Devaluation is not the answer

It is fast becoming accepted as conventional wisdom that Greece should default on its debts, leave the euro, print lots of its own currency so that it can carry on spending and, in the process, achieve a devaluation that would boost its economy. I agree with the first of those points, see the second as unnecessary, and view the third and fourth as misguided. Let me elaborate.

The default point is simple enough – there comes a point where you have so much debt that you can’t afford to service it any more, and bankruptcy is the only sensible option. Putting off the inevitable just drags out the pain. As to leaving the euro, while this may (or may not) be desirable on other grounds, it does not necessarily follow logically from default. Even if Greece defaulted on their existing debts, they could still carry on using the single currency so long as they cut spending sufficiently to balance their budget. This brings to points three and four.

The reason generally given for Greece to leave the euro would be to print money to fund continued high spending, and achieve a currency devaluation in the process. Many people argue this would be a good thing, since (a) sufficiently deep spending cuts are almost impossible in a democracy and (b) devaluation would boost Greece’s competitiveness. There may in some places be some truth in the first of these points, but the second is a fallacy. As Detlev Schlicter put it:

Debasing the currency can never be in the interest of Greek society – or any other society for that matter. Of course, weakening the exchange value of the new drachma would be a temporary shot in the arm to the export industry. As Jamie Whyte explained so lucidly here, and using the UK to illustrate the point, a weak currency is a subsidy to exporters funded by a tax on importers. Debasing the currency never furthers overall prosperity. In terms of access to internationally traded goods and services, the Greek population would get instantly poorer.

To restate the point: devaluation would do nothing to boost real prosperity. Gains to exporters would be offset by the fact that imports have become more expensive. In the short run, you might see a boost to employment, as people substitute domestic goods for imported ones. But that’s only a temporary effect – the inflation that inevitably accompanies money printing will invariably cause all sorts of problems, ranging from increased production costs to systematic capital misallocation, and these will soon wipe out any initial gains brought by devaluation. In the final estimation, all you’ve done is propped up a bloated state sector, eroded your productivity, and unjustly transferred wealth from one part of the economy to another.

Eurozone policymakers sometimes contrast ‘external devaluation’, the process described above, with ‘internal devaluation’, which basically means increasing your international competitiveness by reducing your labour costs. Politically, the latter may be much more difficult – thanks, in large part, to the sticky wages phenomenon. But economically it makes a great deal more sense. Money printing doesn’t boost an economy, other than in the very short term. Becoming more productive does. Indeed, greater productivity is the essence of wealth creation. How have so many people managed to forget that?