Chapter 18. Oh! What a Lovely Currency War

Chapter 18 HEADLINE: Oh! What a Lovely Currency War

In September 2010, the finance minister of Brazil accused other countries of starting a “currency war” by pursuing policies that made Brazil’s currency, the real, strengthen against its trading partners, thus harming the competitiveness of his country’s exports and pushing Brazil’s trade balance toward deficit. By 2013 fears about such policies were being expressed by more and more policymakers around the globe.

“Devaluing a currency,” one senior Federal Reserve official once told me, “is like peeing in bed. It feels good at first, but pretty soon it becomes a real mess.”

In recent times, foreign-exchange incontinence appears to have been the policy of choice in capitals from Beijing to Washington, via Tokyo. The resulting mess has led to warnings of a global “currency war” that could spiral into protectionism.

The roll call of forex Cassandras reads like a who’s who of global finance and politics: German leader Angela Merkel, Federal Reserve Bank of St. Louis President James Bullard, Bundesbank President Jens Weidmann and Mervyn King, the outgoing governor of the Bank of England. And the list goes on…

Currency wars have been a staple of modern finance ever since the collapse of the Bretton Woods system of fixed exchange rates in the early 1970s. As Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co., says: “Most governments believe that their currencies are too important to be left to the markets.” So policy makers have often tried to manipulate the value of their currencies by intervening in the markets.

In recent years, China stands out as the country that has done the most to keep its currency weak in order to boost exports. But it isn’t alone. China’s efforts have sparked what Fred Bergsten, senior fellow at the Peterson Institute for International Economics, calls “emulation and retaliation.”

At their worst, these periodic crosscurrents of intervention have led to “beggar-thy-neighbor” policies—self-defeating attempts to improve one country’s economy at the expense of everybody else’s… .

As developed countries like Japan and the U.S. try to kick-start their sluggish economies with ultralow interest rates and binges of money-printing, they are putting downward pressure on their currencies. The loose monetary policies are primarily aimed at stimulating domestic demand. But their effects spill over into the currency world.

Since the end of November, when it became clear that Shinzo Abe and his agenda of growth-at-all-costs would win Japan’s elections, the yen has lost more than 10% against the dollar and some 15% against the euro.

These moves are angering export-driven countries such as Brazil and South Korea. But they also are stirring the pot in Europe. The euro zone has largely sat out this round of monetary stimulus and now finds itself in the invidious position of having a contracting economy and a rising currency—making Thursday’s meeting of the European Central Bank a must-watch event.

The dirty secret is that using monetary policy to weaken a currency, whether voluntarily or not, is a shortcut to avoid unpopular decisions on fiscal and budgetary issues.

Breakdowns of the global foreign exchange system have occurred with drastic regularity, but that doesn’t mean this currency war will end in tears.

For a start, common sense could prevail, putting an end to the dangerous game of beggar (and blame) thy neighbor. After all, the International Monetary Fund was set up to prevent such races to the bottom, and should try to broker a truce among forex combatants.

If that sounds naive, consider the possibility that this huge bout of monetary stimulus will succeed in engendering a solid recovery driven by domestic demand. Or that fiscal policy will finally be put to work.

Either outcome would take away a big incentive for competitive devaluations and prompt governments to bolster their currencies to avoid stoking inflation.

Growth cures a lot of ills. Even forex incontinence.

Source: Excerpted from Francesco Guerrera, “Currency War Has Started,” The Wall Street Journal, February 4, 2013. Reprinted with permission of The Wall Street Journal, Copyright © 2013 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

Question 1

Question

Currency wars are often seen as a race to the bottom: those that can devalue the fastest and by the greatest amount win. Why are emerging market economies often left out of the race?

Question 2

Question

The U.S. Federal Reserve has a dual focus on domestic price stability and high employment. Should the Federal Reserve consider the effects of monetary policy on global trade when conducting large bouts of expansionary policy?

Question 3

Question

Using data in FRED (Federal Reserve Economic Database), consider the exchange rates for some of the United States’ trading partners, such as Brazil, Mexico, and Thailand. Which currencies appreciated most during the Great Recession?