More on Money

Folks,

If you were able to read up on what money is (and is not), here is more on
Currency Devaluation and Economic Growth, something much in the news. First I
have the URL and then there is the article in case you cannot access the
website.

John

http://www.mises.org/fullstory.asp?control=1345


Currency Devaluation and Economic Growth


By Frank Shostak


[Posted October 3, 2003]


A September 21 announcement by the G-7 finance ministers endorsed less

intervention in the foreign exchange market, and triggered a large sell-off

of the US dollar. On the day of the announcement, in relation to the end of

August, the US currency fell by 4.8% against the Euro and 4.1% against the

Yen.


Many economists have suggested that the weakening in the US dollar could

actually be good for the economy—since a weaker dollar will boost

manufacturing production, which in turn will lift employment and all this

will set in motion economic growth. It follows then that the US dollar

devaluation is exactly what is needed to keep the US economy going.




The popular way of thinking


According to popular thinking the key to economic growth is demand for goods

and services. It is held that increases in demand for goods and services

gives rise to economic growth by triggering the production of goods and

services. Increases or decreases in demand for goods and services are behind

rises and declines in the economy's production of goods. Hence in order to

keep the economy going economic policies must pay close attention to overall

demand.


Now, part of the demand for domestic products emanates from overseas. The

accommodation of this demand is labeled exports. Likewise, local residents

exercise demand for goods and services produced overseas, which is labeled

imports. Note that while an increase in exports gives rise to overall demand

for domestic output, an increase in imports weakens demand. Hence exports,

according to this way of thinking, are a factor that contributes to economic

growth while imports are a factor that detracts from the growth of the

economy.


Because overseas demand for a country's goods and services is an important

ingredient in setting the pace of economic growth, it makes sense to make

locally produced goods and services attractive to foreigners. One of the

ways to make domestically produced goods more in demand by foreigners is by

making the prices of these goods more attractive.


For instance, the price of an identical bag of potatoes in the US is $10 and

10 Euros in Europe. Also, the exchange rate between the US dollar and the

Euro is 1:1 i.e. one–to–one. At the exchange rate of 1 Euro to $1 a European

can get for his 10 Euro one American bag of potatoes.


One of the ways of boosting their competitiveness is for Americans to

depreciate the US dollar against the Euro. Let us assume that in response to

a Fed announcement that it will drastically loosen its monetary stance, the

rate of exchange falls to 0.5 Euro per $1. Consequently, this will mean that

$10 is now worth 5 Euro, which in turn implies that an American bag of

potatoes in Europe is offered for 5 Euro. Consequently, a European can now

purchase for 10 Euro two American bags of potatoes instead of one before the

depreciation of the US dollar. In other words, the purchasing power of

Europeans with respect to American potatoes has doubled.


If we were to apply the potatoes example to all goods and services, one can

reach the conclusion that as a result of currency depreciation, all other

things being equal, the overall demand for domestically produced goods is

likely to increase. This in turn will give rise to a better balance of

payments and in turn to stronger economic growth. Observe that to lift

foreigners' demand, Americans are now effectively offering two bags of

potatoes for one European bag of potatoes. This also means that the price of

the European bag of potatoes in the US is now twice what it was before the

depreciation of the US dollar. This most likely will lower American's demand

for European potatoes. What we have here, as far as the US is concerned, is

more exports and fewer imports, which according to mainstream thinking is

great news for economic growth.


Equally, at the original exchange rate of 1:1 a reduction in the domestic

price of US potatoes from $10 to $5 would also enable a European to exchange

his 10 Euro for two bags of potatoes. In short, changes in the exchange rate

or changes in prices in respective countries will determine so-called

international competitiveness, which is also labeled as the real exchange

rate. This can be summarized as:


Real exchange rate = (domestic prices/foreign prices)*exchange rate


The exchange rate is the number of foreign currency per unit of local

currency.


According to this expression, a fall in the real exchange rate implies

growing competitiveness and a rise means falling international

competitiveness. Hence, following this expression, currency depreciation (a

fall in the number of foreign currency exchanged per local currency) will

lead to a fall in the real exchange rate and thus to an increase in

international competitiveness.


A fall in foreign prices, however, will lift the real exchange rate and

therefore reduce competitiveness. In this way of thinking, it is quite clear

that currency depreciation—all other things being equal—is beneficial for

economic growth.


