Milton Friedman was famous for urging developing countries to adopt more free market policies. The typical policy package adopted consisted of deregulation, lowering trade barriers, opening up to foreign investment, privatizing public industries, and pegging the currency to the dollar. But, if asked, Friedman would assure you that one of these things was not like the others.
I am well aware that Milton Friedman is a hated name among liberals above a certain age.* But on macro issues we really should listen to him, whatever we think of him on micro issues. Milton Friedman was not, for instance, one of those economists who believed that depressions must be passively endured to shake out earlier excesses; he favored countering them with aggressive monetary expansion. He also, as discussed before, warned against the dangers of fixed exchange rates. Focusing greatly on the importance of money as determining the fortunes of an economy, he warned that fixing exchange rates forced the entire economy to adjust to maintain an exchange rate, rather than allowing an exchange rate to adjust to meet the needs of an economy.**
Until I started in a hard course of self-education since the Crash of 2008, I had no concept of just how economically harmful an overvalued currency is. I realized, of course, that an overvalued currency harms an economy in the sense that it hurts exports by pricing them too high. But surely an overvalued currency was a minor, technical issue that was easily resolved, not one that could inflict serious damage on an otherwise healthy economy. There were several important factors that I missed.
For one thing, I thought from the vantage point of an American. Our economy is large enough that foreign trade makes up a relatively small portion of it. If our economy is otherwise strong, we can make up for a loss of exports by consuming more. But the smaller the economy, the more dependent it tends to be on exports, and therefore the greater the damage from pricing them too high.
Second, an overvalued currency floods the country with cheap imports. This is great fun for consumers, but undermines domestic industry. This is not a protectionist argument. One need not argue that domestic industry should be artificially shielded by protectionist policies to believe that domestic industry should not be artificially undermined by over valuing the currency and allowing imports to be undervalued.
Third, an overvalued currency creates deflationary pressure in export sectors. The smaller the economy, the larger a portion of the economy feels immediate deflationary pressure. But since export sectors necessarily compete for workers with the rest of the economy, deflationary pressure spreads. And deflationary pressure (for reasons I will get to) is devastating.
Finally, measures to keep an exchange rate up worsen the crisis. To keep an exchange rate high, you have to encourage money to come into the country, or at least not to leave. The best way to attract money into a country is to raise interest rates. This makes borrowing painful, chokes off credit, and harms the economy. Economic stress, in turn, makes investors want to take their money out of the country, forcing central banks to raise interest rates even higher to convince them to stay, inflicting further distress and perpetuating the cycle.
None of this is to suggest that devaluation is a painless alternative. It is not. Many people across the political spectrum object to currency devaluation because it raises import prices with no corresponding increase in wages, and therefore hurts living standards. But there is no painless way out of an overvalued currency. A currency crisis usually happens when a country has been importing more than it exports for a prolonged period of time and financing the imports with foreign credit. This state of affairs is not sustainable; sooner or later the foreign credit cuts off. Under these circumstances, living standards cannot be maintained; some decline is inevitable. There are two ways to do it, by currency devaluation, i.e., inflation, and by “internal devaluation,” i.e, deflation.
Currency devaluation lowers real wages by inflation. Import prices rise, with no corresponding increase in wages. The effect of rising import prices spreads throughout the economy (the larger the import sector, the greater the effect). Consumption falls across the board. Everyone is pinched. But exports sectors prosper, and over time domestic industry also grows when no longer undercut by cheap imports.
“Internal devaluation” means lowering wages by deflation. Import (and other) prices remain unchanged, but nominal wages have to fall instead. However, wages tend to be “sticky” and resist falling, so downward pressure on wages leads to unemployment. Declining consumption is unevenly and capriciously distributed. Furthermore, deflation inflates domestic debts and raises the debt burden. It also raises the value of cash savings, even as the value of tangible wealth and most financial investments falls. This encourages hoarding of cash instead of investing it in productive uses. Deflation also makes real interest rates higher than nominal rates, making lending onerous and further discouraging investment. And because prices as well as wages tend to be "sticky," other distortions also enter the system.
In short, currency devaluation is bad, but "internal devaluation" is a lot worse. Milton Friedman got this one right.
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*I am also showing my age here. Plenty of younger liberals have never heard of Milton Friedman.
**And, it should be added, he decisively broke with the gold bug faction of libertarianism, regarding it as even more absurd to build an entire economy around the price of a single commodity.
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