Competitive Devaluation and the Prisoner’s Dilemma
With recent turbulence plaguing the once unfaltering Chinese economy, China’s economic growth seems to have entered an uncertain stage where expansion rates have drastically declined. Over the past few months, the Chinese stock market suffered a series of major losses, leading local and foreign investors alike to pull billions of dollars out of the system. As a pillar of the world economy, China’s slowdown pulls the rest of the world along with it, affecting and weakening markets across the globe. The article in the South China Morning Post proposes that when the global economy weakens, countries are strongly incentivized to engage in a practice called competitive devaluation in order to stimulate quick growth. Devaluation of a country’s currency involves intentionally lowering the value of the currency in reference to foreign currencies.
This phenomenon of competitive devaluation can be explained in terms of the Prisoner’s Dilemma. Take Country A and Country B as examples; they each have two choices: to devalue or not. If Country A chooses devaluation, the price of their exports become more competitive, boosting domestic industry, and they increase GDP by attracting foreign direct investment. This growth comes at the expense of Country B, as consumers and investors direct their money away into the newly-cheaper products of the devalued country. Thus, if Country B chooses not to devalue, they suffer while devalued Country A reaps the rewards. Therefore, the only rational response is to devalue as well, even though this sets off a reactionary international chain of devaluation that results in a negative sum game where both countries will suffer consequences, including lower purchasing power and increased trade barriers, reducing international trade.
Similar to the plight of the two prisoners, Countries A and B act in their own self interest and mutually devalue, as the dominant strategy would suggest. However, this results in a less beneficial result compared to if they had both cooperated and not devalued in the first place.
In recent weeks, China devalued the renminbi by nearly 2 percent against the US dollar in response to its economic troubles. This action has prompted criticism from the United States, and it remains to be seen if China’s East Asian neighbors and the rest of the world can avoid slipping into a damaging round of competitive devaluation.
Sources:
http://www.scmp.com/comment/insight-opinion/article/1852110/why-currency-war-last-thing-china-needs
http://www.investopedia.com/terms/c/competitive-devaluation.asp