For instance, in their research study of the Mexican economy, Dornbusch and

Werner have concluded that: "If the currency is not devalued, growth will

not keep pace with the growth of the labor force; the divisions in Mexican

society will widen; and national stability will be threatened."[1]


Furthermore, according to Dornbusch and Werner, "…recent major devaluations

in Finland, Sweden, Italy, Spain and the United Kingdom did not lead to

inflation—in fact, it has come down, as have interest rates. Devaluation was

a boon to these countries."[2]


It seems that the message conveyed by the real exchange rate equation tends

to confirm the experience in the US. Thus since 1999 US competitiveness viz.

Japan has been steadily falling. The real exchange rate, which stood at 138

in November 1999 jumped to 176 in August 2003. The fall in competitiveness

during this period was associated with a sluggish economy. In short, the

data seems to support the view that a rising real exchange rate may be an

important contributing factor to currently subdued economic growth.


Moreover, our statistical analysis indicates that the lagged growth momentum

of the real exchange rate displays good visual inverse correlation with the

growth momentum of industrial production. An increase in the growth momentum

of the real exchange rate (deterioration in US competitiveness) is followed

by a fall in the growth momentum of industrial production. A fall in the

growth momentum of the real exchange rate (improvement in US

competitiveness) is followed by an increase in the growth momentum of

industrial production.




It seems, therefore, that it makes a lot of sense to depreciate the US

dollar in order to revive the economy.


Why boost in exports due to currency depreciation cannot grow the economy


When a central bank announces a loosening in its monetary stance, this leads

to a quick response by the participants in the foreign exchange market

through selling the domestic currency in favor of other currencies, thereby

leading to domestic currency depreciation. In response to this, various

producers now find it more attractive to boost their exports. In order to

fund the increase in production, producers approach commercial banks, which

on account of a rise in central bank monetary pumping are happy to expand

their credit at lower interest rates.


By means of new credit producers can now secure resources required to expand

their production of goods in order to accommodate growing overseas demand.

In other words, by means of newly created credit producers divert real

resources from other activities. As long as domestic prices remain intact,

exporters will record an increase in profits.


However, the so-called improved competitiveness on account of currency

depreciation means that the citizens of a country are now getting less real

imports for a given amount of real exports. In short, while the country is

getting rich in terms of foreign currency, it is getting poor in terms of

real wealth, i.e., in terms of the goods and services required for

maintaining peoples' life and well-beings. As time goes by however, the

effects of loose monetary policy filters through a broad spectrum of prices

of goods and services and ultimately undermine exporters profits. In short,

a rise in prices puts to an end the illusory attempt to create economic

prosperity out of thin air. According to Ludwig von Mises,


The much talked about advantages which devaluation secures in foreign

trade and tourism, are entirely due to the fact that the adjustment of

domestic prices and wage rates to the state of affairs created by

devaluation requires some time. As long as this adjustment process is not

yet completed, exporting is encouraged and importing is discouraged.

However, this merely means that in this interval the citizens of the

devaluating country are getting less for what they are selling abroad and

paying more for what they are buying abroad; concomitantly they must

restrict their consumption. This effect may appear as a boon in the opinion

of those for whom the balance of trade is the yardstick of a nation's

welfare. In plain language it is to be described in this way: The British

citizen must export more British goods in order to buy that quantity of tea

which he received before the devaluation for a smaller quantity of exported

British goods.

Contrast the policy of currency depreciation with a conservative policy

where money is not expanding. Under these conditions, when the pool of real

wealth is expanding, the purchasing power of money will follow suit. This,

all other things being equal, will lead to currency appreciation. With the

expansion in the production of goods and services and falling prices and

thus production costs, local producers can improve their competitiveness and

profitability in overseas markets while the currency is actually

appreciating. Within the framework of loose monetary policy exporters'

temporary gains are at the expense of other activities in the economy,

within the framework of a tight monetary stance gains are not at any one's

expense but just the manifestation of real wealth generation.


Can currency depreciation take place in a free market?


The entire issue of the alleged benefits of currency depreciation is only of

relevance in a hampered market where paper money is enforced by the

government through its central bank. In a free-market economy, there cannot

be such a thing as currency depreciation, which supposedly can grow the

economy.


Within the free market, there cannot be currency depreciation as such. Since

in a true free-market economy money is gold, there cannot be an independent

entity such as a "dollar." Prior to 1933, the name "dollar" was used to

refer to a unit of gold that had a weight of 23.22 grains. Since there are

480 grains in one ounce, this means that the name dollar also stood for

0.048 ounce of gold. This in turn, means that one ounce of gold referred to

$20.67. Now, $20.67 is not the price of one ounce of gold in terms of

dollars as popular thinking has it, for there is no such entity as a dollar.

