Dispatches from the Currency Wars

The value of the yen has fallen sharply since November, owing to the monetary component of Japan’s efforts to jump-start its economy (“Abenomics”). Thus the issue of currency wars is expected to feature on the agenda at the G-8’s upcoming summit in Enniskillen, UK, June 17-18.

The phrase “currency wars” is catchy. But does it have genuine analytical content? It is another way of saying “competitive devaluation.” To use the language of IMF Article IV(1) iii, it is what happens when countries are “manipulating exchange rates…to gain an unfair competitive advantage over other members…” To use the language of the 1930s, this manipulation would be a kind of beggar-thy-neighbor policy, with each country seeking to shift net exports toward its own goods at the expense of its neighbors.

Although the phrase “currency wars” has over the last couple of years been applied to expansionary monetary policy by the Fed, Bank of Japan, and other central banks, the concept does not in truth fit very well. A key point is often missed: Even the direction of the effect (let alone the magnitude) of one country’s monetary stimulus on its trade balance and hence on the demand for its trading partners’ goods is ambiguous: the expenditure-switching effect when the exchange rate responds is counteracted by the expenditure-increasing effect when the expanding country expands. Higher income leads to higher imports.

The phrase fits a bit better countries that deliberately intervene in foreign exchange markets to push down the value of their currencies in order to help their trade balances.

National authorities will and should pursue economic policies that are primarily in their own countries’ interests.There are times when cooperation is fruitful, whether by norms, decisions in multilateral meetings like the G-20, or formal institutions like the WTO and IMF. Indeed, the latter two institutions were conceived by the Allied countries at Bretton Woods NH in July 1944, in an effort to avoid a future repeat of trade wars and currency wars. This was one month before the same countries met at Dumbarton Oaks in Washington to formulate the United Nations, in an effort to avoid a future repeat of real wars.

But there is little point in even attempting international cooperation if the nature of the spillover effects is not relatively clear and agreed upon. Everybody agrees for example that pollution spillovers are negative externalities, not positive externalities. So cooperation means reining in pollution. Most would probably agree the same about tariffs, the original “beggar-thy-neighbor” policy. But the case is not as clear when it comes to monetary policy.

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In the example of fiscal expansion, there may be times when countries can agree that the spillover effects are positive – the locomotive theory, supporting the case for jointly agreed expansion by the largest economies during a time of recession, as at the G7’s Bonn Summit of 1978. And there may be times when they can agree that the spillover effects are negative – moral hazard among members of a currency area like the eurozone, supporting the case for jointly agreed fiscal deficit rules. In the case of monetary expansion the nature of the externality is less often clear.

If unemployment is high and inflation low in the United States, it is natural that the Fed will choose an easy monetary policy, particularly via low interest rates. If the situation is the reverse in Brazil, with the macro-economy overheating (as it was not long ago), it is natural that its central bank will choose a tight monetary policy, particularly via high interest rates. It is also natural that capital will flow from north to south as a result, that it will in turn appreciate the Brazilian real, and that this will have effects.

But that is the beauty of floating exchange rates. Such an exchange rate movement is a sign that the international economic system is working as it should, not the reverse – once one takes as given the difference in cyclical positions of the two countries. It allows both countries to choose their own appropriate policy settings appropriate to their own circumstances.

Of course the exchange rate movement will help US exporters and hurt those in Brazil, other things equal. But such “casualties of war” are not even unintended collateral damage. They are the point of the monetary policies chosen by each of the two countries. If the goal is to stimulate demand for goods produced in the US and cool off demand for goods produced in Brazil, why shouldn’t the exporters in both countries share in that process, alongside construction and the other sectors that are sensitive to the interest rate via domestic demand in the two respective economies? (Frankel, 1988)

More of a dilemma arises if one of the countries had previously been targeting or even fixing the exchange rate. It could have lots of reasons for having chosen such a regime. For example, many governments in Latin America finally succeeded in killing off very high inflation rates in the late 1980s and early 1990s only by means of targeted or fixed exchange rates. Such a country won’t necessarily want to abandon a proven exchange rate regime at the first sign of trouble.

Capital controls and sterilization of reserve flows might help delay the adjustment. Fiscal policy is another relevant tool. (Brazil could have reacted to its fears of overheating by reducing its budget deficit, rather than just by controls on capital inflows and appreciation or sterilization.) But a persistent uni-directional capital flow will eventually force the country with the fixed exchange rate either to allow its exchange rate to adjust or its money supply.

In the case of China during 2004-2011, this meant a choice between allowing some appreciation of the RMB and allowing an increase in the money supply. The Chinese did some of both -- but more of the latter than the former: the monetary inflow eventually turned inflationary, as expected.

It is true that in recent years an impressively wide array of countries have indicated in some way that they would prefer weaker currencies to stronger ones, as a means to improve their trade balances. Opinion is often divided internally, however, e.g., within the eurozone or within the US. The Fed has been attacked domestically for supposedly trying to debase the dollar. Within the eurozone, Germans tend to want a stronger euro than most other members do.

