savings. If it is just caused by an expectation of weaker economic performance in the UK then there is no reason for the current account deficit to narrow.

Looking at the fall in the Japanese Yen caused by the monetary policy of the Bank of Japan (BoJ), we need to look again at the reason for the fall.

The important thing I want to say here is that quantitative easing policies should not much weaken the currency. In practice they have caused very large fluctuations (the USDJPY exchange rate at one stage went up by 65%), but I would argue that these are market over-reactions. The reason is that all QE does is to swap one form of savings (cash) for another (government bonds). To the extent that it reduces the real interest rate (It slightly increases inflation and slightly lowers the interest rate) it should have a moderate impact. But the size of the move in Yen was much to large for the impact of the actual  QE (as I said in February last year when I said Yen was the most undervalued currency in the world). As such, the move was largely driven by speculative flows, not fundamental changes in the value of the output of the two countries.

If hedge funds were building up short positions in Yen then this is a reason for a short term current account surplus, which will be reversed as hedge funds take opposite positions. The longer term impact would come from investment flows going out of Japan and into the rest of the world.

To find the sure-fire way to increase your net exports, one need look no further than the Swiss National Bank (SNB). The simple and reliable way to increase your net exports is to print your own currency, sell it and buy foreign currency with it. By investing in the foreign economy you are increasing your capital account deficit, thus increasing your current account surplus. This also involves a weakening of the currency. By directly investing abroad, this is the only method of the three discussed that definitely increases net exports relative to the baseline.

To summarise, a change in net exports can be approximated as a change in investment out of a country. Thus simply doing economically poorly will not increase net exports. Nor will making good products (people seem to think that Germany's surplus is because of the quality of their exports rather than their saving abroad) or engaging in QE. But direct investment abroad both weakens currency and increases net exports.

3. Does an increase in exports increase GDP?


In order to increase exports, more savings need to flow out of the country than flow into the country. This means that relative to the baseline scenario, more money needs to be saved. There are a number of ways to do this; by suppressing worker share of GDP, by use of tariffs, by use of sovereign wealth fund. But however it is done, this subtracts from domestic demand. It keeps consumer buying power lower. Looking at the equation above, if X goes up (C+I+G) must go down to compensate.

An artificially low exchange rate is bad for the people of the affected country. The goods they import cost  more and their wages are relatively too low for their productivity. Overall they consume and domestically invest less than they would have. It is good for exporting companies, however, who benefit from more sales abroad in domestic currency terms, and higher profit margins.

As such it is just a transfer from workers and other consumers to exporters. There is no empirical link between higher current account surpluses and higher real GDP growth.

4. So is there any point in a surplus?

There are some occasions when a surplus is appropriate. If you are a commodity producer, whose commodity is running out, there are two reasons to run a sovereign wealth fund. The first is to build up savings in other countries, claims against their future production, that can be spent when the commodity runs out. This smooths consumption so that you save when times are good and spend when times are not so good. The other reason is that it lowers the currency so that other industries become more competitive than they otherwise would have been. It helps to mitigate 'Dutch Disease'.

A small country that is not that diversified in its industry may also wish to build up a buffer in case of cyclical or structural decline in that industry. This is understandable and not too destabilising for the rest of the world.

Who should run a deficit then? This would be countries that are starting with a low industrial base, whose productivity can be largely increased by capital investment. By intelligently using capital, they can increase future productivity by enough to pay back the loans. Note that this should always be either in equity or domestic currency. Foreign currency loans are a disaster waiting to happen when downturn strikes.

5. Help, I have a current account deficit, what should I do?

This is actually a simple problem to solve for any country with control of their currency. The deficit is caused by other countries' savers investing in your economy, building up claims on your future production. In fact, most of these claims will never be claimed - savings have a way of just accumulating indefinitely - but you are feeling a bit uncomfortable about the situation where you owe so much.

All you have to do is

  1. Build up your own sovereign wealth fund whereby you print the equivalent of the deficit in your own currency and sell it to buy foreign bonds and stocks. This is exactly what the SNB has been doing. This lowers your currency to fair value and removes your deficit.
  2. Make up for the lost demand with a government deficit large enough to keep domestic inflation at target.
This is all. Philip Hammond, you're welcome. I doubt the advice will be followed though.


  1. So a current account deficit might be conidered desireable if it appreciates the domestic currency allowing domestic consumers to import goods and sevice from abroad and enjoy higher living standards from better real terms of trade.

    Also if I understand you correctly in order to ensure high exchange rates you need to manintain high productivity " The productivity, and expectation of future productivity, of the UK economy fell vs that of the US economy"-is this right

    So you need foreginers savings coming in(but just not the type of investent that increases asset values)to ensure tat the domestic currency is high.

    1. To the first part, I think yes, reserve currencies do benefit in that they receive savings from abroad that realistically never get called back. So in this sense the UK is given more consumption. There is always the risk that the situation reverses, of course.

      With the Brexit situation, there appears to be a prediction that the pound will offer a lower return in future than previously thought. A proxy for this is the real risk free interest rate (for developed sovereign governments this is government bond rate minus expected inflation). The higher this is, the better the country's expected prospects are going forward. The reason for this is that if there were a lot of good opportunities in the UK, people would need more interest from the government to put their money with them instead of taking risk.

      The prospects for the UK economy will undoubtedly be lower in the medium term after Brexit as there is a lot of turmoil. However, I think a lot of bad stuff is priced in already.

      Overall, if you want a strong currency, you want am economy that produces high value added goods and services. Being a reserve currency helps too.


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