3.3.8.4  Balance of Trade and Currency Exchange Rates

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A country's balance of trade, that is to say the value of its exports minus the value of its imports, is mainly controlled by its competitiveness in the markets: worldwide supply and demand.  If its imports exceed its exports it is said to be running a trade deficit and it is building up its foreign debt (both private and public).[1]  Paying the interest on that debt consumes part of the GDP, thereby reducing the amount available for consumers to spend: a lowering of their standard of living.  There are several macroeconomic mechanisms for correcting a trade deficit:

·      Applying tariffs, in an attempt to stem the level of imports, increases inflation (3.3.8.3).  There is also a high risk of retaliatory tariffs and adverse effects on trade, as described later (3.5.4.2).

·      Cutting wages increases competitiveness, but is painful and unpopular.

·      Purchasing power in international transactions depends on the relative strength of the currencies used, so a country can increase the competitiveness of its exports by allowing the value of its currency to drift downwards.  A depreciating currency, though, increases the price of a country's imports so it is inflationary.

·      Some countries have had to apply to the International Monetary Fund (IMF) for a loan to stabilise their finances.  This only provides a temporary respite and, as will be seen at the end of this chapter, there are other governance problems with these international transfers of funds (3.5.5).

In practice, the technique of allowing the value of the currency to 'float' seems to be the least politically difficult €“ though this solution is not available to individual countries within the Eurozone.[2]  But all the mechanisms lead to the same outcome: real wages (and standards of living) have to shrink, or productivity has to increase, until the country€™s competitiveness is restored. 

Governments used to try to manipulate currency exchange rates, [3] for example by devaluing their currencies to stimulate the growth of exports.  After 1971 (the end of the Bretton Woods Agreements, which had denominated currencies against the price of gold as a standard) the only mechanism for most countries to manipulate exchange rates was by changing central bank interest rates, to make the currency more or less attractive to speculators.  This, though, could only work to a limited extent €“ as was dramatically illustrated by Black Wednesday: 16^th September 1992, when the British government was forced to withdraw the British Pound from the European Exchange Rate Mechanism (ERM) due to pressure by currency speculators.[4]  Some governments still control exchange rates but most countries now accept that currency exchange rates have to €˜float€™ according to economic circumstances and are beyond direct political control.  China€™s policy of pegging the renminbi against the American dollar in the early 21^st century has been an egregious exception, but the resulting huge foreign currency inflows might eventually cause inflation.[5]

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