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Sterling in decline: A review essay
Journal of Monetary Economics 18 (1986) 95-102. North-Holland
STERLING IN DECLINE* A Review Essay Alan C. STOCKMAN Universiiy
of Rochester,
Rochester,
NY 14627,
USA
There have been few serious studies of devaluations during periods of pegged exchange rates. This is unfortunate, because devaluations provide economists with opportunities to study large nominal disturbances that appear to have real effects; That there are important real consequences of devaluations (on relative prices, trade, capital flows, output and employment) has usually been taken for granted by specialists in open-economy macroeconomists. Yet, with the nature of, reasons for, and even the existence of monetary non-neutralities being a source of current controversy in macroeconomics, it is important to study more carefully the evidence on which these claims are based. It is easy to imagine a situation in which devaluations would be purely monetary phenomena (if all prices are flexible, if Bicardian equivalence operates to prevent wealth effects from revaluations of currencies as households internalize the return on international reserves, etc.). Yet it appears that devaluations are responsible for changes in real economic variables, such as the relative price of domestic in terms of foreign goods, and internationally traded goods in terms of non-traded goods. If so, perhaps the channels through which these effects operate are applicable to non-neutralities of money more generally, and are related to issues of aggregate fluctuations. Similarly, the general changes in nominal variables that accompany devaluations may have real consequences: e.g., Caimcross and Eichengreen argue, as have Friedman and Schwartz and others, that Britain recovered from the 1930-31 recession more rapidly by leaving the gold standard, allowing the pound to depreciate, and ending the associated deflation. The effects of devaluations are difficult to study because devaluations are usually accompanied by changes in other policies, so the effects must be disentangled from the effects of these other changes. (Because the other changes in policies differ from case to case, they cannot be treated as part of a package of policies collectively called a ‘devaluation’.) Also, the sample of *Sir Alec Cairncross and Barry Eichengreen, 261 pp. 0304-3923/86/$3.50@1986,
Sterling
in Decline
(Basil Blackwell, Oxford, 1983)
Elsevier Science Publishers B.V. (North-Holland)
96
A. C. Stockntan,
Sterling
in decline
independent devaluations available for study (let alone those for which reliable data on main economic time series are available) is small. This makes it particularly difficult to isolate the effects of devaluations from the effects of simultaneous changes in other policies. Another difficulty is related to the problem of obtaining evidence on any potential effects of nominal disturbances on real variables: problems of exogeneity and endogeneity plague statistical analyses. Some of the same difhculties that arise in studies of money and business cycles also arise in studies of devaluations. A devaluation may not be an exogenous nominal disturbance; it may be a choice made by a government which faces changes in real opportunities because of underlying disturbances to technologies or tastes. Clearly, some changes in the economy lead governments to devalue. However, it may sometimes be reasonable to treat the precise timing and magnitude of devaluations as exogenous with respect to certain other changes in the economy, in order to isolate the consequences of a devaluation from its causes. This treatment may be appropriate, particularly when the government imposes extensive controls that prevent losses of gold and limit the ability of speculators to create a balanceof-payments crisis and induce an endogenously timed devaluation (as studied by Flood and Garber, Obstfeld, and others). These controls create still another problem for the study of devaluations: even if controls are not changed at the time of the devaluation, the existence of a comprehensive system of controls on international trade and financial transactions alters the effects of devaluation and makes it difficult to generalize to other cases. It may also be possible to isolate the effects of devaluation from their causes (or other consequences of these causes) if governments are viewed as determining domestic credit or taxes jointly with exchange-rate policies. Domestic credit and taxes are generally treated as exogenous in the literature on endogenous balance-of-payments crises, yet domestic credit can always be adjusted to prevent devaluation, and taxes can be adjusted to provide government with greater resources to defend a currency. Whether or not all or most of the economic changes observed to follow a devaluation result from the devaluation rather than the economic changes that led to devaluation (and would have occurred even without devaluation), some of the changes in real variables generally attributed to devaluation appear to be its results rather than causes (or results of other underlying disturbances that caused the devaluation). It would be difllcult to explain the sharp jumps in relative prices that occur simultaneously with devaluations except as consequences of the devaluations themselves. It does not appear that devaluation can be viewed solely as an endogenous response to other changes in the economy that alter relative prices; rather, it appears that devaluations cause changes in relative prices and, presumably, resource allocation. (It is more difficult to determine that changes in resource allocation result from the devaluation, because reallocations occur over time, in contrast to the large and
