Thursday, April 23, 2009

Exchange Rates Are A Zero Sum Game

With just about all countries in the world suffering from the financial crisis (though to a varying extent), various solutions are offered to remedy this.

One of the least sensible, yet also one of the most popular, is currency devaluations, or depreciations. Particularly in the U.K. and Sweden, many pundits have argued that their own countries are so lucky to have a freely floating currency of their own, so that these currencies can not so much float, but sink in value against the euro. U.K. pundits usually tells of how much better off the U.K. is compared to Ireland (who is part of the euro area), and Swedish pundits usually tells of how much better off Sweden is compared to Finland (who is part of the euro area) and Denmark (whose krone has a fixed exchange rate versus the euro).

Often they go from asserting that their weak currencies benefits their economies to also implying or saying outright, that if only those other countries had floating exchange rates too, then they too would receive those benefits.

Yet all of this overlooks one key truth: exchange rate movements are a zero sum game. One country's currency devaluation/depreciation is always and by necessity a currency revaluation/appreciation for other countries.

Until the day we start trading with space aliens, the weighted exchange rate for the world as a whole will by necessity always be unchanged. And introducing extraterrestrials wouldn't really change the principle, as we could simply reformulate it into "the weighted exchange rate for the universe as a whole will by necessity always be unchanged".

The fact that the weighted exchange rate for the entire world will always be unchanged and that therefore any exchange rate depreciation/devaluation for one country will mean a exchange rate appreciation/revaluation for others, means that it cannot be said to be a cure for the global economic downturn.

Assuming for the sake of the argument the view that a weaker currency will make the economy stronger, then this also implies that a stronger currency will make the economy weaker.

If for example Ireland would follow the advice to reintroduce its pound and Finland would reintroduce its Mark and Denmark would let its krone sink in value, then that might make their economies stronger, but it would at the same time damage other economies, whose exporters would have an even harder time. What if the other euro linked economies also decided to drop out? Since exchange rates are relative, there must be some economy left standing with a strong currency. And who is that supposed to be? Germany, who is already suffering from a sharp drop in exports? Wait until you see how big that drop becomes when not just smaller economies like Ireland, Finland and Denmark but also bigger ones like Spain, Italy and France starts with competitive devaluations. Incidentally, such a trend of competitive devaluations would also eliminate the current assumed gains for the U.K. and Sweden.

Any gains from currency devaluations would thus be of the "beggar they neighbor" kind where you gains at the expense of others. But that only works if those others turn the other cheek and accepts getting fleeced. And more to the point, since everyone can't gain at the expense of everyone, it will obviously not work as a solution to the global economic crisis.

Some floating exchange rate theorists have tried to deny this by using some Keynesian models that says it is beneficial if a country with a strong economy gets some demand redirected to countries with weaker economies through the exchange rate. But apart from the many flaws of Keynesian models, this argument is obviously not applicable to the current situation where all countries are suffering from an economic slowdown.


Blogger Per Johansson said...

Not to mention that unemployment in Sweden has become higher than in Finland and is expected to stay higher through 2010, according to government forecasts. So a sinking currency does not seem to help much.

11:31 PM  

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