The Devaluation Idea Jude Wanniski June 27, 1989

Executive Summary: It may seem like hyperbole, but The Wall Street Journal is correct in citing the devaluation idea as "the most pernicious idea loose in the world today." It destroyed the equilibrium of the Bretton Woods system, brought down two presidents, crippled the Third World economies and now threatens to stymie the liberal reform movements in the Communist world. The idea is lethal chiefly because of its destructive effects on fundamental human values. We review here why this seemingly simple idea of altering trade flows through exchange-rate changes has such pernicious effects. Mexico has finally resisted the idea after 13 years of repeated failures. Now the new government of El Salvador is being urged by the U.S. State Department to try it. China's turmoil flows from the devaluation idea and the Soviet Union is petrified by its implications. Citicorp and the western creditor banks remain oblivious to its destructiveness, which currently is at the heart of Argentina's inflation. The Bush Administration's appointees to key international economic slots have all been devotees of this pernicious idea.

The Devaluation Idea

In its May 23 lead editorial, "Dollar Turmoil," The Wall Street Journal asserts that with the collapse of Marxism as an ideology, "the most pernicious idea loose on the earth today" is that the value of the U.S. dollar should be set to affect international trade flows. This is fairly potent hyperbole, even conceding the Journal's assertion that this pernicious idea was "the most likely explanation of the 1987 stock-market crash." The word pernicious is ordinarily a synonym for the words noxious, lethal, fatal or deadly. For the Journal to finger the devaluation idea as the deadliest, now that Marx has been apprehended, is enough to at least raise an eyebrow, isn't it?

But then consider a further list of devaluation's casualties. It destroyed the international equilibrium of the Bretton Woods monetary system and spawned the global inflation of the era. It wrecked the Nixon and Carter Administrations. It demolished the Mexican economy and most others in Latin America, corrupting governments and their civil service, inviting hyperinflations and the illegal drug trade. It was a key ingredient of the collapse of the Vietnamese economy in 1962. It also fostered the current inflation in China, which threatens a return of another pernicious idea, Maoism. And the Savings and Loan crisis stems directly from dollar devaluations that began in 1971.

This is surely an impressive list of evil deeds, worthy of putting devaluation high up in the Journal's Pernicious Pantheon. The idea is so powerfully entrenched that the Journal itself on May 15 gave half its editorial page over to the foremost champion of devaluation, C. Fred Bergsten, and his essay, "The G-7 Should Drive the Dollar Down." The newspaper offered its readers no warning on the article's perniciousness, and one assumes millions of minds were poisoned. The Journal also regularly invites Harvard's Martin Feldstein onto its page, where he routinely prescribes the sinking of the currency for purposes he believes are desirable, but which turn out to be quite evil.

We can't blame Messrs. Bergsten and Feldstein for the devaluation idea, which has been around for as long as money. But the moment seems ripe for a review of its particulars. Barry D. Wood, economics editor of the Voice of America, writes to me June 16 that "I am one of those economic correspondents still not persuaded -- but wavering -- that devaluations are the wrong thing to do." Sen. Bill Bradley of New Jersey is the first leading Democrat to abandon the idea, advising me he no longer believes in the devaluation idea. In a letter in the June 20 Wall Street Journal, he inveighs against these creditor country tax and exchange-rate policies of austerity that spur capital flight.

The evil in the devaluation idea is a simple one, basic and fundamental to civilization: It weakens the link between effort and reward. The family unit, the community, the state and the nation are knit together by such linkages. When effort is punished and sloth rewarded, the social unit involved is weakened. There are many ways to weaken these links: Favoritism in raising children, carelessness in dealing with a spouse, permissiveness in school, racial or religious bias in employment, injustice in dealing with criminal behavior, an open-ended welfare system. The devaluation idea is in this class, and the greater the devaluation, the greater the destructiveness. In combination with other similar injustices that are well-meaning in intent, it contributes to the drug culture and an erosion of moral values — and this has been true throughout history.