A. C. Stockman.
Sterling
in decline
91
sudden changes in relative prices that occur simultaneously with most devaluations.) Caimcross and Eichengreen study three devaluations of pound sterling: the fall in the pound after Britain left the gold standard in 1931 to adopt flexible exchange rates, and the 1949 and 1967 devaluations under the system of ostensibly pegged rates. The book seeks to explain both the causes and consequences of these devaluations, and Cairncross and Eichengreen argue that it is useful to study the three episodes jointly. The book consists of a brief chapter on the role of Britain and pound sterling in the world economy since the first world war, a chapter on each of the three episodes, and a concluding chapter. There is a good, brief, overview of the theory of devaluation in the introduction, but the subsequent chapters make little use of that theory. All three main chapters include historical narrative of the events leading to devaluation and the subsequent performance of the economy. Although Caimcross and Eichengreen correctly argue in the chapter on 1931 (page 75) that ‘historical narrative alone, even one that makes use of considerable detail on the pattern of reserve gains and losses, does not enable us to distinguish among the various views’ of the causes or consequences of devaluations, they present little beyond such narrative in the chapters on 1949 and 1967. (The chapter on 1967 summarizes numbers estimated by other economists, though without presenting or discussing the models on which they are based.) In contrast, the chapter on 1931 estimates a model of the causes of the devaluation and seriously attempts to distinguish between alternative models. The historical circumstances leading to devaluation, which Cairncross and Eichengreen detail, could play an important role in another type of argument about the effects of devaluations. If the causes of a devaluation are clearly identifiable then it may be possible to present a convincing argument that changes in real variables following a devaluation were results of the devaluation itself. While Cairncross and Eichengreen argue that the devaluations were ‘forced upon’ governments in each case, they argue that subsequent changes in real variables were consequences of the devaluation (or other policies that were permitted by the devaluation), i.e., they implicitly argue that the devaluation was exogenous with respect to these other variables. This is similar to the argument, made by Friedman and Schwartz, that work by Cagan (and others) on the sources of monetary disturbances shows that money supply changes have frequently been exogenous, with associated changes in nominal income the result. However, Cairncross and Eichengreen, who believe that the devaluations (and other policies) were formulated in a ‘haphazard manner’, in which costs and benefits, and other ‘narrowly economic considerations play little part’, find that there were real changes that preceded the break from gold in 1931. While Cairncross and Eichengreen attribute the subsequent real changes to that break, the question arises as to whether they may instead be results of these previous real changes.
98
A. C. Stockman.
Sterling
in decline
The deflation and appreciation that preceded Britain’s return to gold in 1925 was associated with increased protectionist pressure from exporters. Cairncross and Eichengreen say (p. 31) that home currency prices lagged behind exchange rate changes; however, they also point out that, on the basis of 1913, purchasing power parity held in 1925. They attribute the complaints of exporters to real disturbances that reduced the demands for British exports during this period: the iron and steel industry was affected by technological improvements (suited to continental competitors but not to the UK), coal by conversions to oil and petrol, shipbuilding by increased Scandinavian competition, and cotton and wool by a shift in demand to silk and rayon. Increases in world agricultural commodity production lowered prices and particularly affected the outer sterling area, inducing current account deficits. (Australia’s foreign debt, for example, increased by 35% in nominal terms between 1923 and 1928; they were finally forced to devalue.) Caimcross and Eichengreen argue that the appreciation of the pound in the 1920s raised the terms of trade (though returning the UK to PPP based on 1913) and hurt exports, when these real shocks meant that there should have been a full in the terms of trade for equilibrium. The growth of output in the UK was uneven, with manufacturing and export industries doing poorly, while services, retail sales, and other parts of the economy did well. By 1931, the current account was in deficit for the first time since 1926, when the General Strike had temporarily reduced supplies and exports fell, and the deficit in 1931 was three times as large. Cairncross and Eichengreen attribute this mainly to a fall in returns from overseas investments associated with the world depression. Britain’s balance-of-payments deficit of 34 million pounds in 1931 was preceded by a cumulative surplus of 20 million pounds from 1925-30, but with deficits in 1928 and 1929 as well as 1931. Changes in bank rate were politically controversial: there was the threat that the independence of the Bank of England would be reduced or eliminated if its actions were sufficiently unpopular. High rates were blamed for stagnation and high unemployment; tariff protection and devaluation were seen as an alternatives. The Macmillan Committee of 1930 stressed the prevailing view that devaluation and tariff protection would have similar effects on trade, though different effects on prices and on the values of external debts. Devaluation was sometime opposed for the same reason that return to gold at pre-war parity had been favored: as a symbol of commitment by the government and credibility of its long-term policies. Caimcross and Eichengreen argue that there are two possible stories for the 1931 devaluation. In one story, ‘fundamental’ determinants of the balance of payments led to a loss of reserves; Britain was unable to finance continuing losses and chose to leave gold. In the other story, the liquidity crisis associated with the failure of Credit-Anstalt in Austria, the Darmstadter Bank in Germany, and other banks in Germany and Eastern Europe in the summer of
