Any tampering with the currency rate of exchange can only make things much worse as far as the allocation of scarce resources is concerned…
A visible weakness in economic activity in major world economies raises concern among various commentators that world economies have difficulties recovering despite very aggressive loose monetary policies. The yearly growth rate of US industrial production stood at minus 1.1 % in October, against minus 0.1% in September, and 4.1% in October last year. In the euro zone, the yearly growth rate of production stood at minus 1.7% in September versus minus 2.8% in the month before and 0.6% in September 2018. In addition, in China the growth momentum of industrial production remains under downward pressure with the annual growth rate declining to 4.7% in October from 5.8% in September and 5.9% in September the year before.
Some commentators are of the view that what could help is a depreciation in the US dollar. For instance, the price of the euro in US$ terms after closing at 1.58 in March 2008, closed at 1.12 by October 2019. That’s US$ appreciation of 29.1% against the Euro. According to popular thinking, the key to economic growth is demand for goods and services. It is held that increases or decreases in demand for goods and services are behind rises and declines in the economy’s production of goods. Hence, in order to keep the economy going, policymakers must pay close attention to overall demand.
Now, part of the demand for domestic products emanates from overseas. The accommodation of this demand is labeled exports. Likewise, local residents exercise demand for goods and services produced overseas, which are labeled imports.
Observe that while an increase in exports implies an increase in the demand for domestic output, an increase in imports weakens demand. Hence, exports, according to this way of thinking, are a factor that contributes to economic growth while imports are a factor that detracts from the growth of the economy.
From this way of thinking, it follows that since overseas demand for a country’s goods and services is an important ingredient in setting the pace of economic growth, it makes a lot of sense to make locally produced goods and services attractive to foreigners.
One of the ways to strengthen foreigners demand for domestically produced goods is by making the prices of these goods more attractive.
Based on this, one can reach the conclusion that as a result of currency depreciation, all other things being equal, the overall demand for domestically produced goods is likely to increase.
This in turn will give rise to a better balance of payments and in turn to a stronger economic growth in terms of GDP.
Why Boosting Exports through Currency Depreciation Cannot Cause Economic Growth
When a central bank announces a loosening in its monetary stance, this leads to a quick response by participants in the foreign exchange market — through selling the domestic currency in favour of other currencies, thereby leading to domestic currency depreciation.
In response to this, various producers now find it more attractive to boost their exports. In order to fund the increase in production, producers approach commercial banks, which on account of a rise in central bank monetary pumping are happy to expand their credit at lower interest rates.
By means of new credit, producers can now secure resources required to expand their production of goods in order to accommodate overseas demand. In other words, by means of newly created credit, producers divert real resources from other activities.
As long as domestic prices remain intact, exporters record an increase in profits. (For a given amount of foreign money earned, they now get more in terms of domestic money). The so-called improved competitiveness, because of currency depreciation, in fact amounts to economic impoverishment.
The improved competitiveness means that the citizens of a country are now getting less real imports for a given amount of real exports. 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 people’s life and well-being).
According to Ludwig von Mises,
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. In plain language it is to be described in this way: The British citizen must export more British goods in order to buy that quantity of tea which he received before the devaluation for a smaller quantity of exported British goods.1
Contrast the policy of currency depreciation with a conservative policy where money is not expanding. Under these conditions, when the pool of real wealth is expanding, the purchasing power of money will follow suit. This, all other things being equal, leads to currency appreciation. With the expansion in the production of goods and services, and consequently falling prices and declining production costs, local producers can improve their profitability and their competitiveness in overseas markets while the currency is actually appreciating.
Any tampering with the currency rate of exchange can only make things much worse as far as the allocation of scarce resources is concerned.