Brendan Keenan

Tuesday 29 July 2014

Brendan Keenan: Devaluation may be an answer to a problem we don't have

Published 16/08/2012|05:00

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DEVALUATION? Don't make me laugh. Let me tell you what a devaluation was.

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That was when the president or prime minister came on the wireless to announce to you that your money would be worth something different in the morning than it was today. They were quite precise about it -- the value of a British or Irish pound changed from $2.80 to $2.40 in the case of Harold Wilson's 1967 devaluation.

Like bus conductors and vinyl records, that kind of devaluation is a thing of the past. There was a European version for a time, but it was generally much less exciting. European leaders would confer secretly and announce a new range for a troubled currency. Somehow, a new "band" of 2.5pc either way lacked the drama of a change to a fixed currency.

But when things went wrong -- most spectacularly with Britain's forced departure from the European exchange rate mechanism in 1991 -- there was drama aplenty.

There is drama aplenty again and the word "devaluation" swirls around in discussions of the euro crisis. But it has lost its real meaning and should probably have been retired with conductors and LPs.

Without fixed rates to other currencies, there is really no such thing as devaluation. We should have noticed that, in a system of floating currencies, a country cannot decide the value of its currency. The markets decide. Governments can resist, but they cannot devalue, in any meaningful sense of the word.

We should have noticed this not least because of the experience just across the water. With complete freedom to cut interest rates, and even to create new pounds with "quantitative easing" from the Bank of England's cheque book, sterling has not had a simple devaluation but a sharp fall in the early days of the euro crisis, followed by a rise.

Bank of England data shows the value of the pound against a basket of its trading partners falling by 20pc in the 15 months from January 2008. It has risen 9pc since then, but that mostly occurred in 2009. For the last three years, this "effective exchange rate" has shown little change.

Large deficits, low interest rates and bank vaults full of cash ought in theory to be bad for sterling. In practice, this has been overwhelmed by the flight to "safety" sparked by the euro crisis.

Sterling is some 10pc cheaper than at the start of the Great Recession. The alarming thing, from a UK point of view, is that it appears to have suffered some of the theoretical ill-effects of devaluation, but has not reaped the theoretical advantages.

One of these ill-effects is inflation -- which has certainly reared its ugly head. This time last year, UK consumer prices were rising at 5pc a year, when Ireland's increase was 1.5pc. The gap has narrowed since, with the July figures at 2.6pc in the UK and 2pc in this country, but price levels in the two countries are still not narrowing.

That is the harmonised measure used by the EU. On the wider definition of prices -- housing costs in particular -- UK inflation at 3.2pc in Britain last month was double the rate in Ireland.

The arguments for devaluation accept that this sort of thing will happen. But it is supposed to be balanced by an improvement in exports, which are now priced in a cheaper currency. There is certainly no evidence that this has happened in the UK.

Last month's trade deficit was the worst for 15 years. Exports to all of the UK's 10 biggest export markets fell between the first and second quarters of the year. Imports are holding up, which also defies theory and means the trade deficit is not improving.

The main culprit, of course, is the state of the world economy. If demand for a country's exports is falling, making them cheaper through currency changes will make little difference -- even assuming the advantage can be maintained.

It also makes a difference which particular products a country exports. One cotton shirt is pretty much like another, and why not buy the cheaper? The same is not true for machine tools.

The world has changed a lot since Harold Wilson was prime minister, and even more since these simple supply and demand devaluation theories were first proposed. Economists nowadays do see relationships between trade and "real effective exchange rates," where costs and productivity are combined. But even these need decomposing into different sectors of the economy -- such as the manufacture of shirts and machine tools.

Work done by economists in the Central Bank has spurred similar exercises comparing EU countries by the Bruegel thinktank. The results are not always as expected, although Germany generally comes out on top, which is.

Ireland is in the middle -- not highly competitive, as is often said. It seems particularly poor, alongside Spain, at creating jobs. Interestingly, Britain fares badly in terms of a strong relationship between jobs, wages and hours worked. A lower currency may not be especially useful in its particular economy.

It might be a bit more effective in Ireland, but there are two big caveats. In the event of an "Irlexit," where would a new Irish pound settle in terms of its rate against the new Germanic euro, sterling and the dollar? It might well remain inside the wide spread it has covered as part of the single currency. It would certainly not be under the control of the Irish authorities.

The second caveat is what would happen to the important "real" rate. That would depend on what happened to wages and productivity. Experience gives no grounds for optimism that higher wages would not quickly erode any real gains.

With trends like those, a fall in the actual exchange rate, even if it could be engineered, may be an answer to a problem Ireland does not have.

These distinctions become critical in any discussion on who, if anyone, should leave the euro. The three bailout countries, plus Italy and Spain, do all have serious problems. But they are different in each case, whether it be deficits, debt, banks, productivity, employment flexibility or poor governance.

Each, including euro membership, requires a different set of responses. Put crudely: at one end, Italy probably cannot leave the euro without the single currency coming to an end, and Ireland probably does not need to do so.

Whether we will ever get to make the choice is another matter, but it is as well to realise that the answer is anything but obvious.

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