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The NYU professor of economics Nouriel Roubini said in Davos,
Switzerland, on January 25, 2012, that tight policies are making the
recession in the eurozone worse. According to Roubini what Europe needs is less austerity and more
growth. In particular, the NYU professor is concerned about the deep
recession in the eurozone's peripheral countries:
Spain, Portugal, Greece — all are on a strict
regime of austerity. For instance, in Spain the yearly rate of growth of
government outlays stood at minus 12.4 percent in November against minus 15.7
percent in the month before. In Portugal the yearly rate of growth stood at
minus 3.6 percent in December against minus 2.5 percent in November. In
Greece the yearly rate of growth fell to 2.9 percent in December from 6.2 percent
in the prior month.
 
A visible tightening is also
observed in the two major European economies of Germany and France.
Year-on-year government outlays in Germany stood at minus 1.6 percent in
November versus minus 1.7 percent in October. In France the yearly rate of
growth stood at minus 12.4 percent in November against minus 12.3 percent in
the prior month.
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.
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?
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.
By means of new credit, producers
can now secure resources required to expand their production of goods in
order to accommodate overseas demand. In other words, by means of newly
created credit, producers divert real resources from other activities. As
long as domestic prices remain intact, exporters record an increase in
profits. (For a given amount of foreign money earned, they now get more in
terms of domestic money.)
The so-called improved
competitiveness resulting from currency depreciation in fact amounts to
economic impoverishment. The "improved competitiveness" means that
the citizens of a country are now getting fewer real imports for a given
amount of real exports. While the country is getting rich in terms of foreign
currency, it is getting poor in terms of real wealth — i.e., in terms
of the goods and services required for maintaining people's lives and
well-being.
As time goes by, the effects of
loose monetary policy filter through a broad spectrum of prices of goods and
services and ultimately undermine exporters' profits. A rise in prices puts
to an end the illusory attempt to create economic prosperity out of thin air.
According to Ludwig von Mises,
The much talked about advantages
which devaluation secures in foreign trade and tourism, are entirely due to
the fact that the adjustment of domestic prices and wage rates to the state
of affairs created by devaluation requires some time. As long as this
adjustment process is not yet completed, exporting is encouraged and
importing is discouraged. However, this merely means that in this interval
the citizens of the devaluating country are getting less for what they are
selling abroad and paying more for what they are buying abroad; concomitantly
they must restrict their consumption. This effect may appear as a boon in the
opinion of those for whom the balance of trade is the yardstick of a nation's
welfare. In plain language it is to be described in this way: The British
citizen must export more British goods in order to buy that quantity of tea
which he received before the devaluation for a smaller quantity of exported
British goods.
Contrast the policy of currency
depreciation with a conservative policy where money is not expanding. Under
these conditions, when the pool of real wealth is expanding the purchasing
power of money will follow suit. This, all other things being equal, leads to
currency appreciation. With the expansion in the production of goods and
services and the consequent falling prices and declining production costs,
local producers can improve their profitability and their competitiveness in
overseas markets while the currency is actually appreciating. Note that while
within the framework of loose monetary policy exporters' temporary gains are
at the expense of other activities in the economy, within the framework of a
tight monetary stance gains come not at any one's expense but are just the
outcome of the overall real-wealth expansion.
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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