A. C. Stockman,
Sterling
in decline
99
1931, led to speculation on the pound and its separation from gold. While there were substantial reserve losses from the Bank of England around the time of these crises, there were also major reserve losses earlier: as Cairncross and Eichengreen report, Britain lost 19 million pounds of reserves between November 1930 and the end of January 1931. With credits from France and the United States, the Bank of England attempted to sterilize the reserve losses starting in July in order to avoid an impact on the domestic money supply. By late August and early September the loss was increasing substantially, which is not surprising in view of these attempts at sterilization. Caimcross and Eichengreen present and estimate a model to distinguish between these two stories of the 1931 episode. They estimate a model of reserve changes from 1926 through the first quarter of 1931, and use it to predict changes in reserves after that date. The model tracks well over the estimation period, but predicts rising reserves in the remainder of 1931, contrary to the sizable losses actually experienced, so Cairncross and Eichengreen conclude that the ‘fundamentals’ story is not consistent with the evidence. Their model is based on the monetary approach to the balance of payments and faces some of the usual criticisms of that approach. While the equations are estimated by 2SLS with domestic credit treated as endogenously explained by current reserves, lagged domestic credit and lagged reserves, the model is not credibly identified. Identification requires acceptance of the maintained hypothesis that lagged changes in domestic credit and reserves enter the equation explaining domestic credit policy, but are properly excluded from the money demand function (from which the reserve equation is derived). But, particularly with estimation over periods as short as quarters, it is likely that lagged dependent variables would have explanatory power in the money demand function. So, because lagged reserves and domestic credit sum to the lagged monetary base, the estimates may be subject to simultaneous-equation bias. The estimates,which are used for the post-sample predictions, differ substantially from predictions of the model and from the magnitudes that’ are usually obtained in estimation of the demand for money. The coefficient of prices, which should be unity, is close to zero and significantly different from one. The income elasticity of the demand for money, which should be on the order of magnitude of 0.5 or 1, is only about 0.1 (Friedman and Schwartz, in contrast, estimate an income elasticity of about 0.5 for the UK using firstdifferences of variables and 0.9 using levels). These estimates may account for the model’s incorrect prediction for reserves starting in the third quarter of 1931: prices and real income were falling, and if the estimated coefficients had been larger, then the equation may have predicted falling reserves. From 1930 to 1931, on an annual basis, nominal income in the UK fell by lo%, with approximately a 7% fall in real income and a 3% fall in prices. If the income
100
A. C. Stockman,
Sterling
in decline
elasticity of the demand for money were unity and domestic credit and the money multiplier constant, then reserves would have fallen by more than 10% (10% divided by ratio of reserves to the base). The money multiplier actually fell, which would tend to offset this loss somewhat. In any case, if the parameters of money demand had been closer to those usually obtained, the model may have performed better in the post-sample period, and the ‘fundamentals’ story might have looked better. There is also the problem of speculation based on forecasts of fundamentals: if reserves are below a critical level (su8lcient to maintain the pegged exchange rate based on market forecasts of future domestic credit policies and the demand for money), then a balance-of-payments crisis will result in a sudden loss of reserves and force a devaluation. In this case, the fundamentals story would be correct, but would trigger a devaluation not captured by a model missing the correct expectational variables (which are unimportant in ‘normal’ times, and so permit a good performance of the model before 1931). Cairncross and Eichengreen claim that the effects of leaving gold (and of the policies then pursued) included a depreciation against gold and currencies linked to gold, an increase in British competitiveness, an initial deterioration of the trade deficit, and an eventual improvement in the trade balance. They attribute the different short-run and long-run behavior of the trade deficit to greater elasticities of demands in the long run. There was also a shift in the geographical distribution of trade. As Cairncross and Eichengreen note, it is necessary to distinguish between the effects of devaluation and the effects of coincident changes in other policies. Not only did Britain leave gold and follow a non-deflationary monetary policy, it imposed tariffs and other controls starting in 1932. In April a 20% tariff on imports was imposed, with 33:% on iron and steel. Foreign loans and purchases of foreign securities were prohibited. The