A currency devaluation is most commonly thought of as an event that occurs between nations. When Fred Bergsten or Martin Feldstein think of a dollar devaluation, they think of an adjustment in the dollar price of the Japanese yen. Because they believe Japan is gaining an unfair trade advantage with the United States through an undervalued yen, it seems right and just of them to urge a dollar devaluation to U.S. policymakers. They live entirely in this textbook framework, which explains why they can be so arrogant, even sanctimonious, in offering their failed prescriptions.

At the most basic level, though, a currency devaluation alters a contract between two people, most often the citizens of the currency's country of issue. Far more contracts are made in U.S. dollars within the United States than in the import/export market, which is why devaluation is most harmful to the devaluing country. At the global level, a currency devaluation may seem morally neutral. But looked at in microcosm, the moral issue is easily seen: Suppose a baker lends me ten loaves of bread. This credit is denominated in the local currency, and I agree to pay back a dollar a loaf. Then I persuade Nick Brady to devalue the dollar by 20%. Now I only owe the equivalent of eight loaves of bread, because our contract was in dollars, not loaves.

The baker has thereby been cheated out of the fruits of his labor and I have a windfall gain. Multiply this a million times, a billion times, and you have some idea of the colossal destructiveness of the devaluation idea, how it unravels a society's fabric by destroying its values, its confidence in the work ethic and the integrity of its savings, while at the same time increasing the attractiveness of the quick, windfall gain through political influence. The authority of government itself crumbles when it cannot maintain the integrity of the basic unit of account for its citizens. How ironic that Martin Feldstein, who is forever raging about the low savings rate in the United States, is calling for yet another devaluation of the dollar. At the April meeting we had with President Bush at Camp David, I volunteered that I would gladly increase my personal savings rate if I could be sure that he, Feldstein, would fail in his efforts to devalue the dollar!

Devaluation is most often presented as a benefit to a nation's trade, which is how President Nixon was sold on the idea of the 1971-73 devaluations. But there is another wrinkle on the devaluation idea favored by conservative, free-market economists, including Undersecretary of State for Economic and Agricultural Affairs Richard McCormack. When there is an official currency exchange rate that is inconvertible, because of central bank fear that dollar reserves would be depleted if conversion were possible, we hear the argument that the government should devalue the official rate to the black market rate, where the local currency is being freely swapped for dollars at a discount. Free-market conservatives argue that the currency's intrinsic value is thus determined, and insist the official rate should be lowered to the street rate. Thus, protectionists and free-marketeers arrive at the devaluation idea from their own perspectives.

Unfortunately, the effect of this seemingly logical devaluation is invariably an unhappy one. If a government is unable or unwilling to make the official rate convertible at one rate, it will not be able to do so at another. For the most part, this is because of the progressivity of taxation. If the Mexican peso devalues against the dollar, it also devalues against the goods the dollar can buy. Unless Mexico's marginal tax rates are reduced, it will take more goods to pay tax liabilities to the Mexican government at the new nominal level of production, the process we call "bracket creep." Profit opportunities are immediately reduced as a result, and capital that had been attracted to Mexican enterprise goes elsewhere. The new official rate is thus brought under pressure, convertibility is no longer free, and a new black market rate emerges on the street.

If Mexico's tax system was regressive or specific (so many pesos per kilo, per liter, per hectare), a devaluation would have the opposite, positive effect. Effective tax rates would be lowered, profit opportunities increased, and capital attracted, thus enabling the government to maintain the new exchange rate. Individual creditors would still be cheated by the devaluation, but the second-order effects would not necessarily lead to further devaluations. This situation doesn't exist anywhere in the current world of tax progressivity, however.

This was exactly my argument in The Wall Street Journal editorial of September 26, 1976, "The Nickel Peso," warning Mexico that its devaluation from an eight-cent peso to five cents, after 22 years of convertibility, would be destructive: "Because the entire work force will be shifted well upward into higher personal income-tax brackets because of the devaluation's effects on prices and wages, there must be downward price adjustment and soon, or the resultant disincentive effects will send unemployment climbing even faster than it has."

