Soon everybody will be scared about ‘currency war’ again – we should be celebrating

With the dollar continuing to strengthen and now the Japanese yen starting to take off as well central bankers in the US and Japan are likely increasingly becoming worried about the deflationary tendencies of stronger currencies and recent comments from both countries’ central banks indicate that they will not allow their currencies to strengthen dramatically if it where to become deflationary.

This has in recent days caused some to begin to talk about the “risk” of a new global “currency war” where central banks around the world compete to weaken their currencies. Most commentators seem to think this would be horrible, but I would instead argue – as I have often done in recent years – that a global race to ease monetary policy is exactly what we need in a deflationary world.

If we lived in the high-inflation days of the 1970s we should be very worried, but we live in deflationary times so global monetary easing should be welcome and unlike most commentators I believe a global currency war would be a positive sum game.

Over the last couple of years I have written a number of posts on the topic of currency war. The main conclusions are the following:

  1. Currency war is a GREAT THING and is VERY POSITIVE – if indeed we think of it as a global competition to print money. This is what we need in a deflationary world.
  2. As long as we are seeing commodity prices decline and inflation expectations we can’t really say that the currency war is on yet.
  3. Currency war is NOT a zero sum game. It is a positive sum game in a deflationary world.
  4. Don’t think of monetary easing/currency depreciation to primarily work through a “competitiveness channel”, but rather through a boost to domestic demand. Therefore, we are likely to actually see the trade balance WORSEN for countries, which undertakes aggressive monetary easing. The US in 1933 is a good example. So is Argentina in 2001-2 and Japan recently. Sweden versus Denmark since 2008.

I don’t have much time to write more on the topic this morning, but I am sure I will return to the topic soon again. Until then have a look at my previous posts on the topic (and related topics):

Bernanke knows why ‘currency war’ is good news – US lawmakers don’t

‘The Myth of Currency War’

Don’t tell me the ‘currency war’ is bad for European exports – the one graph version

The New York Times joins the ‘currency war worriers’ – that is a mistake

The exchange rate fallacy: Currency war or a race to save the global economy?

Is monetary easing (devaluation) a hostile act?

Fiscal devaluation – a terrible idea that will never work

Mises was clueless about the effects of devaluation

Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

The luck of the ‘Scandies’

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The PBoC’s monetary supremacy over Brazil (but don’t blame the Chinese)

Brazilian Finance Minister Guido Mantega likes to blame the Federal Reserve (and the US in general) for most evils in the Brazilian economy and he has claimed that the fed has waged a ‘currency war’ on Emerging Market nations.

As my loyal readers know I think that it makes very little sense to talk about a currency war and  I strongly believe that any nation with free floating exchange rates is in full control of monetary conditions in the country and hence of both the price level and nominal GDP. However, here the key is a freely floating exchange rate. Hence, a country with a fixed exchange rate – like Hong Kong or Denmark – will “import” the monetary policy from the country its currency is pegged to – the case of Hong Kong to the US and in the case of Denmark to the euro zone.

In reality few countries in the world have fully freely floating exchange rates. Hence, as I argued in my previous post on Turkey many – if not most – central banks suffers from fear-of-floating. This means that these central banks effectively will at least to some extent let other central banks determine their monetary policy.

So to some extent Mantega is right – the fed does in fact have a great impact on the monetary conditions in most countries in the world, but this is because that the national central banks refuse to let their currencies float completely freely. There is a trade off between control of the currency and monetary sovereignty. You cannot have both – at least not with free capital movement.

From Chinese M1 to Brazilian NGDP  

Guido Mantega’s focus on the Federal Reserve might, however, be wrong. He should instead focus on another central bank – the People Bank of China (PBoC). By a bit of a coincidence I discovered the following relationship – shown in the graph below.

China M3 Brazil NGDP

What is the graph telling us? Well, it looks like the growth of the Chinese money supply (M1) has caused the growth of Brazilian nominal GDP – at least since 2000.

This might of course be a completely spurious correlation, but bare with me for a while. I think I am on to something here.

Obviously we should more or less expect this relationship if the Brazilian central bank had been pegging the Brazilian real to the Chinese renminbi, but we of course all know that that has not been the case.

The Chinese-Brazilian monetary transmission mechanism

So what is the connection between Chinese and Brazilian monetary conditions?

