Why Currency Devaluation Is A Misguided Keynesian Policy

[sokal]

If anyone flatly disagrees then I would be interested to hear why.

by Stephen Gordon, Canadian Business Online

Wednesday, February 17, 2010

The Canadian dollar has recovered from the losses it suffered during the financial crisis, and seems set to reach parity with the U.S. dollar within the next year or two. There has also been a recovery in commentaries expressing concern for the effects of this appreciation on exports, particularly in the manufacturing sector. Between 2002 and 2008, our currency rose by 50%, and the manufacturing sector shed more than 300,000 employees. Shouldn’t the Bank of Canada be trying to prevent this from happening again?

Well, no. These arguments miss a key point of international trade theory: exports are costs. The reason we participate in world markets is to obtain goods that we can’t easily produce for ourselves; exports are the price we pay to foreigners in exchange for the imports we want. In a perfect world, we would obtain an infinitely large quantity of imports in return for an infinitely tiny amount of exports. So, a rising dollar is to be welcomed. Why is the US the only country that knows this ?

Although this idea is familiar to economists, some readers may find it surprising. So here’s a simple parable to explain why it’s true.

Suppose that we live in a country where everyone eats only doughnuts. We’re self-sufficient except for one thing: we need to import bananas to make banana cream doughnuts. Happily, foreign producers are willing to exchange truckloads of our trees for truckloads of their bananas. So some workers spend their time cutting down trees to send abroad, and the rest of us work on making doughnuts.

Now let’s suppose that foreigners are no longer satisfied with trees: they will now only exchange bananas for furniture. Some workers must therefore stop making doughnuts and start transforming trees into furniture for export. Even though the national accounts would record an increase in the value-added of exports, this development is bad news. The reallocation of workers away from doughnut production means that we make and consume fewer doughnuts.

What happens if foreigners go back to accepting trees for bananas? The workers who had been making furniture for export can go back to making doughnuts. Although the national accounts would show a reduction in export volumes, we are clearly better off: doughnut consumption will have increased.

This is obviously not a realistic representation of the Canadian economy, nor is it meant to be. But it corresponds closely to what happened in the last two expansions in many important ways. In the early 1990s, commodity prices fell, and the only way for us to obtain the imports we wanted was to shift workers to the manufacturing sector, and to increase the value-added of exports. But devoting more of our productive capacity to making things that are to be consumed by foreigners isn’t a path to prosperity, and workers’ real buying power stagnated.

In 2002, commodity prices rose, and we were able to get the imports we wanted with less resources allocated to the export sector. The expansion of 2002–2008 was characterized by a shift out of export-oriented manufacturing, and these workers were able to produce more for domestic consumption. Export volumes stagnated, but since we were getting better prices for what we sold to the rest of the world, real incomes increased.

Possibly the most important part of our parable is that it assumes laid-off furniture makers could simply go back to making doughnuts. What about those 300,000 manufacturing jobs lost in the real Canadian economy?

It turns out that almost all of that decline can be explained by attrition: workers who left the manufacturing sector were not replaced. Layoff rates — and in particular, permanent layoff rates — remained fairly constant, and they were generally lower than they were during the 1994–2002 expansion. A manufacturing worker was less likely to have lost her job during 2002–2008 than she would have been during the latter half of the 1990s.

If other sectors are expanding fast enough to maintain total employment levels, job losses in one sector are a manageable problem. Happily, job creation is one area where the Canadian economy has traditionally done very well. Unemployment among manufacturing workers actually decreased after 2002. Before the recent recession hit, employment as a proportion of the working-age population was at a record high.

In the short term, the Bank of Canada is right to be concerned with a dollar that may be appreciating too quickly: even though the recession is over, employment growth is still anemic. But in the medium and long terms, an increase in the value of our currency is a positive development. Canada’s prosperity is based not on the volume of our exports, but on their value on world markets.

[lovelomsak]

If I may i would like to add one more thing. A large portion of Canadian trade is with The USA so a strong dollar means we get more goods for our dollar from the neighbour to the south. They will have to stop calling canadians the mexicans from the north.

[Petsma]

That model can't be applied in every situation. Just a Canadian that thinks everywhere has a similar economy to Canada. And why does he think imports and exports are inextricably linked in that way?