entire new-issue securities market became regulated in June. The change in the geographical pattern of trade indicates that some of these other policy changes were important; perhaps they can explain the changes in competitiveness, etc. It is not surprising that Cairncross and Eichengreen are unable to disentangle the effects of these various policies, though they sometimes imply otherwise (with phrases such as, on p. 31, ‘there can be little doubt’ about the real consequences of devaluations). While Cairncross and Pichengreen claim there is a ‘gradual’ adjustment to purchasing power parity, this is not borne out in their estimates, which show that subsequent changes in exchange rates and ratios of wholesale price indexes moved together, but with the exchange rate changing by a greater magnitude than ratios of price indexes. This is similar to the pattern in the 1970s and 80s. If the relative price changes that show up as deviations from PPP were disequilibrium phenomena associated with devaluation, then we would expect a gradual adjustment back to equilibrium over time, and so a gradual adjustment toward PPP. The absence of this gradual adjustment can
A. C’. Stockman,
Sterling
in decline
101
be viewed as evidence that the price changes were (permanent) changes in equilibrium relative prices. Nevertheless, if these price changes and devaluation were joint results of some underlying real disturbances, the questions remain: what were these disturbances, and why do the changes in price occur as sharp jumps at precisely the time of devaluation? This observation, which is common to the three experiences studied by Cairncross and Eichengreen as well as to most other episodes of devaluation, provides the strongest evidence that devaluation itself has real effects. I have concentrated this review mainly on the 1931 case; Cairncross and Eichengreen also devote considerable attention to the 1949 and 1967 episodes. They argue that much can be gained by studying these three incidents together, though the book falls short of its promise to fully exploit the similarities and the differences in these three episodes. Perhaps these three episodes are not sufficient, and studies of devaluation must consider a larger sample. One striking fact that emerges from the book is that - by the variables stressed in this book - the situations in the UK economy were not particularly similar in 1931, 1949, and 1967, preceding devaluations. This may indicate that the important similarities between these episodes (whatever they are) have been neglected in this book. The amazing fact that strikes the reader of this book about the devaluation of 1949 is that there are no fundamental problems of major importance discussed by Cairncross and Eichengreen that led to it! The British economy was subject to an enormous set of controls in 1949. Wartime price controls in Britain were retained until 1949-50; controls remained for some items until 1953. The economic theory of these situations is not well developed, and it is hard to know how to hold fixed other variables in such a unique situation of controls. Moreover, it would be hard to generalize from effects of devaluation with extensive controls to other circumstances. Caimcross and Eichengreen claim that it would have made a big difference if the devaluation had been timed differently by a couple of years (they discuss a ‘point of maximum advantage’ for devaluation). I find this claim amazing given the difhculties in drawing conclusions from this episode. One question that has not received adequate attention is whether the devaluation in 1949 could be usefully viewed as part of an optimal tax scheme in the presence of large war debts. The 1967 episode is also marred (as an experiment) by exchange controls that lasted until Ott 1979. Are devaluations important for the real economy? If so, in what ways? The idea that devaluation has no real effects should only be taken as an alternative hypothesis, and that hypothesis is inevitably bound up with hypotheses about monetary non-neutralities generally. Following the 1931 break with gold, Britain stopped both the deflation and the recession, and entered into a period of rapid growth. As Choudri and Kochin have pointed out, other countries that left the gold standard around that time (or were not on gold to begin with) had similar experiences. This evidence for real effects of monetary
102
A. C. Stockman,
Sterling
in decline
disturbances is more convincing than evidence based on a single time series. Caimcross and Eichengreen go a long way toward extending the discussion of real changes accompanying devaluation, and their discussions will be helpful to anyone who tries to formulate a more comprehensive theory of the real consequences of devaluation. Such a theory should also address issues of the effects of devaluation on credibility of other government policies, and the nature of international reserves under pegged exchange rates. Are reserves different, in principle, from the present value of revenue available to the government from taxes? In what sense did Britain run short of reserves - as opposed to liquid assets - around devaluations? The book contains fascinating accounts of the politics of devaluation. In the world of pegged exchange rates, changes in currency values were much more politically charged, ‘important’ events than in our current world of flexible rates. Even if this book does not present a fully convincing case that the devaluations themselves were responsible for the real economic changes that followed, it contains substantial material on the nature of these changes both before and after the devaluations. As a result, this well-written book will be indispensible to researchers in the field and students of the causes and consequences of devaluation.