First of all since 2008-9 China has been Brazil’s biggest trading partner. Brazil is primarily exporting commodities to China. This means that easier Chinese monetary policy likely will spur Brazilian exports.

Second, easier Chinese monetary policy will also push up global commodity prices as China is the biggest global consumer of a number of different commodities. With commodity prices going up Brazil’s export to other countries than China will also increase.

Therefore, as Chinese monetary easing will be a main determinant of Brazilian exports we should expect the Brazilian real to strengthen. However, if the Brazilian central bank (and government) has a fear-of-floating the real will not be allowed to strengthen nearly as much as would have been the case under a completely freely floating exchange rate regime.Therefore, effectively the Brazilian central bank will at least partly import changes in monetary conditions from China.

As a result the Brazilian authorities has – knowingly or unknowingly – left its monetary sovereignty to the People’s Bank of China. The guy in control of Brazil’s monetary conditions is not Ben Bernanke, but PBoC governor Zhou Xiaochuan, but don’t blame him. It is not his fault. It is the result of the Brazilian authorities’ fear-of-floating.

The latest example – a 50bp rate hike

Recently the tightening of Chinese monetary conditions has been in the headlines in the global media. Therefore, if my hypothesis about the Chinese-Brazlian monetary transmission is right then tighter Chinese monetary conditions should trigger Brazilian monetary tightening. This of course is exactly what we are now seeing. The latest example we got on Wednesday when the Brazilian central bank hiked its key policy rates – the SELIC rate – by 50bp to 8.50%.

Hence, the Brazilian central bank is doing exactly the opposite than one should have expected. Shouldn’t a central bank ease rather than tighten monetary policy when the country’s main trading partner is seeing growth slowing significantly? Why import monetary tightening in a situation where export prices are declining and market growth is slowing? Because of the fear-of-floating.

Yes, Brazilian inflation has increased significantly if you look at consumer prices, but this is primarily a result of higher import prices (and other supply side factors) due to a weaker currency rather than stronger aggregate demand. In fact it is pretty clear that aggregate demand (and NGDP) growth is slowing significantly. The central bank is hence reacting to a negative supply shock (higher import prices) and ignoring the negative demand shock.

Obviously, it is deeply problematic that the Brazilian authorities effectively have given up monetary sovereignty to the PBoC – and it is very clear that macroeconomic volatility is much higher as a result. The solution is obviously for the Brazilian authorities to get over the fear-of-floating and allowing the Brazilian real to float much more freely in the same way has for example the Reserve Bank of Australia is doing.

Bernanke knows why ‘currency war’ is good news – US lawmakers don’t

I stole this from Scott Sumner:

Sen. Tom Coburn (R., Okla.) asks whether all the major central banks easing might diminish the benefits and lead to trade protectionism.

“We don’t view monetary policy aimed at domestic goals a currency war,” [Bernanke] says. Easing policy can be “mutually beneficial” to other countries such as China, which depends on domestic demand in the U.S.

It’s a “positive-sum game, not a zero-sum game,” Bernanke says.

I don’t think Bernanke is reading this blog, but I feel like quoting myself:

Monetary easing is not a negative or a zero sum game. In a quasi-deflationary world monetary easing is a positive sum game.

I have not always been impressed with Bernanke and he has certainly made his fair share of mistakes, but he certainly is more knowledgable about monetary policy than Republican lawmakers.

 

‘The Myth of Currency War’

I know that most of my readers must be sick and tired of reading about my view on ‘currency war’. Unfortunately I have more for you. My colleague Jens Pedersen and I have written an article for the Danish business daily Børsen. The piece was published in today’s edition of Børsen. It is in Danish, but you can find an English translation of the article here.

Regular readers of this blog will not be surprised by the main message in the article: The talk of a “dangerous” ‘currency war’ is just silly. It is not really a ‘currency war’, but rather global monetary easing. Global monetary easing even helps the euro zone despite the ECB’s extreme reluctance to ease monetary policy.

Jens has recently also written an extremely interesting paper on the consequence of the ‘currency war’ for the Danish economy. Jens concludes that the currency war – or rather global monetary easing – is good news for Danish exporters despite the fact that the Danish krone has been strengthening in line with the euro (remember the krone is pegged to the euro). The reason is that global monetary easing is boosting global growth and that is outweighing any negative impact on exports from the strengthening of the krone.