[lannarebirth]

Well, it depends doesn't it? Take Canada for instance. It has hitched its NAFTA star to the US consumer. About 70% of its people live near the border and are dependant on cross border trade. You're going to let your currency go wherever it needs to to keep that trade alive. Yes Canada is a resource rich country, but that provides little employment and it looks like you're selling those industriesl to China anyway. I'm a PR of Canada and IMO the housing bubble is still pretty alive there. A further appreciation in the currency would probably trigger a slide there. Well, anyway good luck with that.

[sokal]

That model can't be applied in every situation. Just an idiot Canadian that thinks everywhere has a similar economy to Canada. And why does he think imports and exports are inextricably linked in that way?

Well they are inextricably linked, if not then explain.

Canada has good demographics which makes it a wealthy country, just because it is easier for Canada to achieve a higher standard of living for its population then another country doesn't change the facts.

[sokal]

Well, it depends doesn't it? Take Canada for instance. It has hitched its NAFTA star to the US consumer. About 70% of its people live near the border and are dependant on cross border trade. You're going to let your currency go wherever it needs to to keep that trade alive. Yes Canada is a resource rich country, but that provides little employment and it looks like you're selling those industriesl to China anyway. I'm a PR of Canada and IMO the housing bubble is still pretty alive there. A further appreciation in the currency would probably trigger a slide there. Well, anyway good luck with that.

Did you read the article ??

A devalued currency is a pay cut. The same people that think they want a devalued currency are the same people that go to some union meeting demanding a pay increase. Make up your mind, do you want a pay cut or a pay increase ?

Exports are the price we pay to foreigners in exchange for the imports we want. In a perfect world, we would obtain an infinitely large quantity of imports in return for an infinitely tiny amount of exports. So, a rising dollar is to be welcomed.

[Abrak]

Well, no. These arguments miss a key point of international trade theory: exports are costs. The reason we participate in world markets is to obtain goods that we can’t easily produce for ourselves; exports are the price we pay to foreigners in exchange for the imports we want. In a perfect world, we would obtain an infinitely large quantity of imports in return for an infinitely tiny amount of exports. So, a rising dollar is to be welcomed. Why is the US the only country that knows this ?

As usual a total misrepresentation of Keynes. One of Keynes's concerns was that the Central Reserve Currency must always by definition generate a current a/c deficit to match capital inflows needed to create reserves and liquidity of the global economy. The central reserve currency would always be overvalued. The Triffin paradox is that demand for central reserve currency necessarily will create a current a/c deficit which will ultimately destroy growth employment and in the country with the underlying currency. I hope you understand a balance of payments must balance.

Now Keynes was against the gold standard as you well know and disagreed with it. He was also one of the major architects behind Bretton Woods at the end of the war. Which involved setting up the US as the Central Reserve Currency (which was bound to mean they gradually expose themselves to ever increasing debt) as well as holding the US to repaying those debts in gold. Now he saw this as a guaranteed way of either bankrupting the largest creditor on earth or ultimately forcing the US to renege on the gold standard. He actually wanted an independent Central Reserve Currency but the US actually thought they as the largest creditor nation in the world would get screwed by inflation (I am not making this up.) Keynes knew how damaging the same position had been to the UK so he ultimately orchestrated an agreement that he realized was so filled with inconsistencies that it would inevitably turn this creditor nation to debt until they defaulted on their obligation to gold.

So please understand he was just as arrogant as you who disabuse him by selling a deal that he knew was against there interests. Ultimately Bretton Woods was about the US taking control to protect their top creditor (asset status). Keynes very much saw the 'burden' not the 'benefit' and did not wish them to commit to a deal they would be forced to ultimately renege on. Ultimately he was working on behalf of the Brits though.

If you dont understand his debt argument it is this. Most transactions are undertaken in the central reserve currency so other countries must accumulate reserves in that currency as security for import payments. Balance of payments must balance so the central reserve currency will always have a built in overvaluation that means it will run a current account deficit and accumulate debt. This will continue until their is a crisis of confidence in the currency and the US loses all its gold reserves or obviously it reneges on its commitment to gold.

So lets turn to your quote. I hope you realize that it really only says this 'Having to work is the cost I bear for having a good lifestyle. In a perfect world I would have a great lifestyle for an infinitely small amount of work - in fact I would be unemployed.'

