Why ‘Inflate and Depreciate’ Won’t Work

There is a new policy for growth in town – one that is neither particularly new nor likely to result in growth. Having conceded that contractionary fiscal expansion failed but not yet being ready to go for expansionary fiscal expansion, economic policy makers are trying their luck with ‘inflate and depreciate’. This is the mood music in Tokyo, Washington, London and even in Frankfurt.

Since the autumn of 2008, the Bank of England has pumped £375 billion into the economy – what has become known as ‘quantitative easing’ (QE). QE serves many purposes the chief of which is to guard against deflation. An important side-effect of QE, however, has been depreciation. The pound has lost 13% against its benchmark basket of foreign currencies and a full 25% against the dollar.

While initially thinking that the crisis could be conquered merely by withdrawing government and leaving the playground to the private sector, the Treasury is increasingly relying on exports to pull Britain out of stagnation. By making British goods more competitive abroad, QE-as-depreciator has an important role to play. And seeing that private sector demand is insufficient to grow the economy and thereby shrink the size of government debt as percentage of GDP, QE-as-inflator has the added advantage of reducing the real net debt burden.

So inflate-and-depreciate it is. In fact, unless the government radically changes its course and starts investing in the economy, inflate-and-depreciate is the government’s only policy for growth and debt reduction.

But here is why it won’t work. First, depreciation is not a sufficient condition for export-led growth. At home, we need to be confident enough in the economy to take the risk of producing something to export in the first place. Abroad, a cheaper pound will not make much of difference to the demand for British goods if consumers have stopped consuming for fear of worse-to-come. The last four years have been a testimony to the insufficiency of depreciation: despite the 13% drop in the pound British exports have only increased by 1%. If this is the way to growth, it requires a near annihilation of the value of the pound to have the required effects.

Second, even if depreciation presented a fail-safe way to exports and growth it still would not present a sustainable policy. Britain is not the only economy going through tough times at the moment. If all her trade partners adopted an inflate-and-depreciate stance to get their economies going it would be the return of currency wars not seen since the interwar years. Countries would have to inflate and depreciate ever more in order to stay ahead of the curve. Keynes characterised such problems as fallacy of composition: what is rational for individuals is not always rational for the group.

In the end, therefore, we come back to the only cure for the current disease, however unappealing for ideologically minded policy makers. The only way out of this slump is by increasing aggregate demand and the only way of increasing aggregate demand is for the government to stop cutting and start investing.