Samuel Brittan and devaluation.

I’ve been a fan of Samuel Brittan for decades, and agree with the thrust of his article in today’s Financial Times. But I don’t agree with his claim that governments should expand deficits “up to the point where the gains to output and employment are offset by the inflationary effects of a fall in the exchange rate”. That should read “up to the point where the gains to output and employment are offset by inflation.” Reasons are thus.

First, it’s a good general principle that what goes for closed economies goes for open economies, only the arguments are a bit more complicated. And in the case of a closed economy it is clearly true to say “up to the point where the gains to output and employment are offset by inflation.” Reason is that exchange rate considerations just don’t come into the picture.

Second, inflation is defined as a CONTINUOUS and excessively fast rise in prices. In contrast, the “price rise” effect of an exchange rate adjustment is not continuous: it’s a once and for all adjustment.

Third, even if we ignore point No. 2 just above and assume that exchange rate adjustments DO HAVE a genuinely inflationary effect, the only limit to the size of the deficit is inflation, period. That’s “total” inflation, or “overall” inflation. Put another way, it’s the “total amount of inflation including any inflationary effects of exchange rate adjustment” that matters. I.e. the CONTRIBUTION to inflation coming from exchange rate adjustment is a complete irrelevance: it might account of 90% of inflation or it might be 10%. Who cares? The only important consideration is TOTAL inflation.

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