LONDON – Once again, the risk of “currency wars” has been invoked by a leading policymaker. The term was coined in 2010 by Brazil’s finance minister, Guido Mantega, to criticize successive rounds of so-called quantitative easing by advanced countries’ central banks, which sent capital fleeing to developing countries in search of higher yields, driving up these countries’ exchange rates in the process.
This time, Bundesbank President Jens Weidmann is warning that the erosion of central-bank independence in some countries – reflected in the Bank of Japan’s recent decision to buy an unlimited number of government bonds to meet its new inflation target of 2% – will trigger competitive exchange-rate devaluations.
Indeed, Weidmann views the BoJ’s decision as an alarming sign of central banks’ growing tendency to bow to political pressure. He cautions that, if central banks’ mandates expanded to include, implicitly or explicitly, economic growth, they would move too close to the political sphere, undermining their independence and credibility.
But, while it is true that central bankers are more vulnerable to political pressures than they were before the global financial crisis, Weidmann’s reasoning is faulty. In fact, severe constraints on economic policy’s potential to support growth have made political pressure on central banks inevitable. The austerity measures that many countries have adopted to reduce public deficits and debt are hampering fiscal policy, while near-zero policy rates in the largest developed economies have constrained their scope for monetary-policy maneuvering.
Economic growth is on everyone’s agenda. Eurozone member countries, the United States, the United Kingdom, and Japan are all working toward the same objectives – to boost demand and support job creation – at the same time, within the limited scope of conventional monetary and fiscal policies.
Moreover, private-sector growth cannot compensate for fiscal tightening, and deleveraging continues to hamper demand. As a result, while growth prospects for this year have improved modestly, the International Monetary Fund recently warned of significant downside risks.
When domestic demand is insufficient to support growth, countries often turn to exports. But if all countries seek export-led growth, they risk creating a zero-sum situation. In this context, policymakers may reach for the low-hanging fruit of competitive devaluations, leading to a series of unilateral policy measures and retributive responses.
Currency wars and beggar-thy-neighbor policies are triggered when one country’s policy measures distort the choices open to others. They have so far been limited to countries that have been struggling to curb currency appreciation and contain disruptive capital inflows since 2008. These countries have flexible exchange rates, relatively open capital accounts, good fundamentals, and “safe haven” currencies.
For example, the Swiss authorities began in 2009 to intervene in currency markets in an effort to stem the franc’s relentless appreciation against the euro, which was threatening the country’s export-dependent economy. But, despite the central bank’s attempts to calm the markets – which cost roughly 140 billion francs ($151 billion) – the franc appreciated by more than 20% against the euro. In September 2011, Switzerland’s central bank surrendered, pegging the franc against the common currency at a rate of 1.20 francs per euro.
Meanwhile, Brazilian authorities also faced currency appreciation – the real appreciated by 40% against the dollar in 2009-2011 – as well as rising inflation. When the central bank raised interest rates to calm inflation, foreign investors flocked to the country. Managing capital inflows – which support further currency appreciation and inflation – required an increase in the financial operations tax and other administrative measures.
Currency policy highlights the limits of financial globalization by crystallizing the tension between domestic agendas and global issues – a tension that both shapes and is shaped by exchange rates. In recent years, much political activity has been directly or indirectly focused on exchange rates in ways that imply new economic and political divisions.
Although countries have not descended fully into protectionism since the global financial crisis began, difficult economic and labor-market conditions in key countries may force politicians to protect domestic markets while trying to gain external competitiveness. But, while vigilance is in order, the chance that major countries will embrace competitive devaluations – initiating genuine currency wars in the process – is slim.
It is well known that Weidmann does not like it when central banks, especially the European Central Bank, buy sovereign bonds. But claiming that unconventional monetary-policy measures would carry the risk of “much stronger politicizing of exchange rates” misses the mark.
Weidmann should take a more constructive approach, encouraging central banks to discuss ways in which monetary policy can complement fiscal policy to support economic growth and job creation, and consider those policies’ impact on other countries. After all, the global economy is too complex to be viewed as a zero-sum game with clear winners and losers. In this environment, focusing only on domestic interests is a myopic – and dangerous – approach.