STERLING IN DECLINE* A Review Essay Alan C. STOCKMAN Universiiy
of Rochester,
Rochester,
NY 14627,
USA
There have been few serious studies of devaluations during periods of pegged exchange rates. This is unfortunate, because devaluations provide economists with opportunities to study large nominal disturbances that appear to have real effects; That there are important real consequences of devaluations (on relative prices, trade, capital flows, output and employment) has usually been taken for granted by specialists in open-economy macroeconomists. Yet, with the nature of, reasons for, and even the existence of monetary non-neutralities being a source of current controversy in macroeconomics, it is important to study more carefully the evidence on which these claims are based. It is easy to imagine a situation in which devaluations would be purely monetary phenomena (if all prices are flexible, if Bicardian equivalence operates to prevent wealth effects from revaluations of currencies as households internalize the return on international reserves, etc.). Yet it appears that devaluations are responsible for changes in real economic variables, such as the relative price of domestic in terms of foreign goods, and internationally traded goods in terms of non-traded goods. If so, perhaps the channels through which these effects operate are applicable to non-neutralities of money more generally, and are related to issues of aggregate fluctuations. Similarly, the general changes in nominal variables that accompany devaluations may have real consequences: e.g., Caimcross and Eichengreen argue, as have Friedman and Schwartz and others, that Britain recovered from the 1930-31 recession more rapidly by leaving the gold standard, allowing the pound to depreciate, and ending the associated deflation. The effects of devaluations are difficult to study because devaluations are usually accompanied by changes in other policies, so the effects must be disentangled from the effects of these other changes. (Because the other changes in policies differ from case to case, they cannot be treated as part of a package of policies collectively called a ‘devaluation’.) Also, the sample of *Sir Alec Cairncross and Barry Eichengreen, 261 pp. 0304-3923/86/$3.50@1986,
Sterling
in Decline
(Basil Blackwell, Oxford, 1983)
Elsevier Science Publishers B.V. (North-Holland)
96
A. C. Stockntan,
Sterling
in decline
independent devaluations available for study (let alone those for which reliable data on main economic time series are available) is small. This makes it particularly difficult to isolate the effects of devaluations from the effects of simultaneous changes in other policies. Another difficulty is related to the problem of obtaining evidence on any potential effects of nominal disturbances on real variables: problems of exogeneity and endogeneity plague statistical analyses. Some of the same difhculties that arise in studies of money and business cycles also arise in studies of devaluations. A devaluation may not be an exogenous nominal disturbance; it may be a choice made by a government which faces changes in real opportunities because of underlying disturbances to technologies or tastes. Clearly, some changes in the economy lead governments to devalue. However, it may sometimes be reasonable to treat the precise timing and magnitude of devaluations as exogenous with respect to certain other changes in the economy, in order to isolate the consequences of a devaluation from its causes. This treatment may be appropriate, particularly when the government imposes extensive controls that prevent losses of gold and limit the ability of speculators to create a balanceof-payments crisis and induce an endogenously timed devaluation (as studied by Flood and Garber, Obstfeld, and others). These controls create still another problem for the study of devaluations: even if controls are not changed at the time of the devaluation, the existence of a comprehensive system of controls on international trade and financial transactions alters the effects of devaluation and makes it difficult to generalize to other cases. It may also be possible to isolate the effects of devaluation from their causes (or other consequences of these causes) if governments are viewed as determining domestic credit or taxes jointly with exchange-rate policies. Domestic credit and taxes are generally treated as exogenous in the literature on endogenous balance-of-payments crises, yet domestic credit can always be adjusted to prevent devaluation, and taxes can be adjusted to provide government with greater resources to defend a currency. Whether or not all or most of the economic changes observed to follow a devaluation result from the devaluation rather than the economic changes that led to devaluation (and would have occurred even without devaluation), some of the changes in real variables generally attributed to devaluation appear to be its results rather than causes (or results of other underlying disturbances that caused the devaluation). It would be difllcult to explain the sharp jumps in relative prices that occur simultaneously with devaluations except as consequences of the devaluations themselves. It does not appear that devaluation can be viewed solely as an endogenous response to other changes in the economy that alter relative prices; rather, it appears that devaluations cause changes in relative prices and, presumably, resource allocation. (It is more difficult to determine that changes in resource allocation result from the devaluation, because reallocations occur over time, in contrast to the large and
