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Will Currency Devaluation Fix the Eurozone?

February 9, 2012Frank Shostak

Tags Global EconomyMoney and Banking


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Figure 2

According to Roubini and other experts, a tighter stance undermines already-depressed eurozone economic activity. The yearly rate of growth of real GDP eased to 1.3 percent in Q3 from 1.6 percent in Q2 and 2.3 percent in Q3 in 2010. Also the growth momentum of industrial production displays softening. Year on year, the rate of growth fell to minus 0.3 percent in November from 1 percent in the month before and 8.1 percent in November 2010.

Figure 3

Roubini is making the point that austerity won't let eurozone countries grow their way out of their predicament. What is now urgently required to improve the eurozone's economic situation is to devalue the euro by 30 percent, argues Roubini. Note that the price of the euro in terms of US dollars fell from 1.48 in April last year to 1.29 in December — a fall of 12.8 percent. Yet despite this depreciation of the euro, the yearly rate of growth of industrial production has fallen from 5.4 percent in April to minus 0.3 percent in November. So why then should a depreciation of 30 percent as suggested by Roubini revive the economy?

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According to popular thinking the key to economic growth is demand for goods and services. It is held that increases or decreases in demand for goods and services are behind rises and declines in the economy's production of goods. Hence, in order to keep the economy going, economic policies must pay close attention to overall demand.

Now, part of the demand for domestic products emanates from overseas. The accommodation of this demand is labeled exports. Likewise, local residents exercise demand for goods and services produced overseas, which are labeled imports. Observe that while an increase in exports implies an increase in the demand for domestic output, an increase in imports weakens the demand. Hence exports, according to this way of thinking, are a factor that contributes to economic growth, while imports are a factor that detracts from the growth of the economy.

From this way of thinking it follows that, because overseas demand for a country's goods and services is an important ingredient in setting the pace of economic growth, it makes a lot of sense to make locally produced goods and services attractive to foreigners. One of the ways to boost foreigners demand for domestically produced goods is by making the prices of these goods more attractive.

For instance, the price of an identical bag of potatoes in the United States is $10 and €10 in Europe. Also, the exchange rate between the US dollar and the euro is 1:1 (one-to-one). At the exchange rate of €1 to $1, an American can get for his $10 one European bag of potatoes.

One of the ways of boosting their competitiveness is for Europeans to depreciate the euro against the US dollar. Let us assume that, in response to the European Central Bank (ECB) announcement to loosen its monetary stance, the rate of exchange falls to 50¢ per Euro. This means that €10 is now worth $5, which in turn implies that a European bag of potatoes in the United States is offered for $5, all other things being equal. Consequently, an American can now purchase for $10 two European bags of potatoes instead of one before the depreciation of the euro. In other words, the purchasing power of Americans with respect to European potatoes has doubled.

If we apply the potato example to all goods and services, we reach the conclusion that, as a result of currency depreciation and all other things being equal, the overall demand for domestically produced goods is likely to increase. This in turn will give rise to a better balance of payments and stronger economic growth in terms of GDP.

Note that, to lift foreigners' demand, Europeans are now effectively offering two bags of potatoes for one American bag of potatoes. This also means that the price of the American bag of potatoes in Europe is now twice as much as before the depreciation of the euro. This most likely will lower Europeans' demand for American potatoes. In short, what we have here as far as Europe is concerned is more exports and fewer imports, which according to mainstream thinking is great news for economic growth.

Why a Boost in Exports on Account of Currency Depreciation Damages Wealth-Generation Process

When a central bank announces a loosening in its monetary stance, this leads to a quick response by participants in the foreign-exchange market through selling the domestic currency in favor of other currencies, thereby leading to domestic currency depreciation. In response to this, various producers now find it more attractive to boost their exports. In order to fund the increase in production, producers approach commercial banks, which, because of a rise in central-bank monetary pumping, are happy to expand their credit at lower interest rates.






It must be appreciated that, contrary to popular thinking, both tight fiscal and monetary policies provide support to wealth generators while undermining non-wealth-generating activities. Roubini and other experts, by pleading for looser policies, are in fact asking to strengthen wealth-destructive activities and thereby recommending a prolonged economic slump.

Summary and Conclusion

According to some experts, what is required to "fix" the eurozone is not tighter fiscal policies but a strong devaluation of the euro. Commentators such as Nouriel Roubini advocate a depreciation of up to 30 percent. Between April and December last year, the euro weakened against the US dollar by almost 13 percent, yet economic activity has continued to slide. Why then should a depreciation of 30 percent revive the economy? We suggest that the recommendation for currency depreciation to fix the eurozone is based on an erroneous framework of thinking. If anything, such a policy can only make things much worse as far as eurozone economic conditions are concerned.

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