I hope you can see that an appreciating dollar does not lead to more imports being paid for by less exports, simply less exports, more imports and therefore more debt whose total liability is increasing. I would like to think you can see that Bretton Woods 2 is what I believe was called a relationship of symbiotic parasites by Lanna. The US is stuck as a central reserve currency that by definition undermines its economy (quite happily by for instance by China). In return it is effectively stating it will no longer honor in good faith the liabilities it is being forced to assume. That is why it is in its best interested to be committed to a weak currency. I do see a degree of wit in the comment though. It is not supposed to be a logical argument. And it only makes sense to Greece - you see Greece joined the Euro and effectively appreciated its currency by 40% over the next 10 years through inflation. This will obviously turn out to be to their advantage if someone pays their debts for them but it really shouldnt end up well.

So the US could maybe appreciate it currency, increase the real value of their debts, increase the rate at which they are accumulated and destroy their growth even faster. To be honest everyone could stop working hand all their jobs over to Asia and simply allow them to finance the whole economy.

Anyway I hope you understand some of these arguments even if you dont agree with them. It is still playing out today. I mean dont you think that China's commitment to a weak currency against the US is to their advantage. Things I hope you can see are panning out very much as Keynes thought they would. Do you really think Bernanke and Greenspan are stupid when they talk about printing presses or are they simply stating a position. A lot about devaluation is about gaining competitive advantage or increasing competitiveness - for most countries though they have a counterbalancing problem of increased foreign liabilities. The US has no such problem but it is difficult to devalue when they have all these countries leeching off them.

And you know even if you think Keynes is misguided please accept that he was not stupid. He helped sell Bretton Woods to the US even though he clearly knew it wasnt in their best interests. And the US took on its role because as the largest creditor nation on earth they wanted to keep people disciplined - which is laughable where we are against now.

Look Sokal I really havent explained things very well - so if it doesnt make sense it is my fault not Keynes. You simply have to see that the chances of Keynes being generally regarded as the greatest economist that has ever lived and him being 'stupid' like you have referred to him before several times probably means you are the one that is missing something. I know you havent called him stupid but misguided in this post which is fine and anyway he clearly thought the US were stupid in taking on a role so fraught with inconsistency - as he saw things taking on the role of central reserve currency combined with a gold standard was a route to bankruptcy or vindication for his argument against it in the first place. How long did it take for the US to turn from the biggest creditor nation to the largest debtor nation - not long which was pretty impressive when they were competing against the UK.

And maybe you can see how we have ended up in a position where everyone is working to there own personal advantage and in bad faith against the mutual best interests of the global economy.

[hhgz]

"If anyone flatly disagrees then I would be interested to hear why."

Rather than cutting and pasting mindlessly, I'd love to read YOUR thoughts...not someone else's.

[Abrak]

Please ignore my previous post.

I have read Sokal's parable and realize that I shouldnt have replied to it in the first place.

[Abrak]

"If anyone flatly disagrees then I would be interested to hear why."

Rather than cutting and pasting mindlessly, I'd love to read YOUR thoughts...not someone else's.

I genuinely cannot believe that parable was cut and pasted from anywhere. Banana doughnuts trees and furnitures. And to be honest I never know when he is joking.

I mean he puts in large bold 'in a perfect world we would obtain an infinitely large amount of imports for an infinite small amount of exports (which would require the US to be lent infinite amounts of money by infinitely stupid people.) So a rising dollar is to be welcomed. (You realize he is Canadian.)

The same people that think they want a devalued currency are the same people that go to some union meeting demanding a pay increase. Do you seriously believe this when the reality is that pay increases without productivity and an appreciating currency without productivity is just short term gain for long term pain.

[Naam]

"If anyone flatly disagrees then I would be interested to hear why."

Rather than cutting and pasting mindlessly, I'd love to read YOUR thoughts...not someone else's.

you can't read what does not exist

[jazzbo]

The OP knows all about J.M. Keynes (and maybe all about The General Theory of Employment, Interest and Money, 1936) just like "I know all about the working girls and thai girls in general" as the OP posted elsewhere.

for those with some spare time: http://www.scribd.com/doc/11392072/The-Gen...erest-and-Money