It is also true, by definition, that not every country can depreciate at once, nor improve their trade balance at the same time. This does not necessarily mean that they are guilty of violating any agreements or norms, especially if they have not devalued but merely stuck with a pre-existing exchange rate regime (float, fixed, or band).

Uncoordinated monetary expansion does not even necessarily leave the world in a worse equilibrium. It might just give theworld what it world needs. Barry Eichengreen and Jeffrey Sachs (1985, 1986) persuasively argued this for the 1930s, the opposite of the conventional wisdom regarding beggar-thy-neighbor competitive devaluations. To the extent that every country devalued against gold, although they could by definition not all succeed in improving their trade balance, they could and did succeed in raising the price of gold and thereby increasing the real value of the global money supply, which is what a world in Depression needed. The same applies today (Eichengreen, 2013): US monetary expansion has contributed to global monetary expansion at a time when it was needed on average.

The specific merits of the “currency war” interpretation vary from country to country.

The US was the target of the man who originally launched the missile, Brazilian Minister Guido Mantega, in September 2010. The currency wars language initially came as Brazil’s response to American efforts to enlist it and other trade competitors of China in a campaign for a stronger RMB. (As side-kick Tonto famously said to the Lone Ranger, “What do you mean we, white man?”) But the accusation is especially misplaced against a country like the United States: the US authorities have not intervened in the foreign exchange market nor talked down the dollar. Depreciation of the dollar is probably not even toward the top of the list of the effects that the Fed had in mind when deciding to undertake Quantitative Easing, though mind-reading is difficult and the right answer must vary across members of the FOMC.

True, the usual channel of monetary stimulus, via the fed funds rate and other short-term interest rates, is all-but-ended by the Zero Lower Bound. But that still leaves effects on longer term and riskier securities, the credit channel, expectations regarding inflation, equity prices, real estate prices, and so on. It doesn’t have to be the currency depreciation channel.

Japan comes a little closer than the United States to meriting the status of currency warrior, in that members of the new Abe government were initially foolish enough as to mention yen depreciation as an explicit goal.

China qualifies in one important respect: the RMB was undervalued by most measures from 2004 to 2009 (less so, by now). But countries have a right to opt for a fixed exchange rate regime. China was continuing a regime that had previously been in place, which does not sound like “manipulation.” True, appreciation was probably in China’s interest. It would have been reasonable, beginning in 2004, for those worried about current account imbalances to propose that China voluntarily allow some appreciation as part of a deal voluntarily agreed among sovereign states -- in exchange, for example, for the US putting its fiscal house in order. But this is different from charging Beijing with having violated international norms or rules and from threatening retaliation (e.g., by tariffs, which are a violation of WTO rules).

Indeed, very few of the countries accused of participating in the currency wars have undertaken discrete devaluations in recent years or otherwise acted to weaken their currencies by switching exchange rate regimes. These are the sort of deliberate policy changes connoted by a phrase like “manipulation,” whether judged “unfair” or otherwise.

Switzerland perhaps comes the closest to meeting the definition. But the Swiss franc was so strong, even at the rate that was newly set September 2011, that the Swiss National Bank cannot really be accused of unfair undervaluation.

Countries have enough serious disputes as it is, without creating unnecessary ones.

See video or slides of a panel on "Printing pressure: Global currency war," held at the American Enterprise Institute, March 18, 2013: Jeff Frankel, Anne Krueger, Rakesh Mohan, and John Makin, organized by Desmond Lachman.

References
Eichengreen, Barry, 2013, “Currency War or International Policy Coordination,” forthcoming in Journal of Policy Modeling. Bellagio Group, Tokyo, January.

Eichengreen, Barry and Jeffrey Sachs, 1985, “Exchange Rates and Economic Recovery in the 1930s,” Journal of Economic History 49, pp. 924-946.

Eichengreen, Barry and Jeffrey Sachs, 1986, “Competitive Devaluation and the Great Depression: A Theoretical Reassessment,” Economics Letters 22, pp. 67-72.

Frankel, Jeffrey, 1988, "The Desirability of Currency Appreciation Given a Contractionary Monetary Policy and Concave Supply Relationships," Journal of International Economic Integration 3, no.1, Spring, pp.32-52. NBER WP No.1110.

Frankel, Jeffrey, 2006, “On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,” in Understanding the Chinese Economy, edited by Gerhard Illing (CESifo Economic Studies, Munich).

Frankel, Jeffrey, 2010, "The Renminbi Since 2005," in The US-Sino Currency Dispute: New Insights from Economics, Politics and Law, edited by Simon Evenett (Centre for Economic Policy Research: London), April, pp.51-60.

Frankel, Jeffrey, and Katharine Rockett, 1988,"International Macroeconomic Policy Coordination When Policy-Makers Do Not Agree On the Model," American Economic Review 78, no. 3, June, pp. 318-340. NBER WP 2059.

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