Why Devaluing the Currency is a Bad Idea?

The European economy is facing a significant downturn. There is a looming financial crisis in Europe which has been caused by excessive borrowing in the past.

However, it is unlikely that this borrowing will stop in the near future. This is because the immigrant crisis in Europe is draining its resources making borrowing inevitable. In this dismal economic climate, Europe is likely to follow the path of devaluing the currency.

The popular myth is that devaluing the currency gives a boost to exports and helps the overall economy grow.

In this article, we will debunk this myth and find out why devaluation is not the solution to anything.

How Will Devaluation Help?

Devaluation is supposed to help countries correct their balance of trade problems. This is because theoretically devaluation makes exports cheaper and imports more expensive. A simple example is as follows.

Let’s say that a European exporter sells his goods in the United States for $100. For simplicity sake, let’s assume that there is a 1:1 ratio between the Euro and the dollar. Hence, the exporter can bring home 100 euros, pay his expenses of 80 euros and still net 20 euros in profit.

If this exchange rate were to somehow fall to 1.5 Euros per dollar, the exporter could sell the same product for $66 in the United States and still net 20 euros in profit. A 33% reduction in price would make the European exporter competitive in the American markets.

There are several problems with this argument. Some of them have been listed below.

Beggar Thy Neighbor

Currency devaluation is a “beggar thy neighbor” policy. It is also commonly known as dumping and is restricted by the World Trade Organization. The problem with this policy is that any gains which are made by the devaluing currency are at the direct expense of other parties involved.

In the above example, the European exporter was gaining at the cost of local American players. It is highly unlikely that other countries allow such economic hooliganism to continue unchecked.

Currency devaluations are often followed by competitive devaluations or impositions of prohibitive tariffs by other nations in an attempt to negate the unfair advantage gained.

Most Exporters are Hedged

Another logical problem with this argument is that under normal circumstances exporters will not obtain the benefit of currency fluctuations. This is because most exporters are hedged in the short term. The use financial instruments like futures and swaps to lock in their currency values. The benefit of devaluation is often pocketed by the speculators who add no value to the economy of either nation!

Exporters are Importers Too!

Also, it needs to be noted that exporters are importers too. For instance, if a country exports cars it may have imported raw materials like tires and seats. A devaluation means a fall in the value of the currency. Hence, as exports become cheap, imports become equally expensive. As a result, the gains of currency devaluation for most countries are offset by the losses caused by currency devaluation too.

Workers Lose Real Wages

Currency devaluation can only occur with debasement. This means that the value of a currency can only be dropped by increasing the amount of currency in circulation. Hence, by definition, devaluation is likely to cause inflation. Inflation means a rise in the price of goods and services in the economy. If all the goods and services in the economy become more expensive and the wages do not rise, the workers are at loss. The nominal wages of the workers are stagnant. However, the real wages have fallen drastically!

The process of devaluation is, therefore, nothing more than a mechanism to transfer the wealth of the working class to the wealthy industrialist. It is wrong to say the devaluation benefits the country when the vast majority of the labour force is at a loss because of it. This excuse is used to obscure the process and convince gullible masses to support the illicit transfer of their own wealth.

The good part about devaluation is that foreign workers are not attracted to countries with lower wages. Hence countries facing a problem with immigrant workers are likely to experience some relief as a result of devaluation.

Consumers Face Higher Prices

Lastly, devaluing the currency is also a bad idea for the general population too. This is because inflation is not good for the masses as well. The purchasing power of the consumers is eroded. Imported goods also become needlessly expensive. This forces consumers to buy local goods even though the local producers may not be competitive.

Like the workers, consumers too are ripped off. The only beneficiaries in this entire game are the wealthy industrialists. It is therefore fair to say that policies like devaluation do not have much of an economic basis. Instead, they are politically motivated.

To sum it up, devaluation is a policy that harms the financials of the country. It is only symbolic of the fact that the central bank of a nation is printing currency faster than its peers.

Devaluation absolutely distorts all prices in the economy. As such it also interferes with the price signals that the market sends. Such distortion of price signals leads to malinvestment in the short run which then further leads to boom and bust cycles in the long run.