Take a look at Jens’ paper here.

Don’t tell me the ‘currency war’ is bad for European exports – the one graph version

It is said that Europe is the biggest “victim” in what is said to be an international ‘currency war’ (it is really no war at all, but global monetary easing) as the euro has strengthened significantly on the back of the Federal Reserve and Bank of Japan having stepped up monetary easing.

However, the euro zone is no victim – to claim so is to reason from a price change as Scott Sumner would say. The price here of course is the euro exchange rate. The ‘currency war worriers’ claim that the strengthening is a disaster for European exports. What they of course forget is to ask is why the euro has strengthened.

The euro is stronger not because of monetary tightening in the euro zone, but because of monetary easing everywhere else. Easier monetary policies in the US and Japan obviously boost domestic demand in those countries and with it also imports. Higher American and Japanese import growth is certainly good news for European exports and that likely is much more important than the lose of “competitiveness” resulting from the stronger euro.

But have a look at European exporters think. The graph below is the Purchasing Managers Index (PMI) for euro zone new export orders. The graph is clear – optimism is spiking! The boost from improved Japanese and American growth prospects is clearly what is on the mind of European exporters rather than the strong euro.

PMIexport euro zone

The New York Times joins the ‘currency war worriers’ – that is a mistake

It is very frustrating to follow the ongoing discussion of ‘currency war’. Unfortunately the prevailing view is that the world is heading for a ‘currency war’ in the form of ‘competitive devaluations’ that will only lead to misery for everybody. I have again, again and again stressed that when large parts of the world is caught in a low-growth quasi-deflationary trap then a competition to print more money is exactly what the world needs. ‘Currency war’ is a complete misnomer. What we are talking about is global monetary easing.

Now the New York Times has joined the discussion with a pretty horrible editorial on ‘currency war’.

This is from the editorial:

If all countries were to competitively devalue their currencies, the result would be a downward spiral that would benefit no one, but could lead to high inflation. Certainly in Europe, altering exchange rates is not the answer; reviving economies will require giving up on austerity, which is choking demand and investment.

It is just frustrating to hear this argument again and again. Monetary easing is not a negative or a zero sum game. In a quasi-deflationary world monetary easing is a positive sum game. The New York Times claims that “competitive devaluations” will lead to increased inflation.

Well, lets start with stating the fact a that the New York Times seems to miss – both the Bretton Woods and the gold standard are dead. We – luckily – live in a world of (mostly) freely floating exchange rates. Hence, nobody is “devaluing” their currencies. What is happening is that some currencies like the Japanese yen are depreciating on the back of monetary easing. The New York Times – and French president Hollande and Bundesbank chief Weidmann for that matter – also fails to notice that the yen is depreciating because the Bank of Japan is implementing the exact same monetary target as the ECB has – a 2% inflation target. After 15 years of failure the BoJ is finally trying to get Japan out of a low-growth deflationary trap. How that can be a hostile act is impossible for me to comprehend.

Second, the New York Times obviously got it right that if we have an international “competition” to print more money then inflation will increase. But isn’t that exactly what we want in a quasi-deflationary world? Can we really blame the BoJ for printing more money after 15 years of deflation? Can we blame the Fed for doing the same thing when US unemployment is running at nearly 8% and there are no real inflationary pressures in the US economy? On the other hand we should blame the ECB for not doing the same thing with the euro zone economy moving closer and closer to deflation and with unemployment in Europe continuing to rise.

When the New York Times joins the “currency war worriers” then the newspaper effectively is arguing in favour of a return to internationally managed exchange rates – either in the form of a gold standard or a Bretton Woods style system. Both systems ended in disaster.

The best international monetary system remains a system where countries are free to pursue their own domestic monetary objectives. Where every country is free to succeed or fail. A system of internationally coordinated monetary policy is doomed to fail and end in disaster as was the case with both the gold standard and Bretton Woods – not to mentioned the ill-faited attempts to coordinate monetary policy through the Plaza and Louvre Accords.

The New York Times and other ‘currency war worriers’ seem to think that if countries are free to pursue their own domestic monetary policy objectives then it will not only lead to ‘currency war’, but also to ‘trade war’. Trade war obviously would be disastrous. However, the experiences from the 1930s clearly show that those countries that remained committed to international monetary policy coordination in the form of staying on the gold standard suffered the biggest output lose  and the biggest rise in unemployment. But more importantly these countries were also much more likely to implement protectionist measures – that is the clear conclusion from research conducted by for example Barry Eichengreen and Douglas Irwin.

