Wednesday, February 18, 2015

Competitive Devaluations

The vast majority of the world's nations used to have money convertible to legally-specified amounts of gold (and, for a few, silver). This is usually called "the gold standard."

What was nice about the gold standard was that it provided a check to inflation. A country could print more money, but when holders of the money began to worry about the value being undermined by the increased supply, they could trade the money in for gold. The central bank (the gold standard didn't require a central bank, but at the end, most countries had one) could either buy more gold to support the exchange rate of money to gold, or it could reduce the money supply. The government could also legally change the specified amount of gold, but that wasn't really they resorted to in normal circumstances, since a regularly-changed rule isn't really a rule at all.

What was not nice about the gold standard was that it restricted the government's ability to inject money into the economy when conditions justified it. Make some money, see your gold reserves dwindle, soak up the money, get back to where you were. Because the gold standard was seen as a good thing, countries tried to stay on the gold standard while creating money, which meant they had to devalue their currencies. The United States went from $20.87 for an ounce of gold to $35 for an ounce of gold, an expropriation of over 40% of all Americans' wealth.

The thing about devaluations, though, is that it only makes you look good in comparison to countries that have no devalued. When your economy begins to recover through increased demand for your exports, other countries can stop this by also devaluing their currencies. This is called "competitive devaluation," and it's generally agreed that it sucks.

Like I said, countries shouldn't resort to devaluation in normal circumstances. The Great Depression, however, wasn't normal circumstances. In his book Golden Fetters, economist Barry Eichengreen shows two things: 1) that "Eichengreen" is an awesome last name, and 2) that countries who left the gold standard sooner experienced recovery from the Great Depression sooner.

But leaving the gold standard was just gonzo devaluation. It was a declaration that no convertibility rate would be too crazy for use, and it only looked good when not everyone had done it.

Beginning with Abenomics, we are now re-entering a world of competitive devaluations. Switzerland, Denmark, and now speculation builds about China. (Maybe China just heard the "competitive" part of the term and their knee-jerk reaction took over. Airport, mall, bridge, et cetera.)

Needless to say, I'm keeping an eye on the China situation with a keen interest. I think a very effective way of teaching my students macroeconomics would be to respond to a 30% pay reduction with a 30% effort reduction, but I don't know if my overlords supervisors would agree.

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