I have plead before for letting the markets have their way with the currencies of Serbia and other countries. This time I want to explore the arguments for it.
The British pound fell 30% against the euro in 2008 and the fall is continuing. Yet the British Central Bank lets it go. It has learned its lesson from 1992 when Soros made US$ 1.1 billion speculating against the pound. Yet surprisingly countries that are new to free markets don't show this reluctance. Russia has spent $200 bln supporting the ruble until now - and has little to show for it. Serbia and other countries keep supporting their currencies too.
Their are basically two supporters for this monetary support: the IMF and the EU:
- the IMF operates defends the interests of foreign creditors. As local companies will need more local money to pay their foreign bills after a devaluation some will get in trouble and go broke. This means that the foreign creditor won't see its money. IMF doesn't like that.
- the EU aims for extending the euro zone. Countries who want to enter this zone need to keep their currencies in line with the euro for some time.
However, one can wonder whether the euro is really such a success as the EU paints it. I love being able to travel without having to change money. But the business case for the euro is weaker: The EU likes to stress how many billions are saved by not having to change money and not having any currency risk. Yet it doesn't show in the rather weak economic growth figures of the euro zone. Given the poor performance of the Euro zone until now in the economic crisis (we do worse than the US) this crisis may well mean the end of the Euro as we know it.
Very threatening is that nowadays people start openly talking that some country in the euro zone might go broke (the favorite examples are Greece and Italy). Italy used to have a high inflation economy and it regularly adapted the exchange rate to keep its currency competitive. This worked very well and Italy had a vibrant economy. Nowadays Italy is in the low inflation euro zone and it seems to have difficulty adapting to it. Being to able to devalue it currency was seen as a blessing by the Italians - not as a curse. This brings me to Slovakia that is very happy that it doesn't have to support its currency as it has entered the euro zone. I wonder whether they still will be happy in a year or two - or that they will broke as it proved to difficult to adapt their economy to the new reality without a devaluation. They are lucky that they didn't have a very skewed trade balance. But the crash of the car market may destabilize their economy.
An often heard objection against devaluation is that people will become poorer as they can buy less for their money. But that ignores that the country is living above its means and that it needs to reduce its trade deficit. Doing so with a devaluation spreads the pain equally over all citizens. The alternative (that the IMF favors) is firing thousands of government employees and stopping most government investment. That means spreading the pain less fair and usually with more damage to the economy.
One has also to consider the price one pays for an overvalued currency. It not only leads to an ever-increasing foreign debt, it also harms the national industry that cannot compete against the foreign imports. Supporting the currency subsidizes foreign imports at the expense of the local industry. All the Asian fast growth economies had an undervalued currency. The only country that used to have a sound economy combined with a strong currency was Germany with the Mark. But Germany compensated it with a very conservative fiscal policy, leading to trade surpluses.
At the moment one can see both models existing next to each other. While Ukraine has - on advice of the IMF - floated its currency that since has halved in value the Baltic states have kept their currency locked to the Euro - and they are paying a heavy price for that. It will be interesting to see which countries come out the best in the long term. In the mean time the Baltics lobby for a fast entry to the Euro zone.