The looming currency war
Jan 25 2013
In the race to the top, the US is always well-placed to use its entrepreneurial ingenuity to great effect
There are indications that the early skirmishes of a currency war have begun. This is a dangerous business. If countries undercut their competitors’ prices by devaluing their currencies, the stability of the world economy is put at risk. A full-fledged currency war invites deflation, a ruinous downward spiral of prices that in turn invites a worldwide recession. The cause of the conflict lies in the failure of the chosen measure to offset a Great Recession since 2008: wave after wave of “quantitative easing” (QE) by central banks to beat stagnant growth. QE was intended to funnel cheap money into national economies to boost economic activity and increase aggregate demand, thereby creating growth and jobs. But persistent QE has had an important unintended consequence. It has removed a key measure by which traders judge sovereign interest, or the ability of a country to pay its way.
Before the financial freeze of 2008-9, traders who worried about a country’s solvency would decline to buy government bonds or insist on a punishingly high return. That mechanism became confused when, to head off a precipitous Great Recession, finance ministers from the leading industrial nations agreed to pump vast amounts of newly minted money into their economies until the danger had passed. QE, or the buying of government bonds by central banks, was intended to reduce general borrowing costs and allow businesses to borrow cheaply to invest, and thereby employ the jobless. That did not happen. Banks — fearful of making imprudent decisions similar to the ones they made on mortgage lending that plunged the world economy into a slump in the first place — have been hoarding money, have bought other banks with it, or have awarded it as bonuses to their executives. Businesses, fearful of making large investment decisions so long as demand remains sluggish, have also sat on their cash reserves. The result is the low- to no-growth economy we are currently enduring. John Maynard Keynes thought this would happen. As he told Franklin Roosevelt, it is “like trying to get fat by buying a larger belt.” Providing endless supplies of cheap money cannot in itself lead to growth. Measures to promote demand can best do that.
Meanwhile, traders have been deprived of the way they traditionally reflect their assessment of a nation’s economic worth. When central banks furiously buy government bonds to keep interest rates low, the bond price mechanism becomes redundant. But traders can continue to express their sovereign concerns via the currency market. It appears some functions of the distorted bond market have been replaced by the currency market. As Paul Kavanagh of Killik Capital told the BBC, “The bond market is, for want of a better word, being manipulated by this QE buying at the moment, making it very hard for it accurately to express sovereign interest, where currencies maybe are.” At present, prices have always been a good reflection of a country’s worth and have become even more so since QE.
Faced with this added pressure on its currency price, and unable to raise interest rates to maintain the price of their currency for fear of making the recession worse, what is a finance minister to do? The answer, it appears, is to turn this dilemma into an advantage. Two major economies appear to be trying to break from the rest of the pack by slyly allowing their currencies to slide. The first is Japan, the world’s third-largest economy, which for decades has been lost in a deflationary economic labyrinth. Earlier this month, Japanese prime minister Shinzo Abe made a bolt for growth. He announced a classic Keynesian $117 billion public spending stimulus and ordered the Bank of Japan to double its conservative inflation target, to 2 per cent. Abe expects his policies will increase real growth by 2 per cent and create 600,000 new jobs a year.
But that is only half of the story. Urged on by Japan’s squeezed exporters, Abe has also been letting the yen slide against the dollar — 15 per cent in the past two months — and despite urgent denials from the Japanese finance minister, it is widely assumed the slippage will be allowed to continue for some time. Devaluing the yen offers a lifeline to Japan’s technology sector, which for years has been out-priced by Korea and China. A similar tacit agreement to let its currency devalue has been taken in Britain, where in recent weeks the pound sterling has slid 3.5 per cent against the dollar. Stuck in a double-dip recession, which on Friday was expected to become a triple-dip recession, the Cameron government’s experiment in austerity appears to have failed. Devaluing the pound is a desperate last throw. Both Abe and Mark Carney, the incoming governor of the Bank of England, are also considering following Ben Bernanke’s example at the Fed by switching from using inflation alone as a guide to future central bank action and making employment an equally important policy goal.
Devaluation is risky. In the short run, exporters gain by cheaper prices, while imports are choked off because they are more expensive. In manufacturing countries like Japan or Britain that have few natural resources, and thus rely on imports for raw materials from which to make goods, more expensive imports soon feed into higher prices all around. Not only do exports slowly become more expensive, but import-led inflation chokes off demand. But desperate times demand desperate measures and, despite anxiety among European officials that devaluations, if widespread, would lead to a destructive currency war, Japan and Britain seem prepared to gamble to haul themselves out of stagnation.
All this is bad news for the US. As the keeper of the world’s reserve currency, used by investors and businesses as a safe haven from the uncertainties of other currencies, the dollar’s value is not merely a reflection of what traders feel about the American economy. The US is therefore, unable to devalue and is prevented from competing in the looming currency war. Nor, despite the death wish of some misguided congressmen, will the US, the richest country in the world, default on its debts. But a high dollar is bad news for Americans as they watch the Japanese, the British and the Europeans manipulate their currencies to make wages cheaper and more competitive. In a race to the top, the US is always well-placed to use its entrepreneurial ingenuity to great effect. In a race to the bottom, however, the US can never win.
(Nicholas Wapshott is the former New York bureau chief of The Times of London)