The Evils Of Devaluation

``The much talked about advantages which devaluation secures in foreign trade and tourism, are entirely due to the fact that the adjustment of domestic prices and wage rates to the state of affairs created by devaluation requires some time. As long as this adjustment process is not yet completed, exporting is encouraged and importing is discouraged. However, this merely means that in this interval the citizens of the devaluating country are getting less for what they are selling abroad and paying more for what they are buying abroad; concomitantly they must restrict their consumption. This effect may appear as a boon in the opinion of those for whom the balance of trade is the yardstick of a nation's welfare.”-Ludwig von Mises, The Objectives of Currency Devaluation, Human Action, Chapter 31

Policies can be said to be socially beneficial if gains exceed the costs.

By such measure we can say that devaluation, as seen by some as a necessary evil, is nothing but an illusion.

How? Because devaluation:

1. Undermines the role of the US dollar as international currency reserve.

The role of the US dollar as the world’s currency reserve is to provide the medium of exchange function not only for national use but for the global economy. This means that the main channel of providing liquidity for international exchange is to have strong (overvalued) currency that imports more than it exports. By expanding current account deficits, the US finances global transactions mostly invoiced in US dollars.

However once the US dollar reaches a point where deficits would be vented on the currency, the role of the US dollar as the sole international currency reserve may be in danger.

The global central bank holdings of US dollar have reportedly been down to about 62% from over 70% during the past years. Moreover, as discussed in What Global Financial Markets Seem To Be Telling Us, the clamor to replace the US dollar standard has been getting strident.

Last week, a Latin American trade bloc of 9 members, the Bolivarian Alternative for the Americas (ALBA) declared that it would cease using the US dollar for regional commerce next year (Chosun English).

All these means that if the US continues to devalue its dollar, to point of losing its privileges from international seignorage [net revenue derived from issuing currency], or its international currency reserve status, this would translate to diminished access to global finance to fund domestic (trade or fiscal) deficits, reduced access to more goods and services worldwide, and a diluted leverage on the geopolitical sphere.

In short, the cost of devaluation greatly overwhelms the alleged benefits.

2. Overestimates the role of international trade as the share of the US economy.

One of the mainstream reductio ad absurdum is to overemphasize or, on the other hand understate, the role of global trade in the US economy, depending on the bias of the commentator.

For instance, some deflation proponents use 13% of import share to the US economy as rationale to downplay the transmission mechanism of global inflation to the US economy.

Using the data from wikipedia.com, we note that exports account for only 9% ($1.283 2008) of the US economy ($14.441 trillion 2008) while imports account for 15% ($2.115 trillion). The point is international trade accounts only one fourth of the US economy.

Yet common sense tells us that policies that allegedly promote 9% (exports) of the US economy at the expense of 91%, which is deemed by some as being net beneficial to the economy, is deceiving oneself or is consumed by political or economic ideological blindness, or is totally ignorant of the tradeoffs of the cost and benefits from said policies or is extending the intoxicating influence of political propaganda.

3. Creates Systemic Inflation Which Overwhelms Advantages From Currency Depreciation

When governments decide to devalue, it embarks on credit expansion or conduct fiscal spending or other monetary tools or a combination of these policies, in support of special interest groups, as in the case of the US, the banking system (for media, the exporters) for a specific goal (debt repudiation or promotion of exports/tourism).

This in essence would lead to a redirection of investments or a diversion of real resources from other activities.

If the currency depreciates as a result of the government actions but the impact of which does not reflect on domestic prices, then the interest groups supported by such policies or those that engage in foreign currency exchange or trade will likely incur large profits.

However, once prices adjust to manifest the impact of the currency depreciation on imports and to producer and consumer goods, then the short term advantage erodes.

According to Dr. Frank Shostak, ``the so-called improved competitiveness on account of currency depreciation means that the citizens of a country are now getting less real imports for a given amount of real exports. In short, while the country is getting rich in terms of foreign currency, it is getting poor in terms of real wealth, i.e., in terms of the goods and services required for maintaining peoples' life and well-beings. As time goes by however, the effects of loose monetary policy filters through a broad spectrum of prices of goods and services and ultimately undermine exporters profits. In short, a rise in prices puts to an end the illusory attempt to create economic prosperity out of thin air.” (bold emphasis added)

In short, the beneficial impact of devaluation to certain groups will likely be short term and will eventually be offset by inflation.