A. C. Stockman.
Sterling
in decline
91
sudden changes in relative prices that occur simultaneously with most devaluations.) Caimcross and Eichengreen study three devaluations of pound sterling: the fall in the pound after Britain left the gold standard in 1931 to adopt flexible exchange rates, and the 1949 and 1967 devaluations under the system of ostensibly pegged rates. The book seeks to explain both the causes and consequences of these devaluations, and Cairncross and Eichengreen argue that it is useful to study the three episodes jointly. The book consists of a brief chapter on the role of Britain and pound sterling in the world economy since the first world war, a chapter on each of the three episodes, and a concluding chapter. There is a good, brief, overview of the theory of devaluation in the introduction, but the subsequent chapters make little use of that theory. All three main chapters include historical narrative of the events leading to devaluation and the subsequent performance of the economy. Although Caimcross and Eichengreen correctly argue in the chapter on 1931 (page 75) that ‘historical narrative alone, even one that makes use of considerable detail on the pattern of reserve gains and losses, does not enable us to distinguish among the various views’ of the causes or consequences of devaluations, they present little beyond such narrative in the chapters on 1949 and 1967. (The chapter on 1967 summarizes numbers estimated by other economists, though without presenting or discussing the models on which they are based.) In contrast, the chapter on 1931 estimates a model of the causes of the devaluation and seriously attempts to distinguish between alternative models. The historical circumstances leading to devaluation, which Cairncross and Eichengreen detail, could play an important role in another type of argument about the effects of devaluations. If the causes of a devaluation are clearly identifiable then it may be possible to present a convincing argument that changes in real variables following a devaluation were results of the devaluation itself. While Cairncross and Eichengreen argue that the devaluations were ‘forced upon’ governments in each case, they argue that subsequent changes in real variables were consequences of the devaluation (or other policies that were permitted by the devaluation), i.e., they implicitly argue that the devaluation was exogenous with respect to these other variables. This is similar to the argument, made by Friedman and Schwartz, that work by Cagan (and others) on the sources of monetary disturbances shows that money supply changes have frequently been exogenous, with associated changes in nominal income the result. However, Cairncross and Eichengreen, who believe that the devaluations (and other policies) were formulated in a ‘haphazard manner’, in which costs and benefits, and other ‘narrowly economic considerations play little part’, find that there were real changes that preceded the break from gold in 1931. While Cairncross and Eichengreen attribute the subsequent real changes to that break, the question arises as to whether they may instead be results of these previous real changes.
98
A. C. Stockman.
Sterling
in decline
The deflation and appreciation that preceded Britain’s return to gold in 1925 was associated with increased protectionist pressure from exporters. Cairncross and Eichengreen say (p. 31) that home currency prices lagged behind exchange rate changes; however, they also point out that, on the basis of 1913, purchasing power parity held in 1925. They attribute the complaints of exporters to real disturbances that reduced the demands for British exports during this period: the iron and steel industry was affected by technological improvements (suited to continental competitors but not to the UK), coal by conversions to oil and petrol, shipbuilding by increased Scandinavian competition, and cotton and wool by a shift in demand to silk and rayon. Increases in world agricultural commodity production lowered prices and particularly affected the outer sterling area, inducing current account deficits. (Australia’s foreign debt, for example, increased by 35% in nominal terms between 1923 and 1928; they were finally forced to devalue.) Caimcross and Eichengreen argue that the appreciation of the pound in the 1920s raised the terms of trade (though returning the UK to PPP based on 1913) and hurt exports, when these real shocks meant that there should have been a full in the terms of trade for equilibrium. The growth of output in the UK was uneven, with manufacturing and export industries doing poorly, while services, retail sales, and other parts of the economy did well. By 1931, the current account was in deficit for the first time since 1926, when the General Strike had temporarily reduced supplies and exports fell, and the deficit in 1931 was three times as large. Cairncross and Eichengreen attribute this mainly to a fall in returns from overseas investments associated with the world depression. Britain’s balance-of-payments deficit of 34 million pounds in 1931 was preceded by a cumulative surplus of 20 million pounds from 1925-30, but with deficits in 1928 and 1929 as well as 1931. Changes in bank rate were politically controversial: there was the threat that the independence of the Bank of England would be reduced or eliminated if its actions were sufficiently unpopular. High rates were blamed for stagnation and high unemployment; tariff protection and devaluation were seen as an alternatives. The Macmillan Committee of 1930 stressed the prevailing view that devaluation and tariff protection would have similar effects on trade, though different effects on prices and on the values of external debts. Devaluation was sometime opposed for the same reason that return to gold at pre-war parity had been favored: as a symbol of commitment by the government and credibility of its long-term policies. Caimcross and Eichengreen argue that there are two possible stories for the 1931 devaluation. In one story, ‘fundamental’ determinants of the balance of payments led to a loss of reserves; Britain was unable to finance continuing losses and chose to leave gold. In the other story, the liquidity crisis associated with the failure of Credit-Anstalt in Austria, the Darmstadter Bank in Germany, and other banks in Germany and Eastern Europe in the summer of
