CAMBRIDGE ― The term “currency wars” is a catchy way of saying “competitive devaluation.” In the wake of the sharp fall in the value of the yen over the last six months, owing to the monetary component of Japan’s efforts to jump-start its economy, the issue is expected to feature prominently on the agenda at the G8’s upcoming summit in Northern Ireland. But should it?
According to the International Monetary Fund, competitive devaluation occurs when countries are “manipulating exchange rates…to gain an unfair competitive advantage over other members…” But a key point is often missed when the term “currency wars” has been applied to monetary expansion by the Federal Reserve, the Bank of Japan, and other central banks in recent years. The impact of monetary stimulus on a country’s trade balance ― and hence on demand for trading partners’ goods ― is ambiguous: the expenditure-switching effect when the exchange rate responds is counteracted by the expenditure-increasing effect of expansion. Restored income growth means more imports from other countries.
“Currency wars” is a more apt description when countries intervene to push down their currencies in deliberate attempts to help their trade balances. But national authorities will and should pursue economic policies that are primarily in their own countries’ interests. International cooperation can be fruitful; but there is little point attempting it if the nature of the spillover effects is not relatively clear to all. Everyone agrees, for example, that spillovers from pollution or tariffs are negative, not positive, externalities. But the case is not as obvious in the case of monetary policy.
For example, if unemployment is high and inflation low in the United States, the Fed will naturally ease monetary policy, particularly via low interest rates. If Brazil is in danger of overheating, its central bank will naturally tighten policy, particularly via high interest rates. It is also natural that capital will flow from north to south as a result, causing the Brazilian real to appreciate against the dollar. That is the beauty of floating exchange rates: both countries can choose their own appropriate policies.
Given that the two countries’ are in different cyclical positions, such exchange-rate movements signal that the international economic system is working properly. Although the stronger real will help U.S. exporters (other things being equal) and hurt those in Brazil, such “casualties of war” are not even collateral damage; rather, they are precisely the point. If the goal is to stimulate demand for U.S. goods and dampen demand for Brazilian goods, why shouldn’t exporters in both countries share in that process, alongside construction and other sectors that are sensitive to interest rates via domestic demand?
A more serious dilemma arises if one of the countries is targeting or even fixing the exchange rate, as many Latin American governments did to kill off high inflation in the late 1980s and early 1990s. Such a country will not necessarily want to abandon a proven exchange-rate regime at the first sign of trouble. Capital controls and sterilization of reserve flows might help to delay the adjustment, but a persistent one-directional capital flow will eventually force the fixed-exchange-rate country to allow either its exchange rate or its money supply to adjust.
True, in recent years, a wide array of countries has indicated a preference for weaker currencies as a means of improving their trade balances. It is also true, by definition, that not everyone can depreciate or improve their trade balance at the same time. But that does not necessarily mean that depreciators are guilty of violating any agreements or norms, especially if they have merely maintained a pre-existing exchange-rate regime.
Uncoordinated monetary expansion does not even necessarily leave the world in a worse equilibrium. Barry Eichengreen and Jeffrey Sachs have persuasively argued this for the 1930s (the opposite of the conventional wisdom regarding beggar-thy-neighbor competitive devaluations). Although all countries could not improve their trade balances simultaneously, when they devalued against gold, they succeeded in raising the price of gold, thereby increasing the real value of the global money supply ― exactly what a world in depression needed.
The same applies today. Brazil’s finance minister, Guido Mantega, coined the term “currency wars” in response to American efforts to enlist Brazil and other competitors of China in a campaign for a stronger renminbi. But the accusation against the U.S. is especially misplaced. U.S. monetary expansion contributed to global monetary expansion at a time when, on average, it was needed. U.S. authorities have not intervened in the foreign-exchange market or talked down the dollar, and currency depreciation was not the Fed’s goal when deciding to implement its quantitative-easing policy.
Japan comes a little closer to qualifying as a currency warrior, because members of Shinzo Abe’s government were initially foolish enough to mention yen depreciation as an explicit goal.
China qualifies in one important respect: the renminbi was substantially undervalued by most measures from 2004 to 2009 (less so now). But countries have a right to opt for fixed exchange rates. Continuing an existing regime, as China was doing, does not sound very much like “manipulation.”
True, renminbi appreciation was probably in China’s interest. It would have been reasonable, beginning in 2004, for those worried about current-account imbalances to propose that China voluntarily allow some appreciation in exchange for, say, the U.S. putting its fiscal house in order. But this is different from accusing Beijing of violating international norms or rules and threatening retaliation (for example, by imposing tariffs, which is a violation of international rules).
Few countries accused of participating in a currency war have undertaken discrete devaluations in recent years or acted to weaken their currencies by switching their exchange-rate regimes. These are the sorts of deliberate policy changes connoted by a term like “manipulation.” Switzerland perhaps comes the closest. But the franc was so strong, even at the new rate set in September 2011, that no one can accuse the Swiss National Bank of unfair undervaluation.
The world has enough serious disputes as it is. We do not need to invent new ones.
By Jeffrey Frankel
Jeffrey Frankel is professor of capital formation and growth at Harvard University. ― Ed.