‘Currency war’ is what we need to get the global economy out of the crisis and monetary easing is much preferable to the populist alternative – protectionism and ‘deflationism’.

HT William Bruce.

Update: It seems like Paul Krugman – who of course blogs at the New York Times – disagrees with the editors of the New York Times.

The root of most fallacies in economics: Forgetting to ask WHY prices change

Even though I am a Dane and work for a Danish bank I tend to not follow the Danish media too much – after all my field of work is international economics. But I can’t completely avoid reading Danish newspapers. My greatest frustration when I read the financial section of Danish newspapers undoubtedly is the tendency to reason from different price changes – for example changes in the price of oil or changes in bond yields – without discussing the courses of the price change.

The best example undoubtedly is changes in (mortgage) bond yields. Denmark has been a “safe haven” in the financial markets so when the euro crisis escalated in 2011 Danish bond yields dropped dramatically and short-term government bond yields even turned negative. That typically triggered the following type of headline in Danish newspapers: “Danish homeowners benefit from the euro crisis” or “The euro crisis is good news for the Danish economy”.

However, I doubt that any Danish homeowner felt especially happy about the euro crisis. Yes, bond yields did drop and that cut the interest rate payments for homeowners with floating rate mortgages. However, bond yields dropped for a reason – a sharp deterioration of the growth outlook in the euro zone due to the ECB’s two unwarranted interest rate hikes in 2011. As Denmark has a pegged exchange rate to the euro Denmark “imported” the ECB’s monetary tightening and with it also the prospects for lower growth. For the homeowner that means a higher probability of becoming unemployed and a prospect of seeing his or her property value go down as the Danish economy contracted. In that environment lower bond yields are of little consolation.

Hence, the Danish financial journalists failed to ask the crucial question why bond yields dropped. Or said in another way they failed to listen to the advice of Scott Sumner who always tells us not to reason from a price change.

This is what Scott has to say on the issue:

My suggestion is that people should never reason from a price change, but always start one step earlier—what caused the price to change.  If oil prices fall because Saudi Arabia increases production, then that is bullish news.  If oil prices fall because of falling AD in Europe, that might be expansionary for the US.  But if oil prices are falling because the euro crisis is increasing the demand for dollars and lowering AD worldwide; confirmed by falls in commodity prices, US equity prices, and TIPS spreads, then that is bearish news.

I totally agree. When we see a price change – for example oil prices or bond yields – we should ask ourselves why prices are changing if we want to know what macroeconomic impact the price change will have. It is really about figuring out whether the price change is caused by demand or supply shocks.

The euro strength is not necessarily bad news – more on the currency war that is not a war

A very good example of this general fallacy of forgetting to ask why prices are changing is the ongoing discussion of the “currency war”. From the perspective of some European policy makers – for example the French president Hollande – the Bank of Japan’s recent significant stepping up of monetary easing is bad news for the euro zone as it has led to a strengthening of the euro against most other major currencies in the world. The reasoning is that a stronger euro is hurting European “competitiveness” and hence will hurt European exports and therefore lower European growth.

This of course is a complete fallacy. Even ignoring the fact that the ECB can counteract any negative impact on European aggregate demand (the Sumner critique also applies for exports) we can see that this is a fallacy. What the “currency war worriers” fail to do is to ask why the euro is strengthening.

The euro is of course strengthening not because the ECB has tightened monetary policy but because the Bank of Japan and the Federal Reserve have stepped up monetary easing.

With the Fed and the BoJ significantly stepping up monetary easing the growth prospects for the largest and the third largest economies in the world have greatly improved. That surely is good news for European exporters. Yes, European exporters might have seen a slight erosion of their competitiveness, but I am pretty sure that they happily will accept that if they are told that Japanese and US aggregate demand – and hence imports – will accelerate strongly.

Instead of just looking at the euro rate European policy makers should consult more than one price (the euro rate) and look at other financial market prices – for example European stock prices. European stock prices have in fact increased significantly since August-September when the markets started to price in more aggressive monetary easing from the Fed and the BoJ. Or look at bond yields in the so-called PIIGS countries – they have dropped significantly. Both stock prices and bond yields in Europe hence are indicating that the outlook for the European economy is improving rather than deteriorating.

