Greece’s inability to devalue its currency is often cited as a reason for the extreme economic pain its citizens are enduring, and many commentators say the country should return to the drachma to restore competitiveness.
In the U.K., which ― unlike Greece ― isn’t part of the euro area and can devalue if it wishes, there’s growing pressure to do so. A letter recently circulated to some 3,000 influential figures proposed deliberately weakening the British pound to boost exports and hence economic growth. Debasing currencies in this way is promoted as an alternative to sovereign default, as well as to other methods of increasing competitiveness, such as cutting nominal wages.
But all this wistful focus on currency devaluation ― the route that countries such as Greece, Spain and Italy cannot take so long as they remain in the euro area ― is a mistake.
To start with, devaluation is not an alternative to sovereign default. When a government decides to devalue, savers who trusted the currency to store their wealth, and creditors who bought bonds denominated in the currency, find the value of their assets cut. That’s sovereign default by a different name.
Official net U.K. debt excluding the effect of financial interventions such as bank bailouts is about 1 trillion pounds ($1.57 trillion), or 36,000 pounds per household. A recent analysis of U.K. pension accounts by Ros Altmann of Saga Group Ltd., an enterprise focusing on financial services for those aged over 50, estimated that the 5 trillion-pound to 7 trillion- pound cost of U.K. unfunded state pensions amounts to at least an additional 180,000 pounds per household. The U.K. government must either default or modify unfunded promises if it is to resolve those debts. Devaluing the pound would be one way to achieve that.
But if the U.K. were to decide to default or reduce unfunded liabilities, it would be better to do so openly, with conscious decisions made as to which creditors will lose out and by how much. A structured default avoids triggering inflation and helps people plan.
Default through devaluation, in contrast, is a policy of deliberate inflation. Inflation is popular with elected governments as it reduces the real cost of national debts without the need to declare default or ask for a bailout. But that comes at a cost. One of the downsides to inflation is the arbitrary way in which it redistributes wealth.
To quote from John Maynard Keynes: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
This lesson was subsequently forgotten by Keynes’s own followers, but was relearned during the stagflation of the 1970s.
The counterargument is that devaluation improves a nation’s relative competitiveness and gives a boost to its export industries. But here’s the rub: Such a boost can only ever be temporary.
The U.K. discovered this again in 2008, when the effect of “crisis resolution” policies, such as dropping interest rates to near zero and printing money in the form of quantitative easing, resulted in the pound losing 25 percent of its value. As the policy took effect, imports became more expensive and prices rose to compensate, triggering inflation. Exporters enjoyed benefits, but these were matched by the costs suffered by importers ― and, in turn, consumers. Like other forms of monetary debasement, such as quantitative easing and bailouts, devaluation creates the mirage of benefits in the short term, but these are paid for by citizens over time.
Should the U.K. repeat the exercise and devalue again through quantitative easing, as suggested by last month’s Bank of England Monetary Policy Committee meeting, it would risk getting trapped on an inflationary treadmill.
The historical record on this issue is pretty clear. No nation has achieved lasting prosperity by undermining its currency. Anyone who has any doubts on this should look at the history of Argentina, which had repeated devaluations and currency crises and remains an economic basket case.
Devaluation is just one of many soft-money tools presently deployed in concerted, but misguided, attempts to fix the financial crisis. Has it escaped the attention of European citizens that the crisis has only gotten worse the longer interest rates have been maintained at near zero levels; the more money the European Central Bank has issued via quantitative easing; and the more cheap funding has been provided to banks to which no market participant would lend?
Partly because Greece, Spain and Italy cannot devalue without leaving the euro, it is often argued that devaluation is a potential savior for countries such as the U.K., which luckily have their own currencies. This is deeply flawed logic. The answer to whatever the U.K.’s current problems are can hardly be more of the same policies that created those problems. Politicians who promise jam and sweeties today at the expense of currency debasement are poor servants of their national interests. Together with the ill-judged decision to bail out bankrupt banks with loss-making business models, this trend has prolonged the crisis that swept the Western world in 2008.
Carmen Reinhart and Kenneth Rogoff’s 2009 bestseller, “This Time Is Different,” charts eight centuries of financial crises and broadly splits them into sovereign defaults and banking collapses. The present Western crisis is severe because we have both. We need solutions to both of these problems and, despite its many fans, currency devaluation addresses neither. It can mask the symptoms of the crisis, but it can’t cure them. Such policies are like plastering over a structural crack in a load-bearing wall: They end in a pile of rubble.
By Gordon Kerr
Gordon Kerr is the founder of Cobden Partners and the author of “The Law of Opposites: Illusory Profits in the Financial Sector.” The opinions expressed are his own. ― Ed.
