All Quiet on the Currency Front

CAMBRIDGE – The term “currency wars” is a catchy way of saying “competitive devaluation.” In the wake of the sharp fall in the value of the yen over the last six months, owing to the monetary component of Japan’s efforts to jump-start its economy, the issue is expected to feature prominently on the agenda at the G-8’s upcoming summit in Northern Ireland. But should it?

According to the International Monetary Fund, competitive devaluation occurs when countries are “manipulating exchange rates…to gain an unfair competitive advantage over other members…” But a key point is often missed when the term “currency wars” has been applied to monetary expansion by the Federal Reserve, the Bank of Japan, and other central banks in recent years. The impact of monetary stimulus on a country’s trade balance – and hence on demand for trading partners’ goods – is ambiguous: the expenditure-switching effect when the exchange rate responds is counteracted by the expenditure-increasing effect of expansion. Restored income growth means more imports from other countries.

“Currency wars” is a more apt description when countries intervene to push down their currencies in deliberate attempts to help their trade balances. But national authorities will and should pursue economic policies that are primarily in their own countries’ interests. International cooperation can be fruitful; but there is little point attempting it if the nature of the spillover effects is not relatively clear to all. Everyone agrees, for example, that spillovers from pollution or tariffs are negative, not positive, externalities. But the case is not as obvious in the case of monetary policy.

For example, if unemployment is high and inflation low in the United States, the Fed will naturally ease monetary policy, particularly via low interest rates. If Brazil is in danger of overheating, its central bank will naturally tighten policy, particularly via high interest rates. It is also natural that capital will flow from north to south as a result, causing the Brazilian real to appreciate against the dollar. That is the beauty of floating exchange rates: both countries can choose their own appropriate policies.