The oil price fallacy – growth is not bad news, but war in the Middle East is

A very common fallacy is to cry wolf when oil prices are rising – particularly in the US. The worst version of this fallacy is claiming that Federal Reserve monetary easing will be undermined by rising oil prices.

This of course is complete rubbish. If the Fed is easing monetary policy it will increase aggregate demand/NGDP and likely also NGDP in a lot of other countries in the world that directly or indirectly is shadowing Fed policy. Hence, with global NGDP rising the demand for commodities is rising – the global AD curve is shifting to the right. That is good news for growth – not bad news.

Said another way when the AD curve is shifting to the right – we are moving along the AS curve rather than moving the AS curve. That should never be a concern from a growth perspective. However, if oil prices are rising not because of the Fed or the actions of other central banks – for example because of fears of war in the Middle East then we have to be concerned from a growth perspective. This kind of thing of course is what happened in 2011 where the two major supply shocks – the Japanese tsunami and the revolutions in Northern Africa – pushed up oil prices.

At the time the ECB of course committed a fallacy by reasoning from one price change – the rise in European HICP inflation. The ECB unfortunately concluded that monetary policy was too easy as HICP inflation increased. Had the ECB instead asked why inflation was increasing then we would likely have avoided the rate hikes – and hence the escalation of the euro crisis. The AD curve (which the ECB effectively controls) had not shifted to the right in the euro area. Instead it was the AS curve that had shifted to the left. The ECB’s failure to ask why prices were rising nearly caused the collapse of the euro.

The money supply fallacy – the fallacy committed by traditional monetarists 

Traditional monetarists saw the money supply as the best and most reliable indicator of the development in prices (P) and nominal spending (PY). Market Monetarists do not disagree that there is a crucial link between money and prices/nominal spending. However, traditional monetarists tend(ed) to always see the quantity of money as being determined by the supply of money and often disregarded changes in the demand for money. That made perfectly good sense for example in the 1970s where the easy monetary policies were the main driver of the money supply in most industrialized countries, but that was not the case during the Great Moderation, where the money supply became “endogenous” due to a rule-based monetary policies or during the Great Recession where money demand spiked in particularly the US.

Hence, where traditional monetarists often fail – Allan Meltzer is probably the best example today – is that they forget to ask why the quantity of money is changing. Yes, the US money base exploded in 2008 – something that worried Meltzer a great deal – but so did the demand for base money. In fact the supply of base money failed to increase enough to counteract the explosion in demand for US money base, which effectively was a massive tightening of US monetary conditions.

So while Market Monetarists like myself certainly think money is extremely important we are skeptical about using the money supply as a singular indicator of the stance of monetary policy. Therefore, if we analyse money supply data we should constantly ask ourselves why the money supply is changing – is it really the supply of money increasing or is it the demand for money that is increasing? The best way to do that is to look at market data. If market expectations for inflation are going up, stock markets are rallying, the yield curve is steepening and global commodity prices are increasing then it is pretty reasonable to assume global monetary conditions are getting easier – whether or not the money supply is increasing or decreasing.

Finally I should say that my friends Bob Hetzel and David Laidler would object to this characterization of traditional monetarism. They would say that of course one should look at the balance between money demand and money supply to assess whether monetary conditions are easy or tight. And I would agree – traditional monetarists knew that very well, however, I would also argue that even Milton Friedman from time to time forgot it and became overly focused on money supply growth.

And finally I happily will admit committing that fallacy very often and I still remain committed to studying money supply data – after all being a Market Monetarist means that you still are 95% old-school traditional monetarist at least in my book.

PS maybe the root of all bad econometrics is the also forgetting to ask WHY prices change.

I am sick and tired of hearing about “currency war” – and so is Philipp Hildebrand

Milton Friedman used to talk about an interest rate fallacy – that people confuse low interest rates with easy monetary policy. However, I believe that we today are facing an even bigger fallacy – the exchange rate fallacy.

The problem is that many commentators, journalists, economists and policy makers think that exchange rate movements in some way are a zero sum game. If one country’s currency weakens then other countries lose competitiveness. In a world with sticky prices and wages that is of course correct in the short-term. However, what is not correct is that monetary easing that leads to currency depreciation hurts other countries.