Mexico's economic difficulties in 1976 can be seen as resulting from the peso's fixed rate to the dollar, but not in the way U.S. bank economists imagined. President Richard Nixon devalued the dollar in 1971 against other currencies, but the peso remained pegged at eight cents. Because of this link, the inflation that followed in the United States was exactly matched by the inflation rate in Mexico. The progressivity of the tax structure in Mexico, though, was steeper than that in the U.S., which meant the inflationary impact of the simultaneous dollar-peso devaluation was sharper in Mexico than in the United States, a faster "bracket creep." Profit opportunities narrowed faster in Mexico, forcing capital flight to the U.S.

If the U.S. economists advising Mexico in its distress had been classical instead of Keynesian, they might have advised an adjustment in the tax rates to offset the bracket creep. Or, if Mexico, like Japan, had allowed the dollar to devalue against its currency in the period after 1971, there would have been no bracket creep and interest rates in Mexico would have remained on a par with Japan's. Instead, Mexico was persuaded to devalue the peso. This compounded the problem and led to a vicious cycle of further devaluations and fiscal austerity.

The peso is now at almost 2,400 to the dollar and devaluation continues at a peso per day. Domestic interest rates are in the 50% range, which not only reflects this peso-per-day devaluation, but also the possibility of another surprise devaluation of major proportions. The U.S. Treasury last winter hammered on the Salinas government to devalue the peso by as much as 20%, but Mexico fended off the move, with the help of Federal Reserve Vice Chairman Manuel Johnson. Another devaluation of this magnitude would destroy the confidence President Carlos Salinas has begun to collect, spur further capital flight, and perhaps even lead to civil disturbance of the kind we've seen in Venezuela.

Bureaucratic corruption in Mexico is widely cited here as a major reason for the nation's economic difficulties. But corruption did not exist on this scale prior to the 1976 devaluation. Government workers are easily corrupted when they see the value of their wages and pensions melting away. Think of the civil servants who in 1976 planned to retire on pensions of 2400 pesos per month ($200), now collecting 2400 pesos per month ($1). It is even worse in Argentina's hyperinflation, where pensions and life insurance policies have been reduced to pennies. Devaluation is a pernicious idea.

While Mexico is safe from the Treasury devaluationists at the moment, El Salvador's new government of Alfredo Cristiani and the Arena Party is being hounded by the State Department to devalue its currency. This is the last thing the Arena Party needs to do to build confidence in the ravaged Salvadoran economy. To his credit, former President Jose Duarte resisted pressures from the State Department and the U.S. Embassy in San Salvador to devalue. Most of the miseries afflicting the beleaguered country are the result of economic policy advice from U.S. economists, especially the confiscatory "land reforms" the country was pushed into by President Carter's diplomats.

As I argued in The Way the World Works, published in 1978, the mixture of confiscatory land reform, steeply progressive taxation, and currency devaluation was the witch's brew that imploded the South Vietnamese economy and ultimately sent 50,000 American troops to their death. The Saigon government was forced to drink this poison by President John Kennedy's State Department in 1961-62, which threatened to withdraw military aid from President Diem unless he did so. Yale's James Tobin, the economist most associated with this policy mix and Fred Bergsten's mentor, was a member of Kennedy's Council of Economic Advisers from January 1961 through July 1962. Indeed, the same "expert" who designed the South Vietnamese land reform that destroyed the fabric of its rural economy, Roy Prosterman, designed the El Salvador land reform that had the same awful results there. More than 30,000 Salvadoran deaths can be chalked up to the land-reform struggle between property owners, who hired death squads as their lands were being confiscated, and the socialists, who were doing the confiscating. The Arena Party grew out of this struggle, its base of support the rural peasantry that was the alleged beneficiary of the U.S.-inspired land reformers.

