History shows currency devaluation may not be a calamity
Over the next few years, the debate about whether or not to remain in the euro will rage in countries like Greece, Italy, Spain, Ireland and Portugal. Opponents will argue that each country must ditch the euro and regain monetary sovereignty or it will be condemned to rising unemployment and stagnation.
Proponents will counter by insisting that retaining the euro is the only way to protect domestic and monetary fiscal credibility. By leaving the euro and devaluing their national currencies, they claim, the afflicted European economies will simply condemn themselves to many years of economic stagnation.
A similar debate took place in France nearly a century ago that may illuminate the problems Europe faces today. After the first world war, which wreaked havoc on the monetary arrangements of the pre-war years, France struggled over the issue of what to do with its currency.
Like most belligerents France went off gold during the war. Wartime inflation made it impossible to return the franc to the pre-war gold exchange rate, but there was a widespread belief that to fail to maintain the gold value of its currency was irresponsible behaviour that condemned a country to economic stagnation.
France struggled mightily to return to the pre-war exchange rate, but it could not. In 1928, yielding to the inevitable, it finally devalued the franc 80 per cent against its pre-war value. France's capitulation to monetary 'irresponsibility' mortified its bankers and its econo my, it was widely believed, would collapse relative to the countries that had returned to the pre-war exchange value.
But this didn't happen. On the contrary, very soon after devaluing, France's economy took off.
Instead, it was France's competitors who struggled. As they fought to maintain their own overvalued currencies, their economies stagnated.
When much of the world collapsed into crisis in 1930-31, France was largely immune. It avoided the deep depressions the US, England, and most of the industrialised world suffered and continued growing.
Eventually, England and a number of other countries were themselves forced to devalue and Paris took advantage of those devaluations to condemn the 'irresponsibility' of the same countries that had so criticised France. As it began accumulating huge amounts of gold, thanks to its undervalued currency and strong export sector, France began increasingly to see itself as the global guarantor of monetary rigour.
But this turned out to be a mistake. As one country after another devalued in the early 1930s, France's competitive position became increasingly weaker. Still, as the self-appointed guarantor of monetary orthodoxy, France was determined not to devalue again.
However, by 1933-34, the French economy began to suffer horribly. As the rest of the world embraced monetary flexibility, France's insistence on monetary rigidity and on forcing adjustments through wages and deflation weakened its economy and brought it to the brink of political and economic collapse.
In 1938, Paris was unable to maintain the value of the franc and it was forced once again to devalue. The cost of waiting was enormous. France was one of the countries most severely hurt by the Depression, even though during the worst years for the rest of the world it had performed so well.
So what are the lessons for Europe? There are at least two.
The first is that when currencies become seriously overvalued, it will not necessarily undermine credibility to resort to a direct intervention and devalue, rather than adjust through deflation and unemployment. It is growth that generates credibility, and if devaluation leads to increasing international competitiveness, the country can easily regain credibility.
Second, excessive respect for orthodoxy may keep central bankers and investors happy, but we should not necessarily believe their warnings about economic calamity once orthodoxy has been violated.
Michael Pettis is the senior associate of the Carnegie Endowment for International Peace and finance professor at the Guanghua School of Management at Peking University