More on currency wars (wonkish)
Menzie Chinn provided a link on his blog to a paper that really gets at what I was mulling over yesterday about the three-economy world and the reaction to deflation in two of the three countries potentially benefiting each while hurting the growing emerging economy because of currency appreciation. The paper, by Barry Eichengreen (PDF), starts with an analysis of the 1930s and then the recent period where “currency wars” were feared as being detrimental to growth. He found (in previous research on the 1930s) that the currency wars (really they are better described as competitive devaluations) were not as damaging as they are assumed to be and this has implications for the current period. Instead, Eichengreen suggests that they represent a second-best outcome that would be improved if global coordination of monetary policy in the deflation countries were linked with contractionary fiscal policy in the growing worlds.
In English that means the governments should have gotten together to chart out monetary stimulus for the deflation countries and get growth countries to commit to fiscal contraction to offset the appreciation of their currency that hurt their exporters and led to the acrimony around the whole idea of ‘currency wars.
As Eichengreen explains about the 1930s:
The analysis here suggests that the history is more nuanced and that more care should be taken in carrying over the lessons of the 1930s to today. In the 1930s, when the countries concerned all experienced an essentially symmetric deflationary shock, what are now referred to as currency wars were part of the solution, not part of the problem. Reflationary policies were needed all around. Under the institutional circumstances of the time, these were achieved by depreciating currencies against gold and hence against the currencies of other countries still on the gold standard. By the second half of the 1930s, global reflation was underway as a result of what was essentially a full round of these so-called beggar-thy-neighbor exchange rate changes and the policy initiatives they made possible. International coordination of these increases in the domestic price of gold would have been better to the extent that it limited uncertainty and international recrimination. Whether the difference would have been large or small is an open question. More concentration on the first-best monetary measures appropriate for countering deflation and less recourse to second-best interventions such as trade and capital controls would have been better still. But binding political, ideological and historical constraints prevented some countries from resorting to first-best measures. That in turn made effective international coordination impossible to achieve.
And about now:
In the recent episode, when the U.S., the Eurozone, the United Kingdom and Japan once again all experienced broadly similar deflationary pressures, quantitative easing bringing about some currency depreciation was again an appropriate symmetrical response. More focus on first-best monetary measures would again have been better, and international coordination of monetary easing might again have reduced uncertainty, although how much difference this would have made is, once more, an open question. The difference in the recent episode is the presence of a second group of economies that were not affected symmetrically. Emerging markets were worried about inflation rather than deflation and about currencies, asset prices and, in some cases, growth rates that were too strong rather than too weak. Their first-best response was fiscal tightening. International coordination of monetary easing in the advanced countries with fiscal tightening in emerging markets would have been better, although once again how much better is a matter for debate. More concentration on first-best fiscal measures appropriate for countering over-strong demand, overheated growth, overvalued currencies and inflation and less recourse to second-best interventions like trade and capital controls, this time too, would have been better still. But once again binding political constraints prevented full recourse to first best measures. And once again they made effective international coordination impossible to achieve.