Ever since the Federal Reserve embarked on its various unconventional monetary policies in 2008, central bankers and politicians around the world have been using the phrase, “currency war.” While no one accepted definition exists of what constitutes a currency war, the general idea is that it happens when governments—either through their Treasury departments or through their central banks—intentionally try to weaken the value of their currencies relative to their trading partners. This type of policy could also be called a “competitive devaluation,” or as a “beggar thy neighbor policy” because a cheaper currency also tends to make exports less expensive and imports more expensive. The resulting devaluation is likely to prop up one economy at the expense of another, without actually creating a net increase in economic activity. The policy simply shifts economic activity instead of increasing it. The difference between a competitive devaluation and a currency war is more one of degree than of kind.
Are we engaged in a currency war?
I don’t think there has been an outright currency war for the last few years, but I do believe that one is developing. The Federal Reserve has not been deliberately targeting the dollar’s exchange rate as part of its monetary policy. A weaker dollar may have been a side-effect of some of the Fed’s policies, but it was not the target of Fed policy. In a currency war, intent matters. Also, it’s hard to argue that the Fed is continuing to engage in a currency war, given that the dollar has strengthened in value relative to a broad measure of exchange rates since the middle of 2011.
Other countries, however, have been deliberately trying to devalue their currencies. Brazilian bankers regularly complain about the strength of the Brazilian real. The Liberal Democratic Party in Japan rode to victory in December promising to devalue to the yen. The Reserve Bank of India said that its monetary policy would depend not just on domestic conditions, but also on the country’s current account surplus (exports minus imports). And just recently, French President Francois Hollande has been calling for action for the euro to weaken to help eurozone exporters.
Policymakers cannot know the current state of a large economy better than the market
What I find most interesting—and disturbing—about President Hollande’s recent comments is that he said that the euro should not fluctuate according to the mood of the markets. Should it be set then according to the whims of politicians? President Hollande is exemplifying what economist and author Friedrich Hayek referred to as the “fatal conceit”: policymakers aren’t omniscient and cannot know the current state of a large economy better than market participants. The diverse interaction of many thousands of individuals in a market probably do a better job of setting prices than a few dozen policymakers do of fixing prices. This doesn’t mean markets always get things right. In fact, especially in the market for exchange rates, markets are prone to “overshooting” where the price tends to swing too high or too low, based on the fundamentals, but policymakers might not be able to do much better.
An exchange rate is a relative price, meaning that one currency is priced in terms of another currency. So if everyone is trying to lower the value of their currencies, it’s a pursuit that’s destined to end badly. If everyone tries to devalue their currencies, you just end up with a lot of inflation and nobody wins. The currency war of 1930 to 1931 is the most visible example of how this can end badly, as it turned an economic downturn into a prolonged global depression.
The brewing currency war doesn’t have to become mutually assured destruction
Today is different than the 1930s, which were so bad not just because of devaluing currencies but the imposition of trade and capital controls. As a result, global trade collapsed. Provided that countries don’t resort to protectionist policies today—closing borders to the flow of goods, services, and financial capital—the brewing currency war doesn’t have to become mutually assured destruction. Countries that impose trade restrictions or capital controls are the ones I’d be second guessing. Brazil has toyed with various controls. Korea has as well. Argentina is perhaps the worst offender. China is beginning to relax its controls, so at least it is headed in the right direction.
In the early 1980s, the U.S. dollar was strengthening considerably relative to the Japanese, West German, French, and U.K. currencies. U.S. exporters began to complain about the strength of the dollar because a stronger dollar was either making their products more expensive in foreign markets or cutting into their profit margins.
Instead of adapting to the stronger dollar, companies did the easier thing: they began lobbying congress and the president to impose trade sanctions on foreign competitors. Of course, what is rarely appreciated is that by imposing trade sanctions on your competitors, you are inviting retaliatory sanctions from them. That, then, results in a trade war. Those only end badly.
If history is a guide, the currency skirmishes will not likely result in a trade war
To forestall a trade war, policymakers from the U.S., West Germany, France, Japan, and the U.K. got together at the Plaza Hotel in New York and agreed to devalue the dollar. This agreement was called the Plaza Accord.
In 1987, those policymakers—in addition to Canada—got together again at the Louvre in Paris. The dollar had weakened too much, and now exporters from the non-U.S. countries were complaining. The resulting Louvre Accord was an agreement to strengthen the dollar—or at least to try to stop it from weakening.
What’s the lesson? We may get a Brussels Accord, of some sort, to devalue the euro and yen relative to the dollar. If history is a guide, the currency skirmishes will not likely result in a trade war, at least amongst the major developed economies.