SYNOPSIS: Under capital mobility and a fixed exchange rate, a currency devaluation is the same thing as lowering interest rates

In today’s world, there are two big “deflation” stories – Japan and Argentina. In both cases the way out almost certainly involves, among other things, a major depreciation of the currency. And in both cases, as the final act draws near, there is a chorus of skeptics.

The argument – which you now hear about both – goes like this: exports aren’t a very large share of GDP. That means that currency depreciation can’t have much impact on aggregate demand; so depreciating the currency is ineffective, and one might as well maintain the current exchange rate.

If you think about it, there must be something wrong with this argument; it seems to suggest that a fixed exchange rate between two economies is more desirable (or at least less costly) the less trade they have with each other. The dollar zone and the euro zone are both largely self-sufficient? Good – let’s fix the dollar-euro rate. Huh?

What’s wrong with this argument? It misses the point that a fixed exchange rate also, under conditions of capital mobility, deprives a country of independent monetary policy. The point of depreciation is to get that monetary policy back; the lift from increased net exports is only part of the story.

Here’s one way to think about it. Suppose that your country is committed to a fixed nominal exchange rate – and that the currency is overvalued. What I mean by “overvalued” is that the price of domestic goods, relative to foreign goods, is higher than it would be if all prices were completely flexible. What one would expect to happen in this case is a process of deflation – certainly relative deflation, with the domestic inflation rate less than the foreign, and quite possibly actual deflation too.

Now ask what this implies for interest rates. Even if the nominal exchange rate is completely credibly pegged – if, say, your economy is dollarized – the nominal rate in your country will be the same as the rate abroad. But because of the ongoing relative deflation, your real interest rate will be higher than it is abroad. And your economy will be depressed both because of depressed exports (the direct result of overvaluation) and because of a high real interest rate.

Nominal depreciation, if all goes well, allows you to go immediately to the equilibrium real exchange rate, eliminating the overvaluation – and therefore allows a reduction in the real interest rate. If exports are a small share of GDP, this real interest rate effect, rather than the “competitiveness” effect, will be the main source of gains from depreciation.

In fact, if the economy faces temporary adverse shocks, it is possible with a flexible exchange rate to depreciate the real exchange rate beyond its long run level, allowing a lower real interest rate in your country than abroad. This is the reason people like Lars Svensson and myself advocate a weak yen policy: the point is that a weak yen is part of a strategy to lower the real interest rate. Focusing only on the direct competitiveness effect misses that point.

Now back to Argentina. The problem with the overvalued peso has been not just the export weakness but the high real interest rate – admittedly a problem exacerbated by the peg’s increasingly shaky credibility. And the point of any new monetary policy should be to get rid of the real overvaluation that is at the root of the problem.

So where does the argentino fit into all this? I have to admit that I don’t get it. If wages and prices are set in pesos – or, worse yet, dollars – introducing another currency does nothing to remove the overvaluation. All it does is make it possible for the government to engage in some printing-press financed spending, which is not the solution (though it may help temporarily.)

What I worry is that the argentino, which doesn’t come to grips with the overvalued peso, will destroy the credibility of any domestic currency – that the de facto result will be dollarization, without the benefits.

I know it’s hard for any Argentine government to face up to the ugly truth that a devaluation – a real devaluation, involving a real currency – is necessary. But the longer this truth is denied, the worse it gets.

Originally published in The New York Times, 12.28.01