Once dismissed as self-serving grandstanding by the Brazilian finance minister in 2010, claims that the world is closer to a currency war have returned. This time the proximate cause appears to be the publicly stated policies of the new Japanese government aimed at shaking off a decades-long economic malaise. Is this another flash in the pan – or are there deeper factors at work (Bordo et al 2012)?
The recurring 'currency wars', however, are not random, inconsequential events. Until the economies of the major trading powers recover or there is a significant shift in national policy mixes, we should expect the currency war to keep breaking out like a rash. This has important implications for the associated blame game.
The inevitability argument
There is an air of resignation – almost of inevitability – to some commentary on today’s currency war. Broken down, the argument goes like this. It starts by noting the widely shared view that one of the major lessons from the 1930s is that economic crises such as these require active monetary policy (Eichengreen 2013). Pumping liquidity into the banking system etc. is seen by many as a legitimate role of central banks during crises. In a world of relatively freely flowing capital and at a time when most large industrialised and developing countries have eschewed managed and fixed exchange-rate regimes, then national monetary policy decisions are likely to affect nominal currency values.
When interest-rate differentials and exchange-rate movements have adverse knock-on effects for trading partners, then accusations of currency war follow. While the major industrial economies remain in the doldrums, differences in timing of monetary policy easing and the like will result repeated charges of beggar-thy-neighbour policymaking and so the currency war reads like a book with many chapters. Before unpacking this chain of logic a little more, it is first worth noting that the apparent inevitability has led to the five rationalisations for the current currency war.
Five rationalisations for the currency war
Accusations that governments have engaged in a currency war have met with several robust responses. As we will see, these responses are themselves pretty revealing. They are:
1. The 'just following orders' defence.
This defence was put well by Philipp Hildebrand, the former head of the Swiss National Bank, in an op-ed piece in this Tuesday’s Financial Times (Hildebrand 2013). In his view, central banks haven’t declared war on trading partners. Rather they’ve sought to revive their national economies taking steps – and this is important – that are entirely consistent with their legal mandates. Of course, critics will hardly be satisfied (a) as the cross-border adverse knock-on effects of monetary easing are what they are, (b) just because something is allowed doesn’t mean it is the right thing to do and (c) that this defence demonstrates just how parochial central bank mandates are.
2. The 'no malice' defence.
In their statement this week the G7 implicitly proffered this defence (G7 2013). Monetary policy that does not seek to target exchange rates is fine on this view. No harm was intended, so what’s the problem? Critics will point to the adverse effects of monetary easing on trading partners and won’t be satisfied with assurances on intent.
3. The omelette defence.
The omelette defence is the ultimate acknowledgement of the inevitability argument. If “you can’t make an omelette without breaking a few eggs”, and assuming you want an omelette, then accept the fate of the eggs. Seeing their commercial interests and economic recoveries treated as such eggs is exactly what worries policymakers in emerging markets.
4. The 'grabbing headlines' counter-attack.
It is said that sometimes that attack is the best form of defence. In this case this amounts to arguing that those who raise currency war concerns are trying to deflect criticism away from their own policy choices. Accusations of beggar-thy-neighbour acts by trading partners are merely a smoke screen for failed domestic policies on this view. This week’s news reports suggest that the governments worried about the currency war have spread beyond the 'usual suspects', so not every critic may be vulnerable to this counter-attack (FT 2013).
5. The Connally defence.
The omelette defence isn’t the only hardball option available to large countries engaging in monetary easing. The fact that prior criticism doesn’t appear to have altered central bank behaviour suggests that there may be another element in their calculations. Those engaging in monetary easing and in some cases direct currency intervention (such as the Swiss) may have concluded that their trading partners either wouldn’t dare or ultimately wouldn’t care enough to retaliate or that the policy options available to harmed trading partners are so unpalatable (such as putting in place capital taxes and controls or resorting to widespread protectionism) that those options would not be implemented. This is a version of the Connally defence named after the US treasury secretary who reacted to European criticism of US economic policy in 1971 by saying: “The dollar is our currency, but your problem.” On this view, the rest of the world needs to adjust to the reality of monetary easing and live with its consequences. One might ask what assumptions are being made about foreign acquiescence and whether foreign governments see the policy choices before them in the same way – and whether they are right.
The status quo, then – which has led to repeated outbreaks of the currency war – has plenty of defenders. Were there really no alternatives?
Was the currency war inevitable?
Is it possible to design an economic recovery package that takes account of the lessons of history while doing the least possible harm – even potentially benefiting – foreign trading partners? For sure some won’t like this question, reasoning no doubt as follows: when (not if) monetary easing leads to economic recovery, the associated expansion in corporate and personal spending will increase demand for foreign goods and services – so in the long run everything will be hunky dory for trading partners, even with monetary easing. Still, the question is a good one because if there are plausible alternatives then (a) maybe the currency war was not inevitable or (b) the decisions not to pursue these policy alternatives points to underappreciated causes of the currency war.
Taking as given that the effect of monetary easing on the exchange rate will harm, at least in the short run, foreign trading partners, what other complementary measures could have been taken to limit international tensions? One such measure would have been to combine monetary easing with expansionary fiscal policy. To the extent that the latter directly or indirectly (through supply chains, the demand for commodities, parts, and components, and induced private-sector capital formation) increased demand for imports then this would have offset, possibly fully, the impact of any currency depreciation by industrialised countries. Seen in this light, no wonder trading partners were worried that currency devaluations that accompanied austerity measures (restrictive fiscal policy) in industrialised economies further harmed their commercial interests. The adoption of austerity measures from 2010 closed the door on policy measures that could have mitigated the international tensions created by go-it-alone monetary easing by in the industrialised countries.
There are other ways to bolster demand for foreign goods and services. Another road not taken in recent years was far-reaching trade and investment reforms, which would have provided a fillip to trade partners harmed by adverse currency movements. It is difficult to see how a package of extensive trade reform and monetary easing could have been received worse by trading partners than what actually came to pass. This is not the place to recount the trials and tribulations of completing the Doha Round, but it is worth noting that the unwillingness to further integrate the world markets has exacerbated today currency war.
The key question to ask if whether emerging market governments would have been so critical of quantitative easing and the like if the policy mix of the industrialised countries contained more measures that offset the harm done by easing-induced currency devaluation? Arguably not. The root causes of today’s currency war lie not just in parochial monetary policy choice but in the backlash against fiscal stimulus packages and the political unviability of trade reform in the major industrialised economies. Pointing fingers at Japan misses the point. The responsibility for this latest outbreak of parochial decision-making goes much deeper.
Bordo M, Owen F Humpage and Anna J Schwartz (2012), "Notes for currency wars: The trilemma of international finance ", VoxEU.org, 18 June.
Eichengreen, Barry. (2013). “Currency War or International Policy Coordination?” Journal of Policy Modeling, January (forthcoming).
Financial Times (2013). “Currency war fears spread across Latin America”, 13 February.
G7 (2013). “Statement by the G7 Finance Ministers and Central Bank Governors”, UK Treasury, 12 February.
Hildebrand, Philipp (2013). “No such thing as a global currency war”, Financial Times, 12 February.