4. Neglects The Role of Division Of Labor In Terms Of Imports and Exports

Adding to the fallaciously oversimplistic methodology by which mainstream seem to look at the world as operating from a homogeneous form of capital, whose product is produced by a single type of labor and sold as one dimensional product to an indiscriminate market affected by the same degree of price sensitivity, they also seem to think that exports have little correlation to imports, whereby final product sold abroad are all locally designed or processed- raw material sourcing, assembly, manufacturing, packaging, testing and etc...

The mainstream forgets about re-exports or imports of semi assembled products, parts or components that make up another product to be re-exported.

Applied to Asia, global parts and component trades have increasingly made up manufacturing output (see figure 3)

Figure 3: ADB: Emerging Asian Regionalism

To quote the ADB, ``In Integrating Asia, the share of parts and components trade (PCT) in manufacturing trade shot up from 24.3% in 1996 to 29.4% in 2006. That is a remarkable rise, not least since worldwide its share has scarcely increased, edging up from 19.6% to 20.2% over the same period.

``As a share of GDP, PCT is among the highest in the world in the ASEAN (especially in Malaysia, the Philippines, Singapore, and Thailand) and in Taipei,China, perhaps because the relatively small size of their economies makes specializing in small niches of comparative advantage particularly important. Broadly speaking, the success of these economies is based on policies that welcome foreign companies, encourage technological upgrading, and build strong connections with world markets, as well as on their proximity to Asian neighbors following similar strategies. PCT is particularly significant among ASEAN countries: it rose from an average of 35% of manufacturing trade in 1996 to 43% in 2006. The PCT share in the PRC nearly doubled over the same period, from 12.5% to 24.0%, while in India it remained at around 10.0%.” (bold emphasis mine)

In short, in a world where the integration of the global economy has been deepening to reflect on the specialization or division of labor, imports has significantly contributed to manufactured products which are eventually re-exported. Such trade specialization constitutes as the lengthening of the economic structure.

Figure 4: ADB: How A Typical Hard Drive Is Produced

As an example, the ADB shows how Asia’s parts and component trade (PCT) for a hard disk drive, assembled in Thailand, is networked within Asia and partly outside the region. And that’s merely for a hard disk, which also is only a component for a computer set.

So currency prices haven’t been the only factor that shapes production, but importantly trade openness, comparative advantages, division of labor and variability of markets as the ADB points out.

Here, globalization reveals that the division of labor and comparative advantage has been more than just “ideal” or “theoretical”. Instead, these economic forces depict of its pervasiveness in the global economic capital construct. They have even proven to be a more potent force than simply acquiring market share via currency price adjustments.

Talk about a genuine multiplier effect from free trade!

5. Overlooks On The Role of Societal Transition

One of the reasons why many support the government’s devaluation policies has been underpinned by concerns that US manufacturing output as a share of GDP has been declining.

The misimpression is that jobs have been exported out to third world countries.

Again, mainstream myopia which only looks at the surface sees jobs as one dimensional in nature. Their highly mechanistic viewpoint can’t seem to distinguish between low-scale low-value highly-commoditized jobs vis-à-vis high value specialized jobs or can’t seem to comprehend or digest the role of comparative advantage and specialization or division of labor in a world which practices globalization or freer trade.

The US supposedly is the premiere representative of the world’s democratic capitalism which implies that she has once been the world’s freest economy. Yet it is when an economy is economically free or open to trade that the advantages of comparative advantage and specialization can be seen and felt most.

For instance: in the 2008 capital goods accounted for the top US exports, according to US Department of Commerce, International Trade Administration, ``Capital goods represent the largest goods export category (end-use) for the U.S. with $469.5 billion worth of exports in 2008. The U.S. trade surplus in capital goods rose $12.8 billion to reach $15.7 billion in 2008, up from a surplus of $2.9 billion in 2007.”

On the other hand, top imports for 2008 crude oil, passenger cars, medicinal preparation, automotive accessories, other household goods, computer accessories, petroleum products, cotton apparel, telecom and video equipments (world’s richest countries). This means that aside from final consumption goods, the US imports parts and components for assembly or re-exports as well as raw materials.

The other way to look at this is that the US sells goods or services which reflect on its advance “technology age” state (capital goods) while buying input goods for reprocessing or commoditized goods for the end user.

