Why Devaluation Doesn't Work Like In The 1930s
You can very frequently these days read pro-inflationist writers point to the experience of the 1930s as "evidence" of the effectiveness of inflation and currency devaluation/depreciation.
The storyline is basically that the countries that first abandonded the gold standars, such as Britain, recovered first, the countries that abandoned it somewhat later, like the United States recovered somewhat later while the countries that held on to the gold standard the longest, like France and Belgium, suffered the longest slump.
Actually, the empirical record wasn't quite as clear cut as it is sometimes claimed, but it is still fair to say that there was a strong correlation between leaving the gold standard and recovering.
Yet if you look at the empirical record for today's Europe, and for that matter the rest of the world, you find no positive correlation between devaluations and economic recovery.
It is true that there are some countries with floating exchange rates that have had a strong recovery, such as Poland and Sweden, and that there are euro area countries that are still depressed, like Greece and Ireland. But there are also strong euro area economies like Finland, Germany, Slovakia and Luxembourg and depressed countries with floating exchange rates, like Iceland, Hungary and Romania.
Furthermore, in the case of for example Sweden, the relative boom came after the krona recovered its previous loss in value (the loss in output in Sweden was actually significantly above the euro area average when the Swedish krona was at its lowest in early 2009) , so it seems very far fetched to attribute its relative boom to a weak currency. Instead, the real explanation is the supply side tax- and social benefit reduction strategy of the Swedish government that caused the strong recovery. The story behind the Polish recovery is similar.
Why then does currency devaluation/depreciation and inflation work so much worse this time than during the 1930s? Well, I hinted this the other day when I discussed the issue of secondary deflation. During the 1930s, the massive collapse of fractional reserve banks caused massive, double digit deflation, something which given the zero bound barrier for nominal interest rates implied double digit levels for real interest rates even for risk free loans. This meant that real interest rates were way above the level reflecting time preferences, or the natural interest rate, and so business activity was depressed. The fact that governments also tried to prevent nominal wage reductions despite the massive deflation also aggravated the crisis. And when other countries abandoned the gold standard, the increase in the exchange rate of the gold standard countries aggravated deflation, and so also the excessive real interest rates and excessive real wages, depressing their economies further.
The current situation, when real interest rates is at or below the natural rate is very different. Just because ending excessive real interest rates will stimulate a recovery doesn't mean that pushing real interest rates further below the natural rate will necessarily boost the economy. It could do so in the short-term under certain circumstances, but the returns are diminishing when interest rates fall below the natural rate. This is especially so if optimism is muted, as it is right now.
The storyline is basically that the countries that first abandonded the gold standars, such as Britain, recovered first, the countries that abandoned it somewhat later, like the United States recovered somewhat later while the countries that held on to the gold standard the longest, like France and Belgium, suffered the longest slump.
Actually, the empirical record wasn't quite as clear cut as it is sometimes claimed, but it is still fair to say that there was a strong correlation between leaving the gold standard and recovering.
Yet if you look at the empirical record for today's Europe, and for that matter the rest of the world, you find no positive correlation between devaluations and economic recovery.
It is true that there are some countries with floating exchange rates that have had a strong recovery, such as Poland and Sweden, and that there are euro area countries that are still depressed, like Greece and Ireland. But there are also strong euro area economies like Finland, Germany, Slovakia and Luxembourg and depressed countries with floating exchange rates, like Iceland, Hungary and Romania.
Furthermore, in the case of for example Sweden, the relative boom came after the krona recovered its previous loss in value (the loss in output in Sweden was actually significantly above the euro area average when the Swedish krona was at its lowest in early 2009) , so it seems very far fetched to attribute its relative boom to a weak currency. Instead, the real explanation is the supply side tax- and social benefit reduction strategy of the Swedish government that caused the strong recovery. The story behind the Polish recovery is similar.
Why then does currency devaluation/depreciation and inflation work so much worse this time than during the 1930s? Well, I hinted this the other day when I discussed the issue of secondary deflation. During the 1930s, the massive collapse of fractional reserve banks caused massive, double digit deflation, something which given the zero bound barrier for nominal interest rates implied double digit levels for real interest rates even for risk free loans. This meant that real interest rates were way above the level reflecting time preferences, or the natural interest rate, and so business activity was depressed. The fact that governments also tried to prevent nominal wage reductions despite the massive deflation also aggravated the crisis. And when other countries abandoned the gold standard, the increase in the exchange rate of the gold standard countries aggravated deflation, and so also the excessive real interest rates and excessive real wages, depressing their economies further.
The current situation, when real interest rates is at or below the natural rate is very different. Just because ending excessive real interest rates will stimulate a recovery doesn't mean that pushing real interest rates further below the natural rate will necessarily boost the economy. It could do so in the short-term under certain circumstances, but the returns are diminishing when interest rates fall below the natural rate. This is especially so if optimism is muted, as it is right now.
posted by stefankarlsson at 11:52 PM
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