A. C. Stockman,
Sterling
in decline
99
1931, led to speculation on the pound and its separation from gold. While there were substantial reserve losses from the Bank of England around the time of these crises, there were also major reserve losses earlier: as Cairncross and Eichengreen report, Britain lost 19 million pounds of reserves between November 1930 and the end of January 1931. With credits from France and the United States, the Bank of England attempted to sterilize the reserve losses starting in July in order to avoid an impact on the domestic money supply. By late August and early September the loss was increasing substantially, which is not surprising in view of these attempts at sterilization. Caimcross and Eichengreen present and estimate a model to distinguish between these two stories of the 1931 episode. They estimate a model of reserve changes from 1926 through the first quarter of 1931, and use it to predict changes in reserves after that date. The model tracks well over the estimation period, but predicts rising reserves in the remainder of 1931, contrary to the sizable losses actually experienced, so Cairncross and Eichengreen conclude that the ‘fundamentals’ story is not consistent with the evidence. Their model is based on the monetary approach to the balance of payments and faces some of the usual criticisms of that approach. While the equations are estimated by 2SLS with domestic credit treated as endogenously explained by current reserves, lagged domestic credit and lagged reserves, the model is not credibly identified. Identification requires acceptance of the maintained hypothesis that lagged changes in domestic credit and reserves enter the equation explaining domestic credit policy, but are properly excluded from the money demand function (from which the reserve equation is derived). But, particularly with estimation over periods as short as quarters, it is likely that lagged dependent variables would have explanatory power in the money demand function. So, because lagged reserves and domestic credit sum to the lagged monetary base, the estimates may be subject to simultaneous-equation bias. The estimates,which are used for the post-sample predictions, differ substantially from predictions of the model and from the magnitudes that’ are usually obtained in estimation of the demand for money. The coefficient of prices, which should be unity, is close to zero and significantly different from one. The income elasticity of the demand for money, which should be on the order of magnitude of 0.5 or 1, is only about 0.1 (Friedman and Schwartz, in contrast, estimate an income elasticity of about 0.5 for the UK using firstdifferences of variables and 0.9 using levels). These estimates may account for the model’s incorrect prediction for reserves starting in the third quarter of 1931: prices and real income were falling, and if the estimated coefficients had been larger, then the equation may have predicted falling reserves. From 1930 to 1931, on an annual basis, nominal income in the UK fell by lo%, with approximately a 7% fall in real income and a 3% fall in prices. If the income
100
A. C. Stockman,
Sterling
in decline
elasticity of the demand for money were unity and domestic credit and the money multiplier constant, then reserves would have fallen by more than 10% (10% divided by ratio of reserves to the base). The money multiplier actually fell, which would tend to offset this loss somewhat. In any case, if the parameters of money demand had been closer to those usually obtained, the model may have performed better in the post-sample period, and the ‘fundamentals’ story might have looked better. There is also the problem of speculation based on forecasts of fundamentals: if reserves are below a critical level (su8lcient to maintain the pegged exchange rate based on market forecasts of future domestic credit policies and the demand for money), then a balance-of-payments crisis will result in a sudden loss of reserves and force a devaluation. In this case, the fundamentals story would be correct, but would trigger a devaluation not captured by a model missing the correct expectational variables (which are unimportant in ‘normal’ times, and so permit a good performance of the model before 1931). Cairncross and Eichengreen claim that the effects of leaving gold (and of the policies then pursued) included a depreciation against gold and currencies linked to gold, an increase in British competitiveness, an initial deterioration of the trade deficit, and an eventual improvement in the trade balance. They attribute the different short-run and long-run behavior of the trade deficit to greater elasticities of demands in the long run. There was also a shift in the geographical distribution of trade. As Cairncross and Eichengreen note, it is necessary to distinguish between the effects of devaluation and the effects of coincident changes in other policies. Not only did Britain leave gold and follow a non-deflationary monetary policy, it imposed tariffs and other controls starting in 1932. In April a 20% tariff on imports was imposed, with 33:% on iron and steel. Foreign loans and purchases of foreign securities were prohibited. The entire new-issue