Easing monetary conditions is about increasing domestic demand (or NGDP). In open economies a side effect can be a weakening of the country’s currency. However, any negative impact on other countries can always be counteracted by that country’s central bank. The Federal Reserve determines nominal GDP in the US. The Bank of Mexico determines Mexican NGDP. It is of course correct that strengthening of the Mexican peso against the US dollar can impact Mexican exports to the US, but the Fed can never “overrule” Banxico when it comes to determining NGDP in Mexico. This of course is a variation of the Sumner Critique – that the fiscal multiplier is zero if the central bank directly or indirectly targets aggregate demand (through for example inflation targeting or NGDP level targeting). Similarly the “export multiplier” is zero as the central bank always has the last word when it comes to aggregate demand. For a discussion of the US-Mexican monetary transmission mechanism see here.

At the core of the problem is that most people tend to think of economics in paleo-Keynesian terms – or what I earlier have termed national account economics. Luckily not everybody thinks like this. A good example of somebody who is able to understand something other than “national account economics” is former Swiss central banker Philipp Hildebrand.

Hildebrand has a great comment on FT.com on why there is “No such thing as a global currency war”.

Here is Hildebrand:

As finance ministers and central bankers make their way to this week’s Group of 20 leading nations meeting in Moscow, some of them may find it impossible to resist the temptation to grab headlines by lamenting a new round of “currency wars”. They should resist, for there is no such thing as a currency war.

This is because central banks are simply doing what they are meant to do and what they have always done. They set monetary policy consistent with their domestic mandates. All that has changed since the crisis is that central banks have had to resort to unconventional measures in an effort to revive wounded economies.

 So true, so true. Central banks are in the business of controlling nominal spending in their own economies to fulfill whatever domestic mandate they have.
Over the last couple of months the Federal Reserve and Bank of Japan have moved decisively in the direction of monetary easing and all indications are that the Bank of England is moving in the same direction. That is good news. Hildebrand agrees:

In the US, for example, the unemployment rate is 2 percentage points above its postwar average. In the UK, output remains 3 per cent below its level at the end of 2007.

In both of these countries, the remits given to the central banks make their responsibility clear: to take action to provide economic stimulus. The US Federal Reserve, for example, has responsibility to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”. In the UK, the Bank of England’s main objective is to maintain price stability. But subject to that, it is required to “support the economic policy of Her Majesty’s government, including its objectives for growth and employment”.

Japan’s problems are different in nature, and longer in the making. Japanese inflation has been negative, on average, for well over a decade. It is an environment that would not be tolerated in any other developed economy. The recently signalled desire for inflation of 2 per cent is hardly a leap towards monetary unorthodoxy, let alone an act of war.

Obviously the side effect of monetary easing from the major central banks of the world (with the horrible exception of the ECB) is that other countries’ currencies tend to strengthen. That is for example the case for the Mexican peso as I noted above. With currencies strengthening these countries are importing monetary tightening. However, that can easily be counteracted (if necessary!) by cutting interest rates or conducting quantitative easing. Hildebrand again nails it:

One can sympathise with emerging economies with floating exchange rates, which may feel they are bearing too much of the burden of adjustment. But surely the answer is not for developed economy central banks to turn away from their remits. Rather, it is for emerging economies to focus their own monetary policy on sensible domestic remits, with their exchange rates free to be determined in the market.

There is one small and particularly open economy where sustained currency movements were not merely the consequence of conventional or unconventional monetary policy measures but where the central bank opted to influence the exchange rate directly. In September 2011, when I was chairman of the Swiss National Bank, it announced that it would no longer tolerate an exchange rate below 1.20 Swiss francs to the euro – and to enforce that minimum rate it would be prepared to buy foreign currency in unlimited quantities.

If Mexico had a problem with US monetary easing then Banxico could simply copy the policies of SNB – and put a floor under USD/MXN. However, I doubt that that will be necessary as Mexican inflation is running slightly above Banxico’s inflation target and the prospects for Mexican growth are quite good.

Hildebrand concludes:

The monetary policy battles that have been fought and continue to be fought in so many economies are domestic ones. They are fights against weak demand, high unemployment and deflationary pressures. A greater danger to the world economy would in fact arise if central banks did not engage in these internal battles. These monetary battles are justified and fully embedded in legal mandates. They are not currency wars.

