Competitive devaluation occurs when countries seek to reduce the value of their exchange rate to make their exports cheaper and gain a competitive advantage in world trade over other countries. This may encourage other countries to respond by also devaluing their currency to maintain their own competitive advantage. If countries are making great efforts to keep devaluing against each other, it could be termed a currency war.
For example. A devaluation of the Japanese Yen makes Japanese exports cheaper; also Japanese imports from abroad will be more expensive. Therefore (assuming demand is relatively elastic) after a devaluation, Japan should see an increase in domestic demand and higher economic growth.
However, if Japan devalues, then other countries, such as the UK and US, will see an appreciation in their currency. Therefore, the UK and the US will lose competitiveness and may see lower domestic demand.
Therefore, if Japan devalues, it may encourage other countries to follow suit and also try and devalue.
Competitive Devaluation in a Recession
In a global recession, demand is low and countries are struggling to escape recession. Understandably, devaluation becomes an attractive option to boost domestic demand.
- It is a relatively painless way to boost domestic demand. (e.g. you don’t need to borrow like fiscal policy).
- One drawback of devaluation is that usually, it can be inflationary, but in a recession, inflation is unlikely to be a problem.
- Devaluing currency usually involves loose monetary policy (e.g. increasing money supply, cutting interest rates). Therefore this provides an additional boost to demand.
Problems of Devaluation
- Beggar Thy Neighbour. Devaluation in a recession is considered to be a ‘beggar thy neighbour‘ policy. The country who devalues gains at the expense of another country who becomes less competitive. In other words, a Japanese devaluation increases Japanese domestic demand, by reducing demand in the US.
- It can cause Central Banks to become more political and exceed their usual authority in manipulating the exchange rate.
- The increased politicisation of the exchange rate could cause a rise in retaliatory tariffs. (e.g. in the past, the US threatened to impose tariffs on China for their alleged manipulation of the exchange rate.
- Can cause excessively loose monetary policy, which leads to future inflation (e.g. hyperinflation in Japan after 1936)
There is a summary of a critique of competitive devaluation by Jens Weidmann, a European Central Bank policymaker.
Defence of Devaluation
I don’t agree with Jens Weidmann’s concerns over a currency war. His concerns primarily reflect the ECB’s misplaced emphasis on low inflation and highlight the unwillingness of the ECB to pursue economic growth.
- The first objective of any country is to pursue the monetary policy which is most suitable for their economic situation. If a country like Japan is experiencing deflation. It is correct to pursue expansionary monetary policies. They should be seeking to reduce the value of their currency and pursuing a looser monetary policy. If Europe faces more deflationary pressure as a result of an appreciating exchange rate, then they are also merited in pursuing a looser monetary policy which may lead to devaluation.
- Competitive Devaluation may lead to shifts in demand. But, there is no overall welfare loss from competitive devaluation. In fact, if a country like Japan uses devaluation to get out of recession, the rest of the world can benefit. If Japan can get out of a recession, then they may experience a positive multiplier effect and there will be a higher demand for exports. When countries are stuck in recession, resources are wasted and resources idle. Efforts should be made to overcome this.
- If a country is severely uncompetitive, with a large current account deficit, then they should allow a devaluation. To artificially keep a currency high in a recession would be a great mistake.
Competitive Devaluation and Currency Manipulation
A competitive devaluation implies that a country pursues the correct monetary policy and allows the market to allow the exchange rate to find its correct level. However, some countries may pursue currency manipulation – using exchange controls to artificially keep the exchange rate below its market level. This is different and can be considered unfair trading practises. E.g. In the early 2000s, China had a huge current account surplus but still intervened to keep the value of the Yuan undervalued.
Leaving the Gold Standard
After the first world war, many countries re-entered the Gold Standard and pre-war exchange rates. However, these exchange rates were often unsuitable. In the case of Britain keeping ourselves in the gold standard kept exports low, and UK interest rates had to be kept high. This led to a recession. Leaving the gold standard in 1931, helped the UK become more competitive and attain some economic recovery. Countries who left the Gold standard first tended to recover from the great depression quicker and faster. Leaving the gold standards and enabling lower interest rates was the correct thing to do.