Tuesday, August 11, 2015

Yuan Lowered -- Pure Test of Silly Theory

Since John Maynard Keynes proposed the idea in the 1920s, academics and folks in the practical world have latched onto the idea that devaluing your currency is a free ticket to prosperity.  The idea on its face is almost ridiculous.  The logic says that devaluing your currency lowers your prices as compared to the prices of identical goods in other countries.  The demand shifts from the higher price countries that have not devalued their currency to those countries that have.

This notion is often advanced by Krugman and others to argue that Greece, for one, would be better off with its own currency so that it can devalue its currency relative to others.  Would that it were that easy.

Keynes and Krugman should be the first to admit that it may not be possible to lower the value of your currency relative to others.  Markets determine currency values, even in a world of fixed exchange rates. If you believe that markets don't determine currency values, then  if country A can lower it's exchange rate with country B, why can't country B return the favor. It was, after all, Keynes who argued that the real wage may not be able to fall in a depression, because prices might fall even faster than nominal wage rates.  Why doesn't an essentially identical argument apply to relative currency values?  The answer: it does.

But more important is that prices can and do adjust even in single currency zones -- for example, in the US.  Where are the high price areas ? --  New York City, San Francisco, etc.   Where are the low price areas? - Alabama, Mississippi, Louisiana, etc.  Prices, in fact, adjust without the need to have a different currency in different places.  Watch Greece for the next real world example of price adjustment within a single currency zone.  Greek prices will fall relative to the prices of identical products within other countries in the Eurozone.  You don't need a Greek currency to pull this off.

The idea that prosperity can be produced by arbitrarily lowering the value of one's currency is bad economics and potentially disastrous economic policy.  Free markets should dictate currency values, not bureaucrats' mistaken notion that there are easy fixes to sluggish economies.  China's devaluation will not pull China out of its current slowdown and could produce an "announcement effect," that suggests that China's economy may be far weaker than the pundits think.

No comments: