“Is Currency Devaluation Overrated”

That’s the title of a symposium in the current issue of The International Economy. Martin Feldstein, Ted Truman, Joe Gagnon, Bill Cline, Mohamed El-Erian, Cathy Mann, and José de Gregorio (among many others) contribute.

Here’s my take:

There’s a long history of skepticism regarding the effectiveness of currency depreciation as a means of spurring net exports and GDP growth. In the post-War period, elasticity pessimism was often invoked as a rationale for foregoing devaluation. In the 1980’s, a more sophisticated argument based on hysteresis effects – big exchange rate appreciations could not be undone be a sequence of small exchange rate depreciations — was forwarded. The most recent incarnation is based upon plausible arguments, but I’ll argue they are only quantitatively relevant in specific cases.

The most recent manifestation of elasticity pessimism is based on the observation that for some countries, the large imported component in some countries’ exports means that depreciation enhances competitiveness only marginally. That’s because a depreciation increases the cost of imported inputs even as it increases the price at which exports can be sold. But, while East Asia – and China in particular – looms large in popular imagination, this region represents an extreme manifestation of global supply chains and vertical specialization (i.e., imports used in exports). In fact, in quantitative analyses of how much vertical specialization alters our perceptions of competitiveness, China is an outlier, rather than the norm.

More closed economies, such as the US, are much less subject to this effect. And even for China, that effect is likely to decrease over time as that country’s producers incorporate more and more domestically sourced labor and inputs in export goods.

For commodity exporters, it’s true that currency depreciation has little effect on export prices, since commodities are mostly priced in dollars. Nonetheless, currency depreciation still serves to reduce imports. Consequently, currency depreciation remains an important part of the policymaker’s toolkit. That doesn’t mean that capital controls are off the table – for some countries, devaluation will be of limited or insufficient effectiveness. For others, financial stability concerns will motivate the use of capital controls. In fact, over the past few years, emerging market economies have already tightened their grasp over financial flows, as measured by the Chinn-Ito index of financial openness.

Perhaps the most important factor mitigating exchange rate depreciation in recent times is not due to reduce trade flow sensitivities, but rather to balance sheet effects. When external debt – both public and private sector – is denominated in foreign currency, the depreciation can, and will, exert a large negative effect on output. For those countries, however, that have built up asset positions in foreign currency, depreciation can have a big positive effect.

A final observation is in order. There is a tendency for observers to view competitive rounds of depreciations – where one country’s depreciation is matched by another country’s – as a necessarily bad outcome. However, in a world where monetary policy is overall too tight (as measured by overly high real interest rates), competitive devaluations and the associated monetary loosening might move the world economy to an arguably better, higher inflation, regime.