The U.S. Treasury's devaluationists are not only a threat to the debtor nations of this hemisphere. Since 1986 they have been hounding South Korea and Taiwan to appreciate their currencies. The idea, of course, is to effectively devalue the U.S. dollar in order to alter trade flows with those two countries without disturbing the dollar's value relative to Japanese and European currencies. The people of Taiwan and South Korea have been furious at the lectures of U.S. Treasury officials on the conduct of their monetary policy. Currency appreciation is no less damaging than devaluation to the links between effort and reward. If a currency appreciates by 20%, it means the debtor who has borrowed 10 loaves of bread must now pay back 12. It never occurs to U.S. Treasury officials, who are following the economic advice of the devaluationists, that their demands are disrupting contracts at the lowest street level of commerce in Seoul and Taipei. Hence they do not connect the civil strife and anti-Americanism that results with their monetary bullying. Sadly, the 1988 Omnibus Trade Act practically requires that the U.S. Government dictate monetary policies for the rest of the world based on this most pernicious idea.

The current inflation in China is not only the direct result of the 100% currency devaluation of 1987, urged on the reformers in Beijing by western economists. It's also the key to understanding the political reaction by the Maoist octogenarians. In the millions of words written about Tiananmen Square and its aftermath, there's been little mention of the fact that the Communist victory of 1949 was fueled by the monetary disorder and great inflation under Chiang Kai-shek's Kuomintang. It was Mao who pledged an end to the chaos of hyperinflation. The men at his side at the time of the Long March, including Deng Xiaoping, have used the current inflation as a rationale for the slowing of capitalist reforms. To the grizzled old communists, currency inflation equates with a breakdown of order and respect for the authority of government. Western economists and journalists have helped by repeatedly blaming China's inflation on economic growth, not the currency devaluation they advised.

In my Polyconomics paper of last September 8, "A Growth Path to the 21st Century," I warned of these developments:

A serious worry at this early stage of economic development in the socialist bloc is the influence of the international financial institutions, especially the IMF. The neo-Keynesians who still dominate the IMF, after several decades of playing the bull in the china shop, have already been successful in getting the ears of policymakers in Beijing -- urging their poisonous brew of "tight fiscal policy and easy money" on the regime. It's only natural that the Socialist nations, if they are to grow along the capitalist road, will have huge trade deficits that match the private capital inflows seeking investment opportunities there. It was just such a trade deficit that led the IMF to counsel Beijing to devalue its currency in the last two years, to discourage imports and promote exports! The devaluation of course has produced a troubling inflation in China, leading the government back toward price freezes. A steady dose of these neo-Keynesian ideas from the West's collection of Nobel Prize winners would undermine the free-market reforms in the USSR and People's Republic of China just as surely as they have ravaged the Third World.

One of the great fears in the Soviet Union about the Gorbachev economic reforms is that the necessary market reforms of the price system might ignite a horrific inflation. The conventional wisdom in Moscow is that there are too many rubles floating around to permit the freeing of prices now set by the command economy. The official rate of the ruble is $1.57. The street rate is reportedly closer to 10 cents. It seems such a colossal obstacle to perestroika that there is almost no discussion in Moscow on how it could be done. It seems impossible.

This is because the Soviets are thinking in monetarist or Keynesian demand-side terms. To a monetarist, a weak currency signals too many dollars or rubles or pesos in circulation. To a Keynesian, a weak currency means taxes are too low or spending is too high or both. To a classical, supply-side economist, a weak currency simply means, for one reason or another, its supply exceeds its demand. The government can correct this in either of two ways.

The most direct way is to issue interest-bearing bonds that mop up the surplus. If the government has difficulty issuing bonds at reasonable interest rates, it invariably means prospective buyers of the bonds are skeptical that a future devaluation will be avoided. The Soviets could achieve credibility to a degree by making the ruble convertible to gold, but Soviet economists are reluctant to extend such a gold standard to Soviet citizens, preferring instead to limit convertibility to foreigners. The fear, is that the Soviet citizenry would rush to turn their rubles (mainly currency) into non-interest bearing gold instead of buying interest-bearing gold-ruble bonds, so that Soviet gold reserves would soon be depleted. In classical theory, which is how the Bank of England managed its currency for centuries, the Soviets could sell notes or bonds to mop-up currency until cash became scarce relative to gold and goods. At the extreme, the last ruble left in circulation could buy the entire GNP, so that gold would lose it's allure. Well before reaching that extreme, though, the citizenry would find the interest rate on notes and bonds more attractive than hoarding gold, which pays no interest.

