Never reason from a price change, example #305 By Scott Sumner

Over at TheMoneyIllusion I have a series of posts exposing the common fallacy of “reasoning from a price change.” (Trademark) This occurs when people assume that consumers will buy less oil when the price is high, or there will be less investment when interest rates are high, or there will be fewer exports when exchange rates are high. In fact, the effect of price changes on equilibrium quantities depends entirely on the cause of the price change. When prices rise due to less supply, quantity falls, when they rise due to more demand, quantity rises.

This “Buttonwood” article (in The Economist) is entitled “Here we go again.” Exactly:

THE game of “pass the parcel” is enjoying another round. The yen has fallen by nearly 17% against the dollar since Shinzo Abe became prime minister of Japan at the end of December last year. That may be a boost to the competitiveness of Japanese exports but foreign-exchange markets are a zero-sum game: if one currency weakens, another must strengthen.

One can make an argument that currency weakness caused by high saving policies (China, the Nordics, Germany) hurt other economies, although I don’t believe it. However currency weakness caused by expansionary monetary policies (Japan) is clearly a win-win when the global economy is depressed. I notice that foreign stock markets go up whenever the Fed tries to depreciate the dollar, and I presume the reverse is also true when the BOJ tries to depreciate the yen.

It is worth remembering that a devaluation is a reduction in a nation’s standard of living: it costs more for domestic consumers to buy foreign goods. That is why governments tended to resist them. By the same token, however, a devaluation is akin to a wage cut, a way of making a nation’s goods more competitive in global markets. And it is a lot easier than asking workers to accept actual cuts in wages.

There’s some truth to the claim that a devaluation is akin to a real wage cut, and just as with wage cuts the impact on living standards depends on why the currency depreciated. If a country suffers currency depreciation due to supply-side problems (bad weather, political turmoil, etc.) then living standards will fall. However if the cause is supply-side problems, then the falling currency is just the messenger. Ditto for real wages. If real wages decline for supply-side reasons then living standards will fall, but the underlying reason is the supply-side problems, real wages are simply a messenger.

On the other hand if a currency depreciates because of an easy money policy that addresses a shortfall in demand, then living standards will rise. The same is true of real wages. When real wages decline due to a boost in AD in a depressed economy, then living standards rise.

The period of March – July 1933 is a perfect example. The US economy was very depressed. The dollar fell very sharply. Real wages fell sharply (when deflated by the WPI.) And living standards rose.