 Again Hildebrand is right. In fact I would go much further. What some calls currency war in my view is good news. We are not in a world of high inflation, but in a world of low growth and quasi-deflationary tendencies. The world needs easier monetary policy – so if central banks around the world compete to print more money then this time around it surely would be good news.
Unfortunately in Europe central bankers fail to understand this. Here is Bundesbank chief Jens Weidmann:
“Experience from previous, politically induced depreciations show that they don’t normally lead to a sustained increase in competitiveness,” Weidmann said. “Often, more and more depreciations are necessary. If more and more countries try to depress their currency, it will end in a depreciation competition, which will only produce losers.”
Dr. Weidmann – monetary easing is not about creating hyperinflation. Monetary depreciation is not about “competitiveness”. What we need is easier monetary policy and if the consequence is weaker currencies so be it. At least the Bank of Japan is now beginning to pull the Japanese economy out of 15 years of deflation. Unfortunately the ECB is doing the opposite.
Maybe Dr. Weidmann could benefit from studying monetary history. A good starting point is Ralph Hawtrey. This is from Hawtrey’s 1933 book “Trade Depression and the Way Out” (I stole this from David Glasner):

In consequence of the competitive advantage gained by a country’s manufacturers from a depreciation of its currency, any such depreciation is only too likely to meet with recriminations and even retaliation from its competitors. . . . Fears are even expressed that if one country starts depreciation, and others follow suit, there may result “a competitive depreciation” to which no end can be seen.

This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . .

How much better the world would be had the central bankers of today read Cassel and Hawtrey and studied a bit of monetary history. Hildebrand did, Weidmann did not.

PS if the Fed and the BoJ’s recent actions are so terrible that they can be termed a currency war – imagine what would happen if the Fed and the BoJ had decided appreciate the dollar and the yen by lets say 20%. My guess is that we would be sitting on a major sovereign and banking crisis in the euro zone right now. Or maybe everybody has forgot the “reverse currency war” of 2008 when the dollar and the yen strengthened dramatically. Look how well that ended.

—-

Related posts:

Is monetary easing (devaluation) a hostile act?
Bring on the “Currency war”
The Fed’s easing is working…in Mexico
Mises was clueless about the effects of devaluation
The luck of the ‘Scandies’
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons
Fiscal devaluation – a terrible idea that will never work

The exchange rate fallacy: Currency war or a race to save the global economy?

This is from CNB.com:

Faced with a stubbornly slow and uneven global economic recovery, more countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.

Japan has set the stage for a potential global currency war, announcing plans to create money and buy bonds as the government of Prime Minister Shinzo Abe looks to stimulate the moribund growth pace…

Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market.

This pretty much is what I would call the ‘exchange rate fallacy’ – hence the belief that monetary easing in someway is a zero sum game where monetary easing works through an “unfair” competitiveness channel and one country’s gain is another country’s lose.

Lets take the arguments one-by-one.

“…countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.”

The perception here is that monetary policy primarily works through a “competitiveness channel” where a monetary easing leads to a weakening of the currency and this improve the competitiveness of the nation by weakening the real value of the currency. The problem with this argument is first of all that this only works if there is no increase in prices and wages. It is of course reasonable to assume that that is the case in the short-run as prices and wages tend to be sticky. However, empirically such gains are minor.

I think a good illustration of this is relative performance of Danish and Swedish exports in 2008-9. When crisis hit in 2008 the Swedish krona weakened sharply as the Riksbank moved to cut interest rates aggressive and loudly welcomed the weakening of the krona. On the other hand Denmark continued to operate it’s pegged exchange rate regime vis-a-vis the euro. In other words Sweden initially got a massive boost to it’s competitiveness position versus Denmark.

However, take a look at the export performance of the two countries in the graph below.

swedkexports
Starting in Q3 2008 both Danish and Swedish exports plummeted. Yes, Swedish dropped slightly less than Danish exports but one can hardly talk about a large difference when it is taken into account how much the Swedish krona weakened compared to the Danish krone.

And it is also obvious that such competitiveness advantage is likely to be fairly short-lived as inflation and wage growth sooner or later will pick up and erode any short-term gains from a weakening of the currency.

