Heard Of Countries Depreciating Their Currencies? This Is Why They Do It
You know what’s the most feared in international economics? Currency wars. Here, countries continuously devalue their currencies against each other leading down a destructive rabbit hole.
Why do they do that?
It’s ironical that though currency wars are fought at an international level, they originate at a domestic level.
Distressing conditions of a dwindling economy, high unemployment, frail banking system, etc. make it hard for a country to generate growth solely by internal measures. In such cases, a country could seek out to bring about growth by increasing their exports. To understand this, let us get back to our fundamentals. What is GDP?
Growth of a nation is measured using the Gross Domestic Product (GDP). Four components correspond to GDP as a whole — consumption (C), investment (I), government expenditure (G) and net exports (X).
GDP = C + I + G + X
Net exports (X) = Exports (Ex) — Imports (Im)
GDP = C + I + G + (Ex — Im)
Consumption (C) is probably in decline in such an economy given their high unemployment, excessive debt or both. Investment (I), though measured separately, is indeed connected to consumption. Lower consumption leads to lower investment — businesses invest in expansion only when they expect people to consume what they produce. Government expenditure (G) is independent of consumption and investment. However, to increase government expenditure, the govt. needs to have money to spend. Given the economic conditions of the state, it’s hard to collect more taxes and justify their spending — though this is exactly what Keynesian economics recommends. Now, our last resort would be to increase net exports.
How do we increase net exports?
The fastest way to increase net exports is to devalue one’s currency. Let’s look at how that works.
Assume a car made in Germany cost € 40,000. Assume that €1 = $1.30. Therefore, the dollar price of this car would be $ 52,000. Now assume, the euro falls down to $1.10. Now, the dollar price of this same car would be $ 44,000. This drop in price would make the purchase more attractive to buyers in the US — hence by increasing car sales. However, note that the German manufacturer is still received the same amount in euros — € 40,000. Hence by devaluing its currency, the German manufacturer is able to sell more cars without decreasing its price. This will increase Germany’s GDP as exports are more attractive now compared to the imports — thereby increasing the net exports.
And also given that euro is the currency all over the EU, this devaluation would mean every single good, both tangible and intangible, is affected. A devalued euro would mean one can import a higher number of Belgian chocolates, French wine, Swiss cheese, etc. All this would boost the GDP of these nations significantly.
Thereby devaluing one’s currency, one can increase their net exports.
How do countries devalue their currencies?
So how does this €1 = $1.30 to $1.10 happen? There are quite some ways to do it.
For starters, we can print euros. Lots of them. More printing would mean, there are more euros available with respect to the dollar — hence by making the euro less valuable.
Next, by lowering interest rates. By reducing interest rates, the euro becomes less attractive for investors. If investors don’t see a good return on their capital, they would rather put their capital somewhere else. Capital out = lesser value.
The ECB can also directly sell euros and buy dollars to deflate the euro with respect to the dollar.
So this seems quite straight forward. Is there any catch to this? Oh yes! There is.
You see, in the current age of globalisation, we rarely produce a complete product at once single place. Take the iPhone for example — designed in the US, raw materials from Inner Mongolia, components from South Korea, Taiwan and France, assembly in China. Similarly, our German car would need components from all over the world. And this costs money. By deflating the euro, the automotive manufacturer would now be paying more euros for the same components. Basically, got to bear higher input costs. And that is not the only issue at hand.
You see, the US can do exactly all the above things with their currency too. And this is when we have a currency war. When would either nations stop devaluing their currencies? Is there an end to this?
And this continuous devaluations would hurt the local manufacturers. So to satisfy them countries would use protectionism as a measure. How would they enforce it? Tariffs. Embargoes. Any trick in the book to affect free trade is a potential instrument.
Putting it simply—devaluing currencies to increase exports isn't as straightforward as we wish it would be.
PS: Currency wars is a great book. I was motivated to write this article, thanks to the author’s succinct explanation. Highly recommended.
