Devaluation Always “Works”
Buttonwood at the Economist, followed by Chris Dillow [edit: fixed link] and Duncan Weldon, are all concerned about weak Sterling. I’ll pick on Chris, who considers whether the fall in the pound this year will raise prices in the UK:
Perhaps, then, the weak pound won’t add much to inflation – though this’ll rise anyway in the next few months for other reasons. History tells us as much. Since 1990, there’s been little link between moves in sterling and in inflation. The devaluation in 1992 did not prevent inflation falling sharply. Nor did sterling’s falls in 2000 and 2003 or its large fall in 2008 have a big effect on inflation.
You might think all this is good news.
It’s not. For one thing, if UK importers and wholesalers can’t pass on higher import costs their profits will be squeezed; this is an especial danger for smaller firms lacking market power. Granted, they’ll try and fight against this by cutting other costs. But this could well mean cutting jobs. In this sense, sterling’s fall could raise unemployment.
It is frankly bizarre to see these right-minded people argue against devaluation for a depressed economy. Would they have made the same case in 1992 when the UK had the wrong monetary policy (Germany’s) or in the early 1930s after the UK had suffered from bad monetary policy, re-entering the gold standard at the wrong level after WW1?
Chris’ doubts about whether Sterling devaluation will add to domestic inflation neatly invokes Bernanke’s reductio ad absurdum: if we can print money, buy foreign assets, and domestic prices never increase in response, we have discovered the biggest free lunch in the history of the world. We could have the Bank print money and buy up every single asset in the rest of the world, and then live a life of luxury off the flow of income. Shall we start with Spain?
This is wrong, and devaluation always “works” if you want to raise domestic prices and spending, because devaluation is monetary phenomenon. I find it much easier to think about the world in terms of nominal GDP and money, than inflation and output (real GDP). If the Bank prints money and buys stuff, whether that is Euros or gilts, then somebody has to hold more money. It is this “excess” supply of money, which bounces around as a “hot potato”, which results in increased spending – more NGDP. Whether or not that results in rising prices in the short run depends on the supply-side response, but in extremis (the Bank trying to buy up the entire world) it must. An expected increase in the supply of money will also raise the velocity of money today flowing around the economy. If that is not intuitive then browse through the results of a Google search for the terms “devaluation panic buying” . “Panic buying” is another name for a spike in the velocity of money.
The UK’s experiment with the European Exchange Rate Mechanism between 1990 and 1992 provides a very clear demonstration of all this. John Major and Norman Lamont very deliberately tightened UK monetary policy in 1990 when they entered the ERM, pegging the pound to the Deutsche Mark at a rather high level. This “worked” by bringing down nominal GDP growth from the 8% to 10%+ annual rates since through most of the 1980s, to a 3% annual rate by late 1992:
The pound’s overvaluation under ERM went hand in hand with tight money, just as devaluation and easier money (faster NGDP growth) went together after Black Wednesday. Inflation was pretty moderate even with much faster NGDP growth after 1992, because UK economy had significant spare supply capacity. If you believe the same applies to the UK economy in 2013, you should welcome devaluation as a sign that monetary policy is being relaxed.