securities market became regulated in June. The change in the geographical pattern of trade indicates that some of these other policy changes were important; perhaps they can explain the changes in competitiveness, etc. It is not surprising that Cairncross and Eichengreen are unable to disentangle the effects of these various policies, though they sometimes imply otherwise (with phrases such as, on p. 31, ‘there can be little doubt’ about the real consequences of devaluations). While Cairncross and Pichengreen claim there is a ‘gradual’ adjustment to purchasing power parity, this is not borne out in their estimates, which show that subsequent changes in exchange rates and ratios of wholesale price indexes moved together, but with the exchange rate changing by a greater magnitude than ratios of price indexes. This is similar to the pattern in the 1970s and 80s. If the relative price changes that show up as deviations from PPP were disequilibrium phenomena associated with devaluation, then we would expect a gradual adjustment back to equilibrium over time, and so a gradual adjustment toward PPP. The absence of this gradual adjustment can
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be viewed as evidence that the price changes were (permanent) changes in equilibrium relative prices. Nevertheless, if these price changes and devaluation were joint results of some underlying real disturbances, the questions remain: what were these disturbances, and why do the changes in price occur as sharp jumps at precisely the time of devaluation? This observation, which is common to the three experiences studied by Cairncross and Eichengreen as well as to most other episodes of devaluation, provides the strongest evidence that devaluation itself has real effects. I have concentrated this review mainly on the 1931 case; Cairncross and Eichengreen also devote considerable attention to the 1949 and 1967 episodes. They argue that much can be gained by studying these three incidents together, though the book falls short of its promise to fully exploit the similarities and the differences in these three episodes. Perhaps these three episodes are not sufficient, and studies of devaluation must consider a larger sample. One striking fact that emerges from the book is that - by the variables stressed in this book - the situations in the UK economy were not particularly similar in 1931, 1949, and 1967, preceding devaluations. This may indicate that the important similarities between these episodes (whatever they are) have been neglected in this book. The amazing fact that strikes the reader of this book about the devaluation of 1949 is that there are no fundamental problems of major importance discussed by Cairncross and Eichengreen that led to it! The British economy was subject to an enormous set of controls in 1949. Wartime price controls in Britain were retained until 1949-50; controls remained for some items until 1953. The economic theory of these situations is not well developed, and it is hard to know how to hold fixed other variables in such a unique situation of controls. Moreover, it would be hard to generalize from effects of devaluation with extensive controls to other circumstances. Caimcross and Eichengreen claim that it would have made a big difference if the devaluation had been timed differently by a couple of years (they discuss a ‘point of maximum advantage’ for devaluation). I find this claim amazing given the difhculties in drawing conclusions from this episode. One question that has not received adequate attention is whether the devaluation in 1949 could be usefully viewed as part of an optimal tax scheme in the presence of large war debts. The 1967 episode is also marred (as an experiment) by exchange controls that lasted until Ott 1979. Are devaluations important for the real economy? If so, in what ways? The idea that devaluation has no real effects should only be taken as an alternative hypothesis, and that hypothesis is inevitably bound up with hypotheses about monetary non-neutralities generally. Following the 1931 break with gold, Britain stopped both the deflation and the recession, and entered into a period of rapid growth. As Choudri and Kochin have pointed out, other countries that left the gold standard around that time (or were not on gold to begin with) had similar experiences. This evidence for real effects of monetary
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disturbances is more convincing than evidence based on a single time series. Caimcross and Eichengreen go a long way toward extending the discussion of real changes accompanying devaluation, and their discussions will be helpful to anyone who tries to formulate a more comprehensive theory of the real consequences of devaluation. Such a theory should also address issues of the effects of devaluation on credibility of other government policies, and the nature of international reserves under pegged exchange rates. Are reserves different, in principle, from the present value of revenue available to the government from taxes? In what sense did Britain run short of reserves - as opposed to liquid assets - around devaluations? The book contains fascinating accounts of the politics of devaluation. In the world of pegged exchange rates, changes in currency values were much more politically charged, ‘important’ events than in our current world of flexible rates. Even if this book does not present a fully convincing case that the devaluations themselves were responsible for the real economic changes that followed, it contains substantial material on the nature of these changes both before and after the devaluations. As a result, this well-written book will be indispensible to researchers in the field and students of the causes and consequences of devaluation.