Currency devaluation is seen by nearly every macro-economist to be the cure for trade deficits. Recently they have recommended it to Greece arguing for the reintroduction of the drachma so that the Greek economy can become "competitive", and "rebalanced". This widespread assumption is easily demonstrated to be incorrect.
Empirical evidence confirms the error: in the post-war years Germany and Japan were the strongest exporting nations despite persistent rises in their exchange rates, and the UK consistently the weakest, despite the sought-after benefit of sterling depreciation. Hong Kong dropped currency management entirely in favour of a currency board tied rigidly to the US dollar, and despite having to import everything, managed very well.
Common sense provides an initial explanation: the benefit to an economy from a falling currency can only be transitory, before the benefits of lower domestic production and processing costs are outweighed by rising external costs and domestic price inflation.
The lobby interest, which helps explain why devaluation has widespread support, is of a transfer of profits and capital values in favour of exporters at the expense of all other economic participants. No wonder the multinationals favour a lower currency. They stand to benefit most, yet it is to these same companies that politicians turn for guidance on industrial policy, and often for campaign funding. So the push for managing currency rates obviously has vested interests at its heart.
In a sound-money economy free from government interventions, consumers as well as buyers of raw materials and capital goods pay for all their purchases out of their own production, money merely being the means of exchange. In other words, imports are always paid for by exports, with any tendency for an imbalance in prices adjusted through the exchange rate.
This must hold true except where an expansion of credit is involved. An individual drawing on bank credit is bringing forward future consumption. If bank credit as a whole is stable, then the effect on the trade balance will tend to be neutral. But if banks as a whole are expanding credit, then there is a cyclical effect, which may lead to a temporary trade deficit. Furthermore the lower rates of interest associated with a credit expansion accelerates the bringing forward of consumption by discouraging saving.
In this case the distortion comes from a credit-induced business cycle for which central bank monetary policy is always the culprit, but it is reversed later in the credit cycle if bank credit is permitted to contract without a corresponding increase in narrow money supply. Therefore, a credit cycle on its own does not lead to a persistent trade deficit. An expansionary monetary policy designed to counteract credit contraction is another matter, because it will tend to offset the cyclical correction.
Government intervention by deficit spending is a further distortion on the trade balance, and often the overriding factor. For a while, there may be a trade-off between contracting bank credit and the stimulus of government spending, but this hobbles the economy by discouraging the reallocation of resources from businesses no longer demanded in the market economy. Overall capacity is therefore compromised by growing levels of malinvestment, and the domestic economy becomes less efficient at satisfying demand. Deficit spending therefore cannot be satisfied by domestic production without a significant rise in prices, but it can be by more efficient foreign production. Inevitably, a trade deficit then arises to satisfy this excess demand.
This is a simplified explanation of how excess government spending worsens the balance of trade, which is the opposite of the effect intended. It is known as the twin deficit hypothesis, and there are numerous empirical examples that bear it out.
In Greece's case recommendations for devaluation through a new drachma has more to do with a hoped-for smooth transfer of wealth from domestic depositors to foreign creditors in an ironic reversal of the old cliché about being wary of Greeks bearing gifts. Recommendations to make the economy competitive or rebalanced are no more than straw-man arguments. The only cure for trade deficits is to reduce government and monetary intervention and let the private sector manage itself.
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