The Dangers of Devaluation

04/01/2015 12:12 pm ET | Updated Jun 01, 2015

One of the countries I am involved with has been hit badly by the drop in the price of oil. Government revenue has been significantly reduced given that the government owns the oil companies.

What effect has all this had on the nation?

Well, first, the government now spends considerably less. This has effectively reduced demand and so today there are fewer transactions within the economy, all of which has had a negative economic effect on the country. People are beginning to feel the pinch.

So the cabinet recently placed the subject of currency devaluation on the agenda. The idea being that the goods the nation has to offer will cost less with devaluation. This will encourage exports, which in turn will bring more foreign currency into the country. Presumably all of this will help replace the monetary loss brought about by the low oil prices.

Good idea, right? Many countries have resorted to this economic maneuver in order to increase exports. So where is the problem?

Let me offer an analogy.

In medicine we understand (and accept) the concept of side effects.

A doctor when diagnosing an illness often considers prescribing drugs. But he (or she) must take into account the side effects of the drug. All drugs have some side effects. The question always is: are the benefits of the drug greater than the cost of the side effects?

The same concept needs to be applied to the "economic therapy" called devaluation.

What happens when people find that their life savings -- all at once -- are worth less?

Also, importing essential goods, like food, which must be imported because much of it is not available locally, suddenly costs more. The increases in the cost of food adversely impacts morale.

There is more to it.

I suggest to you that devaluation, like inflation, causes people to lose trust in the currency of the country. They feel cheated by the government. Devaluation is usually announced as a surprise. The public feels ambushed by the government it has elected. Everyone -- from all socio-economic groups -- feel undermined by those they have chosen to lead their government.

Loss of trust becomes the price of devaluation. Devaluation has short term benefits, but long term costs.

The benefits are easy to see: an increase in exports. That increase is clearly measurable. The costs, however, are more difficult to assess or even notice. But they are there.

Here are some of the effects. People cut their saving, which impacts capital formation. Consumption begins to increase as people start ridding themselves of money because it has an unstable value.

And, most important of all, the lack of trust in government has its own repercussions, which are also hard to quantify, but they are there. Over time, for instance, the percentage of people voting probably will decline. The status of elected politicians will suffer; and serving as political leaders will no longer appeal to many of the nation's more desirable candidates.

Devaluation is a mechanistic solution: cut prices, increase volume. Simple. Done. The costs (or side effects) are organic.

The country I am involved with voted NOT TO DEVALUE its currency.

I am thrilled with the decision.