The indirect way of strengthening a weak currency is to increase the profit opportunities in the currency's country of origin. A weak currency almost always signals unnecessarily high tax rates and tariffs and regulations burdensome to commerce. Price controls also weaken a currency, because shortages and queues lead to barter and the use of foreign money. These discouragements to production signal prospective buyers of the country's bonds that the government will have difficulty collecting taxes in order to service the bonds, and at some point will resort to devaluation in order to lighten its debt burden. The bondholders, of course, are the first to suffer capital losses in a devaluation. In Mexico and in the U.S.S.R. at the moment, the clearest path to a strengthening of their respective currencies lies in this direction. As production of real goods increases, there is need in the economy for more ruble and peso notes for simple transaction purposes. It is much more pleasant to strengthen a currency in this fashion, increasing the demand for it instead of reducing its supply.

The hyperinflation we're now observing in Argentina is the inevitable result of the devaluationist idea. Keynesians set tax rates high to discourage "inflationary" growth and consumption. Monetarists urge the printing of money at less than the inflation rate. Bondbuyers can't be found at any interest rate. The markets observe that the policymakers in Buenos Aires simply switch back and forth between monetarist and Keynesian austerity plans. (The new finance minister, a businessman, is said to be a big fan of Lawrence Klein, the Nobel Prize-winning Keynesian at the University of Pennsylvania.) Horst Schulman, executive director of the Institute for International Finance, a Washington outfit that represents 150 creditor banks in the United States, announces that Argentina is "undertaxed," and various financial journalists write hopefully of a new crackdown on tax delinquents.

As Alan Reynolds points out, the combined income, payroll and sales taxes on labor in Argentina is 85%, second only to Peru's 90%. Peru would have even worse hyperinflation than it does, except that its central bank accepts deposits from the cocaine trade. An 85% marginal tax rate on labor means that for an employer to hire a worker to bake 100 loaves of bread per day, the various taxes on both employer and worker add up to 85 loaves per day. In Peru, it is 90 loaves. In Peru's cocaine trade, which produces half the U.S. supply, the marginal tax rate on labor is zero. The new Argentine government of Carlos Saul Menem, we are advised June 25 by Peter Passell of The New York Times, is going to use "shock tactics" that "should break inflationary expectations overnight."

To tame capital flight, the new currency would almost certainly be pegged to the dollar at a very low rate [i.e. devalued]. The Government would restrain wages through informal pressure and public campaigns. And to reduce the government's budget deficit, which now absorbs 16 percent of national output, taxes and utility rates would be raised sharply.

Is this madness or is it not? Eighty five loaves out of a hundred isn't enough. Taxes must be "raised sharply." One might assume that Citicorp's John Reed and the other creditor bankers in the West might eventually get an inkling of what's going on around them. But they do not. Their myopia when their own vested interests are involved is extreme and shows no signs of getting any better. Nor has the Bush Administration made any progress compared to the Reagan Administration in the key positions where the devaluation idea could be stamped out. The top Bush appointees on international economics to State, Treasury, and the International Monetary Fund, are all devaluationists of one stripe or another.

What is even more puzzling is that the most pernicious idea loose in the world today does not even do what it is supposed to do, i.e., alter trade flows in a predictable direction. In almost 20 years of asking devaluationists-for evidence, I've gotten not a scrap. "Common sense," they say, tells us it works.

Yet "common sense" is precisely that normal good sense in practical matters gained by experience of life, not by abstract study. Classical economic theory advises that government cannot change the terms of trade by changing the value of the unit of account. A currency devaluation cannot alter a trade flow. The record of experience of the devaluation idea serves as a strong warning to policy-makers in the Bush Administration that this most pernicious idea is still a road to disaster.

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