Simply said, if the world has evolved from the agricultural era (agricultural economy) to the industrial era (manufacturing economy), then we are presently in a transition towards the information age or the post industrial society as identified by Alvin Toffler in his Third Wave Theory.

This means that the lengthening or expanding phase of an economy’s capital structure in an information age extrapolates to a bigger share of contribution from information and technology based goods and services relative to the overall economy.

As much as the share of output in agriculture shrank relative to the overall economy during the industrial era, today’s modern economy should see a smaller or declining contribution from the vestiges of the agricultural and the industrial output relative to economy.

Figure 5: Carpe Diem: Manufacturing Output and Productivity at Record Highs

Nevertheless, contrary to mainstream’s fanatical obduracy, US manufacturing in terms of productivity is at a record high (left window).

Moreover, while manufacturing jobs have been on a decline to reflect on productivity gains (right window), it is only during the last year’s recession where a drop of manufacturing output from record highs occurred. Still yet, all these, signify the advancement and not retrenchment of US manufacturing at the present state.

As University of Michigan’s Professor Mark Perry recently observed, ``More and more manufacturing output with fewer and fewer workers should be considered a positive trend for the U.S. economy, not a negative development. We should think of it the same way as the trend in farming over the last 150 years - we're much better off as a country, with a much higher standard of living, with 3% of Americans working on farms compared to 150 years ago when about 65% of Americans toiled on farms. If we can continue to produce more manufacturing output with fewer workers, we'll be better off as a country, not worse off.” (bold highlights mine)

So anyone who expects a return of the conditions of the industrial manufacturing age in today’s post industrial society simply suggest of the curtailment of progress or a throwback in time similar to Argentina in the 1930s or is against human progress.

And to adopt a protectionist economy combined with massive devaluation, which likewise signifies fear of competition, is a sure route towards decadence.

6. Promotes Capital Flight

Mainstream outlook seem to discern people as irresponsive to the incentives provided for by the governing circumstances. They haughtily presume of better intelligence than most of the society. While they could be somewhat correct, in terms of information (and not knowledge), we know that macro thinking is a poor substitute to the knowledge of F.A. Hayek’s “man-on-spot”.

This implies that when major policies which tend to have a momentous impact on society are undertaken, people consequently will respond in accordance to how such policies are transmitted into their respective fields or industries. In other words, in the marketplace a micro outlook is fundamentally superior than a presumptive model based macro analysis.

And devaluation policies would likely have an unintended effect: capital flight!

While there will be some sectors or interest groups that would benefit from a reconfiguration of investment flows, the alternative bet would be for capital to flow out of the country which have been engaged in policy devaluation and flow into assets of foreign currencies which have not or to real assets.

Economist David Malpass, a columnist at Forbes magazine, recently wrote an incisive article articulating how capital flight will subdue any tinge of benefits from devaluation.

Mr. Malpass wrote, ``Some weak-dollar advocates believe that American workers will eventually get cheap enough in foreign-currency terms to win manufacturing jobs back. In practice, however, capital outflows overwhelm the trade flows, causing more job losses than cheap real wages create. This was the lesson of the British malaise, the Carter malaise, the Mexican malaise of the 1990s, Yeltsin's Russian malaise through 1999 and the rest. No countries have devalued their way into prosperity, while many—Hong Kong, China, Australia today—have used stable money to invite capital and jobs. The more the dollar devalued against the yen in the 1970s and '80s, the more Japan gained share in valued-added manufacturing, using the capital from weak-currency countries to increase productivity. China is doing the same now. It watches in chagrin as the U.S. pleads with it to strengthen the yuan, adding productivity fast with the dollars rushing its way in search of currency stability” (bold emphasis mine)

Figure 6: Casey Research: Drumbeats For The US Dollar

Systemic inflation aggravated by capital flight is likely to overwhelm any purported gains from devaluation.

Currently, foreign flows into the US by both private and official sectors appear to be in a swan dive as the interest to own US securities have evaporated (see figure 6).

If capital flight from US residents and foreigners snowball into a tsunami, then the risks of exchange controls could be in the horizon.

This would be different from the recent capital controls imposed by Brazil, which uncannily slapped a 2% tax on foreign capital flows into fixed income and the stock market (Bloomberg). Such unorthodox move was meant to stem the tide of capital inflows where the Brazilian government deems the recent surge of the real and its stock market as indications of a seminal bubble.

