Bulletin July 2012 – Does Devaluation reduce the Standard of Living?

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July 15, 2012 by johnmillsjml

It seems, at first, sight, to be obvious that if the value of the pound falls, so that the British economy charges out its labour costs to the rest of the world at a lower price than before, this must reduce the standard of living. There is thus a widespread view that a devaluation must make everyone in a devaluing country poorer on average than they were before. This view is not, however, correct. On the contrary, the reverse is almost invariably the case. This Bulletin explains the reason for this apparently paradoxical result and why the apparently common sense view is wrong.

This issue can be looked at in two different ways – first by looking at the economy as a whole and then considering what happens to individual people.

Taking first the economy as a whole, the effect of a devaluation is to make the economy’s exports more competitive than they were before compared to world prices and thus to increase demand for them. This increased demand makes the economy grow faster than would otherwise have been the case. If this happens, and the population of the devaluing country stays the same as it would have been without the depreciation, as a matter of simple arithmetic the Gross Domestic Product (GDP) per head must be higher and not lower than it otherwise would have been.

Now GDP per head is not quite the same as the standard of living, not least because one of the effects of faster growth is to increase the amount of investment which takes place. With GDP being whatever size it is, more investment must mean less consumption. The increased investment, however, does not belong to nobody. It will very largely belong to the citizens of the devaluing country and they will be the main beneficiaries of the extra output it will be capable of producing. In fact what happens is that saving increases to finance the extra investment and this saving belongs to the people. Thus the effect of extra growth is to produce higher incomes, some of which materialises as extra saving, with the balance made up of consumption. The two, taken together, however must be greater than they were before on average across the population because it is total investment plus total consumption which add up to GDP.

Turning now to the individuals making up the economy, how can it be that a devaluation allows the depreciating economy to sell its labour to the rest of the world at a lower price without this reducing the standard of living of its citizens? Does it not stand to reason that if you charge the rest of the world a lower price for your labour this must make you poorer?

No, it doesn’t and here’s why. If the value of the pound goes down on the international exchanges, the value of the UK’s exports will decrease in international – say dollar – terms. This is what makes them more attractive to foreign buyers. The price in sterling for these exports does not, however, decrease. It is almost certain to go up in many cases as exporters use some of their enhanced competitiveness to increase their margins. At the same time, if the economy grows faster than it would otherwise have done, there is more output to share out among everyone.

Yes, but won’t these gains all be offset by higher import prices? No, they very probably won’t. Certainly import prices will rise but there are lots of other prices and costs which will fall. With a lower pound, taxes can be lower. So can interest rates. Unused resources of labour and machinery will be drawn back into use. Orders will be switched from foreign to domestic suppliers. This is why devaluations very seldom produce the extra inflation that those who focus only import prices always expect.

So what actually happens is this. Everyone on average is better off because UK shoppers do not pay for their purchases in dollars but in pounds which stay worth the same as they were before, while at the same time incomes – or at least GDP per head – goes up.

Is it all really as easy as this? Unfortunately not. There will be some increased costs which people do not like. Holidays abroad will be more expensive, for example and so will almost all imported goods, services and raw materials. This will require some adjustment in expenditure patterns. Furthermore, the British economy will look smaller in international league tables. If the size of British GDP is measured at $1.60 to £1.00 it will appear to be a third larger than if it is calculated at $1.20 to £1.00. In real terms, however, none of this is nearly as important as the real rise in living standards which a devaluation will produce.

This is reflected in the way in which statistics measuring living standards are produced. British statistics are complied in pounds and not in dollars because what counts for the British public is the size of their incomes in pounds and the stability of the value of the currency, not what these might be in dollars at whatever the current rate of exchange might be. If, therefore, we now turn to the statistics which are readily available showing the impact of lots of different devaluations, we see very clearly the two effects highlighted in this Bulletin. These are:

1. Devaluations have a very strong tendency to increase total GDP as they make the depreciating economy more competitive in international terms.

2. The standard of living – at least as measured by GDP per head – almost invariably goes up.

Here are the figures for numerous devaluations, showing that the conventional view that devaluations either reduce living standards at all rather than increasing them, or add significantly if at all to inflation, are simply wrong:

