Thinking out loud about currency wars
Thinking out loud here about the ‘currency war’ idea that the FT’s Alphaville blog mentioned this morning. In a quick summary they quote from Capital Economics:
First, a “currency war” takes place when countries actively compete to gain an advantage against each other by weakening their currencies, thus making their exports cheaper and imports more expensive. In practice, many policies will have some impact on the value of a currency, either directly or indirectly. For the term “currency wars” to have any meaning, policy surely has to target the exchange rate specifically. Second, loosening monetary policy is not, in itself, an act of war. It is of course true that, other things being equal, monetary easing is likely to result in a weaker currency. But this is just one of the many ways in which monetary policy operates. Indeed, it may not even be an important one.
Would it not be the case that in a three country world where two of the countries are experiencing slow growth nearing deflation and the third is growing from a lower base, a ‘currency war’ (defined as actions that raise their target inflation rate relative to other countries) would not be pointless for the two countries experiencing low growth, even if the effect of the policies leaves their currencies unchanged.
These countries with low growth and low inflation verging on deflation will not get the benefit they are aiming for: weakening their currencies relative to the other and thus boosting their exports. But, the policies that would lead to a tick up in the expected future inflation rate (that would be the end result of policies designed to depreciate their currency) would be stimulative for their economies.
In fact, having both of the deflation countries employ the ‘currency war’ policies where their economies trade a lot with one another would seem to be almost a necessity to keep the exchange rates even so that the depreciation of one currency to benefit its’ exporters don’t hurt the exporters of the other deflation country.
The loser in the three country set up is the third country that is growing from a lower base; its currency would strengthen relative to the two deflation countries which would hurt its exporters. However, where the two deflation countries represent a large share of the market for the growing country, the long-term effect could be net positive if the return to growth in the deflation countries increases long-term demand for the exports of the growing country.
And, just to make it clear, I am thinking of the two deflation countries as analogous to the developed countries (the EU, US, and Japan, in particular, and abstracting the EU as a whole, which misses some of the dynamics within the Eurozone) and the growth country as developing countries (Brazil’s finance minister is credited with designating 2010 as the start of a currency war, for right or wrong).
UPDATE: According to Mohamed El-Erian, my position puts me in direct opposition to the German Bundesbank, which is a place I usually feel comfortable being: “Some countries, like the U.S., are advocating a broader adoption of “reflationary national policies” around the world. Essentially, they believe that the income effects will dominate the prices effects. Others, such as Germany, worry about the inflationary implications and related financial fragilities of such policies.”