Danger! Danger! Devaluation!

Right now, Brexiters keep claiming that devaluation is good for the economy. They're almost certainly wrong.

Intuitively, a fall in the pound is a bad thing: anything we buy from overseas goes up in price and since a high proportion of what we buy comes from overseas, our cost of living will go up.

But then Brexiters jump in and say "Devaluation is great, because it means more exports and that will make the economy grow." As a general rule, because Brexiters often distort the truth, you should be skeptical. So, are they wrong here too?

It's a good question. Recently I was at my Dad's house and we were watching a TV show called "Factory Wars" on the Yesterday channel. I was surprised to find a bloke from The Institute of Economic Affairs. Why was an economist from a lobbying organisation with secretive funding (hint, Big tobacco and the climate denying US groups like the Heartland Institute) on a history show?

Basically he was using it to push free market ideology. He claimed that the UK escaped the recession in the 1930s because it implemented austerity unlike the US which implemented a Keynesian New Deal. This was completely different to how I'd understood these economies in the 1930s: on the basis that austerity empirically doesn't work; its easy to explain why, and it was the Keynesian New Deal that empowered the US to manufacture the armaments that helped the allies overcome the Nazis.

It's not coincidence that the IEA offered a completely different explanation than what is normally understood: they're based at 55, Tufton Street where Vote Leave was also based. So, again we have another ideologue whose views we should suspect.

So, I checked out what really happened in the UK's economy in the 1930s? Economics Help is really useful. Basically, the crash of 1929 caused a lot of hardship in the UK, but in the mid to late 1930s we dropped the gold standard; which lead to a deflation of the pound and this lead to a mild economic recovery in the south, but the North still had it tough.

So, it looks like Brexiters might be a bit right, and the IEA were misleading as normal. But is it?

Devaluation Model

Actually we can work this out ourselves, because it's easy to model. In our model (for a business, but it can apply at a larger scale) we consider just three variables:

1. Profits
2. Internal costs (labour minus rises in the cost of living due to buying overseas goods, maintenance of equipment etc). We assume this is a constant.
3. Imports (including the increases in the cost of living for employees from overseas goods).

Case A

In the first scenario, we consider a company with reasonably high import costs (50%), a profit margin of 30% and the rest is internal costs (20%). If the pound deflates by 25%, then imports go up to 50*1.25 = 62.5%. So, now our profits are 30-12.5 = 17.5% profits. This means that the company needs to sell 30/17.5 = 71% more goods, but the domestic market will buy less, and the overseas market will only find its products are 25% cheaper (due to devaluation).

So, the question is: is it like overseas customers will buy 71% more, if it's 25% cheaper? This seems unlikely to me.

Case B

Let's consider the second case: profits are 70%, internal costs 20% and imports are 10%. Imports increase by 25% => 12.5%, so we now need to sell: 70/(70-2.5) = 3.7% more. OK, so in this case our product is 25% cheaper, and we only need to sell 3.7% more for us to make more profit, this seems plausible.

So, we have to ask ourselves, what kinds of businesses are like this? Mass market manufacturing (cars, aircraft, smoke alarms) will rely a lot on imports and will make a relatively small profit. Apple, for example has margins between 20% to 30%. Dyson is also about 21%. DELL has an operating profit of just 1.1%. Companies producing consumer items such as smoke alarms have fairly low margins which explains why they would move to cheaper EU countries.

What companies are like case B? Services and financial companies are like that. However, financial companies are likely to move out of the UK due to Brexit, so this means service companies would benefit.

However, to some people, UK manufacturing companies can look good: namely, if you hold a lot of offshore wealth, then UK manufacturing companies struggling under devaluation look like a good buy. In other words, disaster capitalists with offshore accounts, such as people like Jacob Rees Mogg and a large proportion of Conservative party members and MPs.

Epilogue

Brexiters are wrong: it's just a front for their disaster capitalist mission. We can summarise our model and convey why in a simple table:

So, why did the UK not crash due to a double-whammy of austerity and devaluation in the 1930s? That's pretty simple, being the biggest power bloc at the time meant that although most of its food (91%?) was imported along with a significant proportion of goods, a great deal of this was essentially an internal market, with the added advantage that many resources, particularly coal were internal.

Thrifty Business

In the run-up to the UK General Election 2015, I ended up writing so many similar posts on facebook on why Austerity doesn't work that I thought I'd turn it into a blog entry.

Nobel Prize-winning economist Paul Krugman has written an excellent piece in the Guardian about the Austerity delusion. He covers the historical developments over the past 5 years and provides evidence for a negative correlation between austerity and economic growth.

All I want to do is show why the common-sense argument of the analogy from thrift isn't correct.

 The thrift argument is that, if I'm in debt, I have to cut back on my own spending until everything's under control and I can (and have) paid it off.

[*]And that's the right thing to do, however, it's not the whole story. In reality what happens is that when you cut back to pay off your debt, the people you trade with lose income. In a sense, they're soaking up the imbalance of your finances, but it works, because they're only losing a little bit when you cut back by a lot. The key thing is that your income stays the same while your outgoings shrink (a lot), and their income shrinks (a bit) while their outgoings stay the same - so you're passing on your debt, they take a bit of a hit too.

And therefore, it won't work if everyone is simultaneously in debt. When everyone starts cutting back, everyone's income shrinks and so they become less able to repay their debts. That's what happens when governments enact austerity: the private purse shrinks, internal trade stalls (and this in fact is what happened - banks stopped lending and started calling in debts, which is why businesses failed) and if the government acts along with it by reducing its spending in accordance with its lower tax revenue, it just adds to the problem.

The right thing to do then, if private lenders won't lend, is for the government to provide the cash to keep the economy going - and that means public borrowing during a financial crisis. That's half of Keynesianism, in essence.

Keynesianism, relies on another insight - that cash isn't a substitute for goods as we normally think, instead, cash is a medium for exchange. That is, cash operates as a pipe for transporting goods; the size of the pipe is the amount of cash we have, it determines the rate we can exchange and trade; it's not a representation of what we have.

So, if we go back to [*], we can see that's what's happening in the example. Your original debt is distributed across the entire system. It's the capacity of your input pipes (income+loans), which is the same as your output pipes capacity (spending), which determines the sizes of others' input pipes (income). When you cut back, the whole network capacity shrinks. Which is to say your debt was distributed everywhere all along. It's a really powerful concept to get one's head around, I've barely scratched the surface.