Svensson on “Competitive Devaluation”
The usual responses I hear to the suggestion of currency devaluation in a depressed economy are split equally between:
a) “If we devalued, that would hurt our trading partners by making our exports too cheap!”
b) “If we devalued, that would damage our terms-of-trade and hurt domestic consumers!”
Both of these really miss the point, but it is always seems particularly obtuse to think we can “hurt” foreigners by selling them cheap(er) stuff. And people generally only switch to (b) after insisting that monetary policy is “impotent” at the ZLB. Impotent, that is, except in that it can obviously “create inflation”.
With monetary easing from the Fed last week, and the Bank of Japan this week, concerns about “competitive devaluation” have resurfaced. Lars Svensson demolished the argument in his papers on the “Foolproof Way“, so I can do little better than quote him verbatim:
The second issue is whether escaping a liquidity trap via a currency depreciation has negative consequences for the trading partners of the country. When a country attempts to stimulate its economy by depreciating its currency, this is often called a “competitive devaluation” or a “beggar-thy-neighbor policy,” invoking associations of negative consequences for trading partners. For instance, Fischer (2001) suggests that a yen depreciation could not be pushed too far because of beggar-thy-neighbor concerns.
However, we have already seen that the optimal way to escape from a liquidity trap, which involves expectations of a higher future price level, would directly lead to a corresponding depreciation of the currency. Indeed, absence of a currency depreciation indicates a failure to induce such expectations.
My emphasis here; and a quick diversion to look at what has happened to Sterling over the last year. Has the Bank of England induced expectations of a rising future price level?
Not obviously; Sterling is up 6.5% in the year to August 2012.
Back to Svensson:
The Foolproof Way is just a method to implement approximately the optimal way to escape from the liquidity trap through the back door, by starting with a currency depreciation. Indeed, any expansionary monetary policy that succeeds in increasing expectations of the future price level and lowering the real interest rate will imply a currency depreciation. Thus, opposing a currency depreciation is an argument against any expansionary monetary policy – which seems nonsensical.
Because of the short-run stickiness of the domestic price level, a currency depreciation implies a temporary real currency depreciation, that is, an increase in the price of foreign goods relative to domestically produced goods and services. This is a terms-of-trade improvement for the trading partners and in itself beneficial to them. But one concern is that this will increase the domestic trade balance, the net export from the country and hence decrease the net export to the country from the trading partners.
But the effect on the trade balance involves both a substitution and an income effect, of opposite signs. The substitution effect due to the change in relative prices from a depreciation favors domestic exporters and import competitors and increases the trade surplus (or reduces the trade deficit). But the income effect due to increased output, consumption and investment in the domestic economy implies increased import of raw materials, intermediate inputs and final goods and reduces the trade surplus (or increases the trade deficit). The net effect on the trade balance may therefore be quite small, as indicated by simulations in Coenen and Wieland (2003) and McCallum (2003). Thus, a currency depreciation will involve some sectoral shifts, but it need not involve any beggar-thy-neighbor policy. For Japan, with an economy operating far below potential GDP, the income effect on the trade balance, which is favorable to the trading partners, could actually be quite large.