Currency devaluation – why is it useless in some cases?

Due to the Tuesday call for referendum by the Greek Prime Minister, George Papandreou, it is becoming more and more likely that Greece will chose its own path out of further bailouts and enforced austerity and into default and exit from the euro. I have covered a more negative scenario (full euro break up), and today I will touch upon the effects of currency devaluation. 

The devaluation of a currency will yield two immediate effects: an increase of exports (since domestic goods are now cheaper for foreigners so they will want to buy more of them) and a decrease of the value of domestic wages in terms of the foreign currency, making domestic workers more competitive on the international markets.

However, there are many other indirect effects that are likely to completely crowd out any positive effects of currency devaluation. Since Greece is the first most likely to exit the euro and devalue its currency, I will look at the effects from a Greek perspective. The Greek people and businesses were, just like the Greek government, running high debts and used them to fuel their consumption previous to the crisis. An increase of the exchange rate would imply higher interest payments in drachmas for all those with outstanding loans with the banks, leaving the households and businesses with less disposable income. As a response to this effect the labour unions may negotiate higher domestic wages in terms of foreign currency (the euro) which will crowd out the devaluation effect and yield an inflationary effect of roughly the same size as the devaluation, thereby undermining the increase in competitiveness. Besides, Greece needs to completely change and restructure its labour market and labour market conditions if it wants to make its workers more competitive on the international market. No currency devaluation will resolve the deep structural problems of the labour market, no matter how competitive they may seem to appear due to cheaper currency.

Concerning the export increase (due to lower export prices), if the labour unions do increase the wages and spur an inflationary effect over the economy, this will increase the prices of domestic goods further offsetting positive devaluation effects. Besides, currency depreciation can work only in countries which have high production levels and a huge industry such as Japan or China. Greece isn’t like that as it runs mostly a service based economy. 

In short, devaluation of a currency doesn’t have to be the right answer and can very likely yield no particular positive effects, only inflation in the long run. One should think about the specific country conditions when deciding to impose currency devaluation and how it might react. The textbook cause and effect relations don’t work for all countries the same way, and policymakers and economist who propose such ideas should keep that in mind. 

Comments

  1. John Turpin5 November 2011 at 00:27

    I agree Greece needs to restructure its labour market and that it's suffering from deep structural imbalances.

    But I don’t think the depreciation would endanger the restructuring, as you seem to imply, I think it could work in favour of it. Think about it; it would be much easier to do the necessary restructuring if the labour force is slightly more competitive thanks to the devaluation. Argentina had structural problems in the labour market, massive strikes and a recession similar to Greece where its tight dollar peg made them attract more foreign capital before the crisis (just like Greece attracted more foreign capital thanks to the euro) making them vulnerable to a credit stop. A deep recession was partially due to its currency peg, just like Greece. It was fiscal policy as well, but foreign borrowing imbalacnes did the trick. A devaluation is a good start to fix this

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  2. Vuk Vukovic5 November 2011 at 11:54

    it's true that capital flows led to imbalances in the current account of not just Greece, but Spain and Portugal as well.

    However, I don't see your point in why would a devaluation make it "easier" to do a restructuring. I don't see any causal relationship between the two variables.
    Do you think that once they are more competitive, the workers (organized in unions) will accept labour market reforms more likely? I'm not so sure. With or without a devaluation the workers will still offer a hard opposition to any change.

    look at the situation now - strikes are spread out throughout the country - even the revenue collecting staff and customs officers are striking and adding to the woeful situation (as this implies less revenues collected and further increase of the deficit). Greek's unions are very well organized and a push for higher wages as a consequence of increasing interest payments after the devaluation is very likely to expect.

    the labour market needs a political incentive to start restructuring, and in the case of Greece, taking into account its turbulent history in the last 60 years, I'm worried about the final political outcome of such a hostile situation.
    this is why I can't see the devaluation as necessarily good for Greece, as it can add to the imbalance further and result in an inflationary effect (another historical "enemy" of this country)

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  3. Vuk Vukovic9 November 2011 at 23:41

    btw, here's something about the Argentina scenario from Tyler Cowen's Marginal Revolution blog:

    http://marginalrevolution.com/marginalrevolution/2011/11/hows-the-argentina-recovery-coming-along.html

    ReplyDelete

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