Devaluation fallacies
Andrew Alexander
Wise men in politics and shrewd men in economics ask themselves a simple question from time to time. What are we doing or say ing at the moment which will, in retrospect, look silly ? It is hard to believe in politics, for example, that British politics and in particular Tory politics were so passionate on the subject of 'east of Suez' defence. Nothing is heard about that now.
Similarly, in economics there was a prevailing belief less than a decade ago that Britain could not, must not, devalue. The British people were practically crucified on an exchange rate of S2.80. Then we devalued and there followed, not disaster, but the chancellorship of Roy Jenkins. But the great and the good were still adamant on one thing: s2.40 had to be maintained. And of course floating was a ridiculous idea favoured only by eccentrics who did not understand the real world. It would be next to impossible, it was explained, for world trade to flourish under a regime of floating exchange rates. But in due course we floated (*They never told us we could do that', one Labour ex-minister wailed at the time)—and so did most others. And world trade has got along very nicely.
What, then, to return to the original question, are we doing now that will look equally silly in retrospect ?The answer is undoubtedly: working ourselves up into such a lather about the exchange rate again. Now that we are floating, we are obstinately refusing to accept the freedom it offers. Instead, we borrow, we hurl our reserves into the breach and then borrow again.
One reason for this apparently irrational behaviour is the myth, mentioned here be fore, that a declining exchange rate increases the cost of living. If anything, the myth is getting worse. It certainly dominated much of the thinking (sic)at the Labour Party conference. And the great and the good are assuring us that every time the exchange rate goes down 4 per cent, the cost of living rises 1 percent. The BBC and ITN are particularly keen on this myth critical thinking being apparently outside their correspondents' terms of reference.
Let me return to the old argument with two new points. If it really was true that a falling exchange rate caused inflation --as opposed to merely reflecting it—than we would expect to find that the 1967 devalua
tion of over 14 per cent added nearly 4 per cent to Britain's then going rate of inflation.
But in the twelve months following devalua tion, the rise in the retail price index was 5 per cent—most of which was accounted for specifically by Mr Jenkins's heavy increases in indirect taxation (petrol, spirits, beer, wine, tobacco, vehicle duty, purchase tax etc). And of course there were other familiar, inflationary forces at work.
The only way in which the DevaluationCauses-Inflation (DCI) school can square the 1967-68 experience with their theory would be by claiming that, but for devaluation, Britain would have experienced a fall in her cost of living in 1968. I have yet to hear such an improbableclaim advanced.
There is another way of illustrating the folly, not to say absurdity, of the theory. All seem to agree at any rate that a decline in the exchange rate deflects differential inflation rates between countries. Splendid! Then we can construct a model to demonstrate the incompatibility of the two beliefs. Suppose the outside world sets in train for itself an average rate of inflation of 5 per cent, while an irresponsible British government sets in train a rate for Britain of 25 per cent—not, unhappily, an inconceivable situation. In that case, the differential is 20 per cent and, other things being equal, the pound will duly decline by that amount. But after a year, according to the DCI school, this will add 4 per cent to Britain's rate of inflation. So our rate then accelerates to 29 per cent! The rest of the world, on the other hand, since the DCI theory only applies to heavy importing countries, will still have an inflation rate around 5 percent. So the differential in inflation is now 24 per cent and that will mean a further decline in the exchange rate of the pound of 24 percent.
But this will add a further 6 per cent to the British rate of inflation which duly accelerates away to 35 per cent per annum. And so on. It would all be very exciting—if it ever happened. But of course it does not. The DCI school does not explain why it does not for the simple reason that it never seems to have thought about it. Try tackling some DCI believer and you will soon see what I mean.
What the DCI school is really saying, consciously or unconsciously, is that I nflationCauses-Inflation. But if this ICI theory were really true, we would see remarkably neat series of patterns reflecting the inflation rate in all importing countries. Inflation, once it started, would accelerate away year by year until somethingquite drastic happened, probably involving a re-issue of the currency. No such pattern is discernible for the simple reason that no such pattern exists because. in turn, the ICI theory is as mathematically and economically ridiculous as the DCI theory.
The crucial point about devaluation needs to be made again. If the cost of imports rises, and if consumption patterns do not change, then--unless the Government deliberately chooses to inflate the money stock—the rise in spending on imports leads to a decline in spending on domestically produced goods and services. In that case, the latter fall in price and this counterbalances the rise in the price of imported goods.
Trying to get the argument across is the most painfully uphill work since the early days of the debate on floating. One day perhaps we shall succeed. But those who said that we must stick to 82.80, that we could not float and that devaluation caused inflation will by then probably be crucifying us on something else. And if past experience is anything to go by, the fact that they were wrong in the past will not have the slightest effect on the number of people who insist on listening to them and who will be quite happy to endure a clumsy crucifixion.
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