Home > Inflation, Monetary Policy > Devaluation Always “Works”

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:

Sterling ERM Experiment, 1990-1992

Sterling ERM Experiment, 1990-1992

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.

Categories: Inflation, Monetary Policy
  1. ChrisA
    March 11, 2013 at 05:52

    You have the wrong link for Chris Dillow’s blog, I think this is the correct one;


    But the rest of your post is spot on, a fall in the pound is unequivocally going to raise exports pari passu. Since the pound has fallen by about 10% in the last few months, as far as the rest of the world is concerned everyone in the UK has taken a 10% salary cut but kept the same productivity. This must boost manufacturing and other such sectors (tourism etc) and employment, and cut imports, versus what they would be otherwise. However, in regard to GDP, it is a bit of a red queen race in the UK right now between dramatically falling oil and gas production and the rest of the economy. No cut in sterling is going to improve oil production. Sumnerians need be a bit cautious if Carney does bring in a version of NGDP targeting as GDP could well stay flat in the UK or even continue to fall even with a decent amount of stimulus and NGDP growth, don’t want to have people coming to the wrong conclusions.

    Also, just eyeballing the chart, it seems like the rebound in GDP already started under the ERM mechanism, even while NGDP was falling. Does not that negate your point a little?

    • March 11, 2013 at 08:24

      Chris – thanks for your comment. I’ve fixed the link.

      I agree with your comments on the supply side and whether faster NGDP will bring faster RGDP – I did pose my final paragraph as a question and I wanted to avoid the supply-side for this post as much as possible. You’re right about the RGDP recovery under ERM; I don’t think it undermines the demand-side argument, that’s a point about the short-run adjustment after nominal shocks.

      I was trying to make the the point that devaluation really is not about “boosting exports” per se, and I don’t think it helps to think like that; the point is to boost the domestic price level and/or NGDP. That is why Bernanke’s reductio ad absurdum is such a powerful argument.

      • ChrisA
        March 12, 2013 at 01:01

        Thanks Britmouse, I agree on Bernanke’s argument, actually it is shocking that there are still apparently clever people who are still arguing against this. I can only think it is one of those clever people mistakes, due to all the research about the 1930’s when there was a gold standard. I often think the confusion around NGDP targeting is also a clever persons mistake, mostly the man on the street would think in NGDP terms, but economists and other technocrats have been so trained to think in RGDP that they cannot see the simple point that NGDP growth is important.

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