Recently, we looked at whether a strong currency would help the economy – Is a strong currency a good thing?
The other side of the equation is – to what extent will a devaluation will help an economy? Commentators frequently write that devaluation (1) should help ‘rebalance’ the economy and help create an export led recovery. But, since 2008, we’ve seen a 25-30% devaluation in Sterling and we are left with only very weak recovery, cost push inflation and a surprisingly large current account deficit. It seems the depreciation in the pound has done very little to help the UK economy. (This all makes a very good A – Level question – discuss the macroeconomic effects of a depreciation in the exchange rate? – because there’s plenty of scope for evaluation.
In theory, a devaluation will cause the following to happen:
- The price of UK exports will be lower in foreign currencies. This will increase the competitiveness of UK exports and should cause an increase in demand for UK exports.
- The price of imported goods into the UK will increase. This will reduce our spending on imports and instead we will be more likely to buy domestic goods.
- The increase in (X-M) should cause an increase in AD, economic growth and cause a reduction in unemployment.
- The increased competitiveness should cause an improvement in the current account.
What has happened in the UK since late 2007?
The pound has fallen considerably against the Euro.
1. Economic growth. In terms of economic growth, the past five years have been worse than the great depression. The devaluation hasn’t really caused any significant export led growth.
2. Current account deficit. The current account deficit has actually got bigger.
In 2008, the current account deficit was less than 2% of GDP. At the end of 2012, this current account is getting close to 5% of GDP. (more at current account balance of payments) This seems to contradict economic theory – you would expect a devaluation to improve the current account not worsen it.
How do we explain failure of devaluation to rebalance the economy?
1. Inelastic demand for exports and imports Evidence suggests that demand for UK exports is relatively inelastic. UK exports have become less price competitive as we’ve moved away from low-cost manufacturers to a variety of services and high-tech manufacturing; these goods tend to have relatively few close substitutes. Therefore, even if the price falls, the increase in demand is relatively low. Similarly, demand for imports is relatively inelastic meaning we continue to pay the higher price. (The Marshall-Lerner condition states a devaluation will worsen the current account if PEDx + PEDm >1)
2. Firms haven’t passed on the effects of devaluation In theory, devaluation leads to a lower price of exports. However, firms could choose instead to keep the foreign currency prices the same, but increase their profit margins instead. Rather passing the devaluation onto foreign customers, UK exporters just make more profit. In a recession, exporters are keen to improve their cash balances and so are keen to increase profit margins.
In 2008, the Bank of England showed that the rapid devaluation hadn’t caused a fall in the UK terms of trade. UK export prices didn’t fall, but actually increased. I’m not sure if this is still the situation five years later. But, it explains how a devaluation may not cause lower export prices.
3. Weak external demand
A devaluation is not much help if your main export partners are in a recession. The double dip EU recession means there has been a fall in demand for UK exports. This has outweighed the more competitive prices. The weak external demand is a key factor in disappointing current account figures.
4. Higher import prices
The problem of devaluation is that it leads to higher import prices. Raw materials used in production increase in price and contribute to cost-push inflation. To some extent, higher raw material costs offsets the lower export prices. Recently, the Bank of England deputy governor, Paul Tucker stated he would be open to a weaker pound, but the benefits of a weaker pound would be lost if inflation expectations rose. (Reuters)
The impact on inflation has been muted because of the negative output gap; but, in the past few years, the inflationary impact of devaluation has often been greater than the Bank of England forecast and was a major factor in explaining the cost push inflation we have seen in recent years.
5. Poor Productivity growth
Devaluation only really affects demand. The other side of the equation is supply and productive capacity. The past five years have been very disappointing from the perspective of UK productivity. Devaluation doesn’t necessarily do anything to promote investment and higher productivity. Some even argue that devaluation can reduce the incentive to be efficient because you become competitive without the effort of increasing productivity. Poor productivity could be another factor explaining the current account deficit.
Overall Impact of devaluation
Devaluation has had less impact on the economy than we might expect. Devaluation is certainly no magic bullet, which solves the ills of the economy. Part of the reason is that the whole global economy, and Europe in particular, is depressed. In a depressed global environment, the benefits of a devaluation are muted. However, despite the limited impact of devaluation, I believe the economy would be significantly worse, if we were in the Euro and 30% overvalued. If that was the case, we would be struggling to regain competitiveness through internal devaluation – an even deeper recession.
I would come to the same conclusion as Martin Woolf who says in the FT that A weaker pound is welcome but no panacea
(1) See technical difference between depreciation and devaluation here. I sometimes use devaluation when correct term is depreciation only because in everyday language people tend to talk about devaluations when strictly speaking it is a depreciation.