Thursday, January 22, 2009

Dean Baker reminds the New York Times of a basic fact it forgot.

A country can live in apparent prosperity based on an overvalued currency.  In the process, it destroys its ability to sell its products in the global marketplace.

The Pound Is Falling Because It Was Over-Valued

The British Pound, like the U.S. dollar, had been seriously over-valued in recent years. That is why it had been running a large trade deficit.

This relationship is pretty straightforward. A higher value of the currency makes imports cheaper and exports more expensive to those living in other countries.

In most contexts reporters are able to understand the relationship between higher prices and demand, but for some reason in the context of trade, they discuss the topic as though there is no relationship. Hence in an article on the falling British pound, the NYT tells readersthat Britain's prosperity over the last decade "camouflaged a steadily weakening manufacturing base."

Of course, the prosperity did not just "camouflage" a weakening manufacturing base, to a large extent, the prosperity was directly related to the weakening manufacturing base (except for the laid-off manufacturing workers).

The over-valued pound allowed the British to buy imported goods at lower prices than their own industry could produce them. However, this led to a large current account deficit which could not be sustained indefinitely.

In this respect, an over-valued currency is very similar to tax cut leading to large budget deficits. In the short-term it can allow for higher living standards, but in the longer-term it is necessary for the currency to fall to bring the current account deficit down to a sustainable level, just as taxes must eventually be raised or spending must be cut, to bring budget deficits down to sustainable levels.

In this context, the decline in the pound, like the future decline in the dollar, is not an unfortunate occurance, but rather an essential part of an economic adjustment.

1 comment:

Gary Baumgarten said... at 5 PM New York time Wednesday February 4.

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