Dollar was just a name for 0.048 ounce of gold. On this Rothbard wrote, "No

one prints dollars on the purely free market because there are, in fact, no

dollars; there are only commodities, such as wheat, cars, and gold.[3]


Likewise, the names of other currencies stood for a fixed amount of gold.

The habit of regarding these names as a separate entity from gold emerged

with the enforcement of the paper standard. Over time, as paper money

assumed a life of its own, it became acceptable to set the price of gold in

terms of dollars, francs, pounds, etc. The absurdity of all this reached new

heights with the introduction of the floating-currency system.


In a free market, currencies do not float against each other. They are

exchanged in accordance with a fixed definition. If the British pound stands

for 0.25 of an ounce of gold and the dollar stands for 0.05 ounce of gold,

then one British pound will be exchanged for five dollars. This exchange

stems from the fact that 0.25 of an ounce is five times larger than 0.05 of

an ounce, and this is what the exchange of 5-to-1 means.


In other words, the exchange rate between the two is fixed at their

proportionate gold weight, i.e., one British pound = five US dollars. The

absurdity of a floating currency system is no different from the idea of

having a fluctuating market price for dollars in terms of cents. How many

cents equal one dollar is not something that is subject to fluctuations. It

is fixed forever by definition. [4]


The present floating exchange rate system is a byproduct of the previously

discredited Bretton Woods system of fixed currency rates of exchange, which

was in operation between 1944 to 1971. Within the Bretton Woods system the

US dollar served as the international reserve currency upon which all other

currencies could pyramid their money and credit. The dollar in turn was

linked to gold at $35 per ounce. Despite this supposed link to gold, only

foreign governments and central banks could redeem their dollars for gold.


A major catalyst behind the collapse of the Bretton Woods system was the

loose monetary policies of the US central bank which pushed the price of

gold in the gold market above the official $35 per ounce. The price, which

stood at $35/oz in January 1970 jumped to $43/oz by August 1971 – an

increase of almost 23%. The growing margin between the market price of gold

and the official $35 per ounce (see chart) created enormous profit

opportunity, which some European central banks decided to exercise by

demanding the US central bank redeem dollars for gold.




Since Americans didn't have enough gold to back up all the printed dollars,

they had to announce effective bankruptcy and cut off any link between

dollar and gold as of August 1971. In order to save the bankrupt system

policymakers have adopted the prescription of Milton Friedman to allow a

freely floating standard.


While in the framework of the Bretton Woods system the dollar had some link

to the gold and all the other currencies were based on the dollar, all that

has now gone. In the floating framework there are no more limitations on

money printing. According to Murray Rothbard:


One virtue of fixed rates, especially under gold, but even to some extent

under paper, is that they keep a check on national inflation by central

banks. The virtue of fluctuating rates—that they prevent sudden monetary

crises due to arbitrarily valued currencies—is a mixed blessing, because at

least those crises provided a much-needed restraint on domestic inflation.

Through policies of coordination, central banks maintain synchronized

monetary pumping so as to keep the fluctuations in the rate of exchanges as

stable as possible. Obviously, in the process such policies set in motion, a

persistent process of impoverishment through consumption is not backed up by

production of real wealth.


Furthermore, within this framework, if a country tries to take advantage and

depreciate its currency by means of a relatively looser monetary stance this

runs the risk that other countries will do the same. Consequently, the

emergence of competitive devaluations is the surest way of destroying the

market economy and plunging the world into a period of crisis.


On this Mises wrote, "A general acceptance of the principles of the

flexible standard must therefore result in a race between the nations to

outbid one another. At the end of this competition is the complete

destruction of all nations' monetary systems."



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Frank Shostak is an adjunct scholar of the Mises Institute and a frequent

contributor to Mises.org. Send him MAIL and see his outstanding Mises.org

Daily Articles Archive. Special thanks to Michael Ryan for his comments.



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[1] Dornbusch R. and Werner A. 1994. "Mexico, stabilization. Reform and no

growth," Brookings Papers on Economic Activity, Vol 1, pp, 253–315.


[2] Ibid.


[3] Murray N. Rothbard. "The Case for a Genuine Gold Dollar," in Llewellyn

H. Rockwell, Jr., The Gold Standard: An Austrian Perspective (Lexington,

Mass: D.C. Heath, 1985), pp. 1–17.


[4] Ibid.

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