Are Currency Warriors’ Gloves Coming Off?

There is much hype about “currency wars” in the international media this week, reaching the heights of the Davos gathering. The excitement seems to have been started by Bundesbank president Jens Weidmann, who earlier this week aired his concerns about an apparent politicization of exchange rates owing to an erosion of central bank independence and rising political pressures for more aggressive monetary policies. Japan is the current focus of attention, as the deflation-worn nation is said to have kicked off a new round in the covert global battle for competitive advantage through currency manipulation by announcing a somewhat higher inflation target as well as new quantitative easing measures. In fact, the yen has depreciated markedly since last Fall against the U.S. dollar and even more so against the euro in anticipation of fresh policy moves by the Japanese authorities.

There is of course nothing new about sharp movements in the yen’s exchange rate. With zero interest rate policies in place for more than a decade, the yen for long won the popularity contest as carry-trade funding currency; with corresponding gyrations seen in winding versus unwinding phases in the global carry trade game. So the yen has appreciated strongly since the global crisis as the spectrum of funding currencies increased. Nor would it be the first time that the Japanese authorities have sought out deliberate measures designed to weaken the currency despite officially hosting a “floating” exchange rate determined “by market forces.” Long before the global crisis hit, Japan championed a version of quantitative easing that focused on FX reserve accumulation. The key difference is that other nations used to view such moves more benignly when times were still better at home. Today, with all key advanced economies still struggling to recover, and each of them hoping for relief through exports, zero tolerance and envy meet the nation that is seen as getting ahead in the common campaign for a competitive currency.

The euro appears to be the “victim” in all this. Paradoxically, as it may seem at first, while other currencies tend to weaken as their monetary authorities take on a more aggressive easing stance the euro has actually appreciated since Mario Draghi’s famous pledge to do “whatever it takes” to preserve the euro, promising—conditional—support for public debt of euro crisis countries. The ECB’s peculiar ways, its reluctance to be more forthcoming with monetary support, except when the euro seems to be on the verge of breakup, is being identified as the factor that might explain why the euro is the odd man out at the current juncture.

Yet, viewing the euro as the victim seems to be saying that the euro is more deserving of continued weakness than others, supposedly so as to foster and support the currency bloc’s recovery from crisis. Arguably, this would be somewhat akin to the more tolerant attitude towards Japan in this matter in pre-global crisis times. Yet, has this approach really helped Japan to recovery lastingly on the back of export-driven growth? Also, has it helped the world economy to contain global current account imbalances that were later identified as contributing causes behind the global crisis?

The point is that currency wars do not only pertain to currencies. An exclusive focus on exchange rates in judging whether countries may or may not conform in their policies with the requirements of equilibrium in the global economy is therefore misguided. Presumably attaining some kind of global economic equilibrium is what the G-20 “Framework for Strong, Sustainable, and Balanced Growth” is all about. At its Pittsburgh Summit in 2009, the leading G-20 nations committed to assure that henceforth their individual policies would be collectively consistent at the global level with the group’s common goals. Shrinking—or preventing the re-emergence of rising—global imbalances was considered a key part of the whole exercise aimed at preventing future crises.

So are the policies of the supposed “victim” Euroland compatible with the framework and global economic equilibrium? The euro area had a roughly balanced current account prior to the global crisis. At the time this provided the basis for the euro authorities’ claim that they were keeping their own house in order while others were behaving perilously. Similarly, the German authorities argued that Germany’s huge current account surplus should not be subject to global debate in the first place since the euro area—where the deficit counterparts were largely to be found—was balanced overall. True at the time, in a sense, but no longer true today. The euro area’s external position is turning sharply positive while Germany’s surpluses are simply moving away from the currency bloc to the rest of the world. All along, euro area GDP “growth” is driven by net exports only. More precisely, positive growth contributions from net exports are containing the damage arising from plunging domestic demand, both in Germany and the euro area as a whole. (See here.)

So notice that “beggar-thy-neighbor” policies actually come in two forms. One is through exchange depreciation, i.e. expenditure switching, which is the focus of debates on currency warfare. The other is through freeloading on external demand while suffocating domestic demand, for instance, by means of not-so-expansionary austerity, as practiced in Euroland but somehow ignored in this debate. Clearly, from a global perspective, individual (or group of) countries’ policies are only neutral to the rest of the world if the two spill-over channels offset each other. By implication, the allegedly “stability-oriented,” but de facto expenditure-crushing, macro policies of Euroland should be accompanied by euro strengthening, namely as a way of containing the damage at its source. Euroland should not expect the rest of the world to overspend and take on more debt on its behalf, so as to allow the area’s mindless austerity to succeed. The consequences of austerity should be felt where they are inflicted. Seen from this perspective, other countries with more growth-friendly macro policies are entitled to weaker currencies as a means of protection against Euroland’s suicidal austerity proclivities.

Of course this is not the way Mr. Weidmann may wish to see things, since Bundesbank traditions of central bank independence and the German model of export-led growth are based on a track record of getting away with what may be dubbed “currency warfare conducted through price stability,” i.e. inflation that is lower than in trade partners that are locked into stable nominal exchange rates. That model backfired badly when it was exported to Euroland, pushing Euroland into existential crisis and saddling Germany with its “euro trilemma”: Germany just cannot have all three, perpetual export surpluses, a no-transfer/no-bailout monetary union, and a “clean” independent central bank. Today, rather than facing its trilemma, Germany is turning Euroland into a larger Germany. It is time for the German and euro authorities to understand that the German model is not the right model for Europe!

The real irony, then, is that it is Mr. Weidmann’s glorified institution and its over-towering stability-oriented legacies which are keeping the ECB’s gloves more firmly tied when it comes to currency warfare. Just as the “no-bailout” clause of the Maastricht Treaty turned out to be a weakness rather than strength of the euro regime, the Bundesbank model of independence turns out to be another liability. That does not make Euroland a victim though, other than a victim of its own folly. The euro institutions and policies are deeply flawed, and it is for Euroland alone to change that. There is no natural right for Euroland to freeload on external growth, but an obligation to end the global spreading of instability arising from its flawed institutions and policies.

See http://www.levyinstitute.org/pubs/wp_721.pdf  and http://www.levyinstitute.org/pubs/wp_738.pdf