Conventionally, capital controls are instituted to curb capital from stampeding out of a national economy or from the region.

Applied to the Asian financial crisis of 1997 which had been largely blamed by the domestic officialdom on speculative hedge funds, Joe Studwell in Asian Godfathers, Money and Power in Hong Kong and Southeast Asia argue that local tycoons were more culpable, ``An enquiry after the crisis found little evidence that hedge funds and other leverage investors played a significant role. There was widespread in the region of massive capital flight orchestrated by local tycoons; but Singaporean and Hong Kong banking secrecy is such that this is impossible to quantify.”

Exchange controls only serve to appropriate the properties of its constituents and of foreigners. By adopting a close door policy in finance and trade, the impact would be to dramatically increase the risk profile of a country. This should translate to a reduction of wealth via a markdown on assets as investors will pay less to own income flows or property or demand higher premium than where there is full convertibility of the currency.

The bottom line is present policies aimed at attenuating the US dollar risks not only capital flight from foreigners but also from local residents.

7. Raises The Risks Of Global Currency War

The perils of using models for prediction would be the assumption that conditions of the past have similar dynamics today. For instance, when Fed Chair Ben Bernanke used the Great Depression as paradigm for measuring the success of devaluation, he probably assumes that the US dollar today can devalue against other currencies without much resistance or would be cordially tolerated by other central bankers.

This would be highly presumptuous.

During the Great Depression, the US managed to devalue because it operated under a gold standard. President Franklin D. Roosevelt’s EO 6102 basically confiscated gold from every Americans in 1933 from which gold’s role as the public’s medium of exchange had been indefinitely suspended.

Since President Richard Nixon closed the Bretton Woods standard in 1971, otherwise known as the Nixon shock, the US dollar has assumed the role of gold as transaction currency for international exchange and as anchor reserve currency for global central banks.

Compared to gold based notes whose rate of issuance would depend on the rate of output from extracting gold from the ground, which is vastly limited due to the high cost and the attendant risks from mining, should the US decide to massively devalue, it could easily facilitate these using the Federal Reserve’s printing press or the technology enhanced digital press. Yet this would impact fundamentally all currencies, given its role as the world’s foreign reserve currency.

To consider according to wikipedia.org, 14 countries are unofficial users of the US dollar or has a dollarized economy. In addition, 23 countries are pegged to the US dollar. If the US dollar continues with its descent in response to the prevailing policy actions, then basically all 37 countries will be importing inflation from the US. Yet, their economies haven’t been afflicted by the same debt woes.

This may lead to a supply shock, where massive waves of money will be chasing after scarce supply of real goods or property.

Moreover, one can’t discount that the other central bankers may not be as cordial or as permissive as Ben Bernanke expects them to be and might attempt to counteract the US devaluation policies by arbitrarily conducting their own currency weakening process.

At the end of the day, if more and more government hops into the devaluation bandwagon then we could countenance a global currency war. And a global currency war risks a horrendous hyperinflation on a worldwide scale.

Ludwig von Mises has admonished us on the possibility of such risks, ``If one looks at devaluation not with the eyes of an apologist of government and union policies, but with the eyes of an economist, one must first of all stress the point that all its alleged blessings are temporary only. Moreover, they depend on the condition that only one country devalues while the other countries abstain from devaluing their own currencies. If the other countries devalue in the same proportion, no changes in foreign trade appear. If they devalue to a greater extent, all these transitory blessings, whatever they may be, favor them exclusively. A general acceptance of the principles of the flexible standard must therefore result in a race between the nations to outbid one another. At the end of this competition is the complete destruction of all nations' monetary systems.” (bold emphasis mine)

Devaluation is a risk endeavor which US policymakers appear likely to undertake (or in my view “gamble on”) in order to neutralize the impact from an unmanageable debt burden plaguing its system.

And this has been cheered upon by their exponents. Yet given the above, it would seem that policymakers and their cheerleaders don’t truly have the necessary understanding or comprehension of the risks involved or has vastly underestimated them.

Devaluation isn’t a necessary evil. Devaluation can take the form of the inflation demon, from which having emerged from the inferno, may wreak more systemic havoc than expected. After all, in the context of history, devaluations have been the seeds to the extinction of currencies. This time may not be different.