That’s correlation, folks! Theory and reality go hand to hand

30/08/2014 di Giovanni Caccavello

Japan's 2013 and 2014 economic figures can give us lot of insights into the relationship between devaluation and trade balance. U.S and British ones, too

Correlation does not imply causation –  Despite the recent conventional wisdom (unfortunately present also at the academic level), devaluation and the balance of trade are not related by any causal effect, hence “causation”. As we wrote months ago, correlation does not imply causation. But, what does it mean?

The principle is, in itself, very simple, yet difficult to grasp, for many.

Causation (or if you prefer causality) is the relation between an event (the cause) and a second event (the effect). The effect is a consequence of the cause. An easy example of causality can be the following: “Paul jumped into the lake with his cell-phone. Now the cell-phone is broken”.

When we talk about correlation, we want to highlight another type of relationship. Correlation simply means that two variables, let’s say A and B, have something in common – maybe A can explain B – but the causes underlying the correlation may be indirect and unknown. B could also be explained because of C and D (other variables).

Japan’s deterioration – Very sadly, economics is not a simple social science and data and facts remind us about it. Look at Japan. In the second half of 2012, the Bank of Japan decided to devalue the Yen. It was 23 months ago, at the end of September. Since then the Yen has lost 20% of its value, but the country’s trade balance has not improved substantially, yet. On the contrary, we could argue that Japan’s balance of trade has dropped-away in these two years. As the Financial Times wrote 10 days ago, it is 25 months (since June 2012, just few months before the important decision of the Japanese Central Bank to devalue) Japan’s trade balance is negative.

Yen Exchange rate History: August 31st, 2009 - August 29th, 2014.
Yen Exchange rate History: August 31st, 2009 – August 29th, 2014. Source: University of Strathclyde data.

United Kingdom similar path – This shows us the non-existent causality between devaluation and trade balance. However, someone can argue Japan could be “the exception that proves the rule”. Well, if we take into consideration the United Kingdom, we can detect a similar path. In September 2009, the Bank of England opted to use non-conventional monetary policies, with the aim – among the others – to lower the value of the Pound. Once again, data and figures put emphasis on the fact that the U.K balance of trade did not improve. Despite fluctuations – a quite common phenomenon in international economics and trade -, Great Britain runs consistent trade deficit mainly due to increase in demand of consumer goods, decline in manufacturing and deterioration in oil and gas production since 1998. Furthermore, in August 2009, just before the BoE action to intervene in the bond market, the trade deficit of the UK was of around £1500 million, while in June 2014 it reached a deficit just below £2500 million.  Someone could correctly point out that the pound today is as strong as it was in the autumn of 2009. If we have a look at the overall trend of the UK’s trade balance from 2009 to 2014, we can see that it is slightly negative. In this case, there is little proof of conventional wisdom, too.

The U.S amazing trade deficit – Since the beginning of the financial crisis, the United States have been the country that uses expansionary monetary policies. Ben Bernanke launched for the first time in U.S history the so-called “Quantitative Easing” at the beginning of 2009. Then again, the Federal Reserve opted for a second round (QE2) in November 2010 and, finally, it went through QE3 in September 2012. On 7th June 2010 the exchange rate between the Dollar and the Euro equalled to 0,83. After hitting a low of 0,68 at the end of April 2011, the current exchange rate between the two world’s most international currencies is 0,74 (11% Dollar Devaluation). Following the suggestion of current conventional wisdom, we would imagine the U.S balance of trade to surge. Reality, instead, shows us that the U.S trade balance shrank constantly after June 2009. In fact, if in June 2009 the trade deficit was a bit lower than $25,000 million, now it floats around minus $41,000 million.

What can we say –   The point we want to stress is the following: economic theory goes hand to hand with reality in this case. There is no causation between devaluation and the balance of trade. Alfred Marshall and Abba Lerner wrote that despite a probable positive effect, a reduction in value of a nation’s currency does not immediately – or necessarily – improve the country’s trade balance. There are many reasons that explain the data we reported, but few are noteworthy. The first reason is that today’s world is completely different from the world we used to live in the ’80s or ’90s. The second reason is that there is not direct causation between devaluation and improvement in the balance of trade as many other variables should be taken into account (Marshall and Lerner looked at price elasticity, for example) and, third, that we do not live in a simplified world made by only two countries and one central bank. Assumptions are vital for economic research, but when we look at reality we should avoid – or at least try to avoid – silly analyses. Citizens deserve to be properly informed and not to be taken for a ride.

The following two tabs change content below.

Giovanni Caccavello

Studente universitario Comasco, nato nel 1991 studia Economia ed International Business attualmente presso la "University of Strathclyde", prestigiosa università di Glasgow, Regno Unito. Nel corso della scorsa estate ha lavorato due mesi come analista di mercato in Cina, a Shanghai e di recente ha partecipato al G8 giovanile tenutosi a Londra come "Ministro dello Sviluppo" per la delegazione Italiana.
blog comments powered by Disqus