The Large and Obvious Risks of Currency Devaluation

There's an interesting story in the WSJ today (subscription) about the perils of trying to devalue your way out of a debt-laden financial crisis.  The story focuses on Hungary's troubled currency, the forint, which took quite the tumble last week after some rather, umm, clumsy remarks from Hungarian officials about the chances that their country might default on its debt.  Here are the key passages:

The forint lost 4.8% against the euro and 7.3% against the Swiss franc last week. Pledges by the new Fidesz government that it will stick to a budget-deficit target equal to 3.8% of gross domestic product failed to reverse much of the losses Monday. That suggests the market has lost confidence in government policy and communication. But the decline also risks triggering a downward spiral: at the public debt level, around 45% of Hungary's debt is denominated in foreign currencies, so a sharp fall in the forint immediately causes the debt-to-GDP ratio to rise.

Hungarian debt-to-GDP at 78.3% in 2009 is already far above its Czech and Polish peers. For the heavily indebted private sector, things are even worse. As of April 2010, 63% of individuals' residential mortgages were denominated in foreign currency, according to the National Bank of Hungary. That means declines in the forint versus the euro and especially the Swiss franc directly translate into increased debt burdens and reduced household spending power.

There is also the question of timing. Exchange rate shifts can take time to work through; witness the U.K. where the Bank of England has been puzzled by the failure of the steep decline in sterling at the end of 2008 to boost exports as much as hoped. If the problem is demand, rather than price, then the impact of devaluation on growth may be muted. But the effect on debt and spending is much swifter. 

Although it's blatantly obvious that there are huge, systemic differences between the United States and Hungary, I think that we still can learn a couple lessons from Hungary's mess and the WSJ article about it.  First and foremost, globalization and its attendant interdependence have made apparently "simple" fiscal moves like currency devaluation a lot more complicated and unpredictable.  For Hungary, its foreign-denominated debt (publicly and privately-held) makes devaluing its way out of any debt obligations pretty much impossible, and any forint devaluation will just pummel residential mortgage-holders (among others).  While this certainly isn't the case in the United States, our import consumption habits mean that a US dollar depreciation will have painful ramifications for lots and lots of American families and businesses.  In other words, a cheap dollar means that American families' paychecks won't stretch as far for basic necessities (e.g., energy, clothing and footwear - most of which is imported these days), and that American companies will pay more for imported inputs.  Considering that almost 60% of all imports are these industrial inputs, a cheaper dollar will end up hurting a lot of American manufacturers' bottom lines.  Ouch.

Second, the UK experience referenced above demonstrates that any currency devaluation doesn't guarantee an instant boost in a country's exports either.  As the article mentions, you also need overseas demand for the stuff that you make.  This is certainly going to be a problem for US exports to Europe for the foreseeable future (although the US dollar couldn't depreciate against the Euro right now if it tried).  In the case of the US-China trade relationship, there's likely demand in China for sure, but a significant amount of stuff that the US specializes in, like high-tech goods, can't (by law) be exported there because of our export controls.

In sum, Hungary's and the UK's own devaluations provide further proof of something that I've been trying to show here for a long while now: you should immediately stop listening to anyone who argues that a weaker dollar is abso-tively going to resuscitate the US economy.  Because they just don't know what they're talking about.