The Federal Reserve and the Currency Wars

NEW YORK – The United States Federal Reserve’s recent decision to launch a third round of “quantitative easing” has revived accusations by Brazil’s finance minister, Guido Mantega, that the US has unleashed a “currency war.” In emerging-market countries that are already struggling with the impact of rapid currency appreciation on their competitiveness, expansionary measures announced in recent weeks by the European Central Bank and the Bank of Japan have heightened the sense of alarm at the Fed’s decision.

My sense is that both sides are right. The Fed was right to adopt new expansionary monetary measures in the face of a weak US recovery. Furthermore, tying it to improvements in the labor market was a particularly important step – one that other central banks, especially the ECB, should follow.

Of course, monetary expansion should be accompanied by a less contractionary fiscal stance in industrial countries. But the advanced economies’ room for fiscal maneuver is more limited than it was in 2007-2008, and America’s political gridlock has deepened, all but ruling out further stimulus through budgetary channels. Although the effectiveness of a new round of quantitative easing will be limited, as Mantega argues, the Fed had no choice but to act.

But Mantega is also right. Given the role of the US dollar as the dominant global currency, the Fed’s expansionary monetary policy generates significant externalities for the rest of the world – effects that the Fed is certainly not taking into account. The basic problem is that there are essential imperfections in an international monetary system that is based on the use of a national currency as the world’s main reserve currency.