% Real % Real GDP Year on

GDP Population per Head Year

Year Change Change Change Inflation

Britain – 31% 1930 -0.2 0.4 -0.6 -2.8

Devaluation against 1931 -5.4 0.4 -5.8 -4.3

the dollar and 24% 1932 0.6 0.6 0.0 -2.6

against all currencies 1933 1.00.4 1.6 -2.1

in 1931 1934 7.1 0.3 6.8 0.0

1935 3.8 0.4 3.4 0.7

19363.0 0.4 2.6 3.4

France – 27% 1956 5.9 0.9 5.0 2.6

Devaluation 1957 6.0 1.1 4.9 3.6

against all 1958 2.9 1.1 1.8 9.1

currencies in 1959 3.2 1.0 2.2 10.2

1957/58 1960 7.2 1.0 6.2 4.8

1961 5.5 1.1 4.4 3.6

USA – 28% 1984 7.3 0.9 6.4 3.7

Devaluation 1985 3.8 0.9 2.9 3.2

against all 1986 3.4 0.9 2.5 2.2

currencies over 1987 3.4 0.9 2.5 3.0

1985/87 1988 4.2 0.9 3.3 3.4

1989 3.5 0.9 2.6 3.8

Italy – 20% 1990 2.0 0.2 1.8 8.2

Devaluation 1991 1.4 -0.2 1.6 7.6

against all 1992 0.8 0.2 0.6 4.5

currencies over 1993 -0.9 0.3 -1.2 3.9

1990/93 1994 2.2 0.3 1.9 3.5

1995 2.9 0.2 2.7 5.0

Finland – 24% 1990 -0.5 0.6 -1.1 5.8

Devaluation 1991 -4.8 0.4 -5.2 1.6

against all 1992 -3.3 0.6 -3.9 1.0

currencies over 1993 -1.1 0.6 -1.7 1.8

1991/93 1994 4.0 0.4 3.6 2.0

1995 3.8 0.4 3.4 3.6

Spain – 18% 1991 2.3 0.2 2.1 7.1

Devaluation 1992 0.7 0.2 0.5 6.9

against all 1993 -1.2 0.2 -1.4 4.3

currencies over 1994 2.3 0.2 2.1 4.0

1992/94 1995 2.7 0.2 2.5 4.8

1996 2.4 0.2 2.2 3.2

Britain – 19% 1990 0.6 0.3 0.3 7.6

Devaluation 1991 -1.5 0.4 -1.9 6.7

against all 1992 0.1 0.3 -0.2 4.0

currencies 1993 2.3 0.3 2.0 2.8

in 1992 1994 4.4 0.3 4.1 1.5

1995 2.8 0.4 2.4 2.5

Argentina 2000 -0.8 1.1 -1.9 1.0

Devaluation 2001 -4.4 1.0 -5.4 -1.1

against all 2002 -10.9 1.0 -11.9 30.6

currencies 2003 8.8 0.9 7.9 10.5

early 2002 2004 9.0 0.9 8.1 9.2

2005 9.2 0.9 8.3 8.8

% Real % Real GDP Year on

GDP Population per Head Year

Year Change Change Change Inflation

Iceland – 50% 2005 7.5 0.2 5.5 2.8

Devaluation 2006 4.6 0.2 4.4 8.8

against all 2007 6.0 0.2 5.8 5.7

currencies 2008 1.4 0.2 1.2 11.8

2007/09 2009 -6.9 0.2 -7.1 8.3

2010 -3.5 0.2 -3.7 6.7

2011 3.1 0.4 2.7 5.0

Britain – 18% 2006 2.8 0.5 2.3 3.1

Devaluation 2007 2.7 0.5 2.2 3.0

against all 2008 -0.1 0.5 -0.6 3.0

currencies 2009 -4.9 0.6 -5.5 1.4

2007/09 2010 1.3 0.5 0.8 2.9

2011 0.4 0.5 -0.1 2.3

Sources: Economic Statistics 1900-198 byThelma Liesner. London: The Economist 1985. IMF International Financial Statistics Yearbooks, supplemented by data from various Internet sites.

Inevitably the data in the table above are affected by other factors than just exchange rate changes. In particular, the figures for recent big exchange rate changes in Iceland and Britain were undoubtedly heavily influenced by the financial crisis which peaked in 2008. Nevertheless the over all picture is clear. Devaluations – even very big ones like those experienced in Argentina and Iceland – both tend strongly to improve growth rates and to increase living standards when measured by GDP per head. They also have much less impact on inflation than is often imagined. In this respect, the British devaluations of 1931 and 1992 are particularly striking. In both cases dire predictions were made by establishment figures of all political shades – and by academics and media commentators – that inflation would rise and the national income would decline. In both cases, they were proved comprehensively wrong.

If there is a devaluation in the UK, the cost of British labour measured in US dollars will undoubtedly go down, making UK exports more competitive but UK consumers do not shop in the UK in dollars. They shop in pounds. Harold Wilson was right in saying, at the time of the 1967 devaluation that “It does not mean that the pound here in Britain, in your pocket, in your purse or bank has been devalued.” It was true then and it would be just as true now if the value of the pound on the foreign exchanges was reduced to a level which enabled the British economy to pay its way in the world again, instead of having a huge balance of payments deficit every year. It is this deficit, which sucks demand out of the economy, thus making government and consumer borrowing unavoidable to avoid the economy slumping. We cannot, however, go on running up debts. Instead we have to generate enough output to avoid needing to borrow. The only way we can do this is by reducing our cost base to the rest of the world through getting the pound down to, say, $1.20 or €0.85. The really good news is that we could do this without any sacrifice to our living standards or our inflation rate, if only we had the clarity of vision required to do it.

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