The important difference between Denmark and Sweden in 2008-9 was hence not the performance of exports.

The important difference on the other hand the performance of domestic demand. Just have a look at private consumption in Sweden and Denmark in the same period.

SWDKcons

It is very clear that Swedish private consumption took a much smaller hit than Danish private consumption in 2008-9 and consistently has grown stronger in the following years.

The same picture emerges if we look at investment growth – here the difference it just much bigger.

swdkinvest

The difference between the performance of the Danish economy and the Swedish economy during the Great Recession hence have very little to do with export performance and everything to do with domestic demand.

Yes, initially Sweden gained a competitive advantage over Denmark, but the major difference was that Riksbanken was not constrained in it ability to ease monetary policy by a pegged exchange rate in the same way as the Danish central bank (Nationalbanken) was.

(For more on Denmark and Sweden see my earlier post The luck of the ‘Scandies’)

Hence, we should not see the exchange rate as a measure of competitiveness, but rather as an indicator of monetary policy “tightness”.When the central bank moves to ease monetary policy the country’s currency will tend to ease, but the major impact on aggregate demand will not be stronger export performance, but rather stronger growth in domestic demand. There are of course numerous examples of this in monetary history. I have earlier discussed the case of the Argentine devaluation in 2001 that boosted domestic demand rather exports. The same happened in the US when FDR gave up the gold standard in 1931. Therefore, when journalists and commentators focus on the relationship between monetary easing, exchange rates and “competitiveness” they are totally missing the point.

The ‘foolproof’ way out of deflation

That does not mean that the exchange rate is not important, but we should not think of the exchange rate in any other way than other monetary policy instruments like interest rates. Both can lead to a change in the money base (the core monetary policy instrument) and give guidance about future changes in the money base.

With interest rates effectively stuck at zero in many developed economies central banks needs to use other instruments to escape deflation. So far the major central banks of the world has focused on “quantitative easing” – increasing in the money base by buying (domestic) financial assets such as government bonds. However, another way to increase the money base is obviously to buy foreign assets – such as foreign currency or foreign bonds. Hence, there is fundamentally no difference between the Bank of Japan buying Japanese government bonds and buying foreign bonds (or currency). It is both channels for increasing the money base to get out of deflation.

In fact on could argue that the exchange rate channel is a lot more “effective” channel of monetary expansion than “regular” QE as exchange rate intervention is a more transparent and direct way for the central bank to signal it’s intentions to ease monetary policy, but fundamentally it is just another way of monetary easing.

It therefore is somewhat odd that many commentators and particularly financial journalists don’t seem to realise that FX intervention is just another form of monetary easing and that it is no less “hostile” than other forms of monetary easing. If the Federal Reserve buys US government treasuries it will lead to a weakening of dollar in the same way it would do if the Fed had been buying Spanish government bonds. There is no difference between the two. Both will lead to an expansion of the money base and to a weaker dollar.

“Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market”

This quote is typical of the stories about “currency war”. Monetary easing is seen as a zero sum game and only the first to move will gain, but it will be on the expense of other countries. This argument completely misses the point. Monetary easing is not a zero sum game – in fact in an quasi-deflationary world with below trend-growth a currency war is in fact a race to save the world.

Just take a look at Europe. Since September both the Federal Reserve and the Bank of Japan have moved towards a dramatically more easy monetary stance, while the ECB has continue to drag its feet. In that sense one can say that that the US and Japan have started a “currency war” against Europe and the result has been that both the yen and the dollar have been weakened against the euro. However, the question is whether Europe is better off today than prior to the “currency war”. Anybody in the financial markets would tell you that Europe is doing better today than half  a year ago and European can thank the Bank of Japan and the Fed for that.

So how did monetary easing in the US and Japan help the euro zone? Well, it is really pretty simple. Monetary easing (and the expectation of further monetary easing) in Japan and the US as push global investors to look for higher returns outside of the US and Japan. They have found the higher returns in for example the Spanish and Irish bond markets. As a result funding costs for the Spanish and Irish governments have dropped significantly and as a result greatly eased the tensions in the European financial markets. This likely is pushing up money velocity in the euro zone, which effectively is monetary easing (remember MV=PY) – this of course is paradoxically what is now making the ECB think that it should (prematurely!) “redraw accommodation”.

The ECB and European policy makers should therefore welcome the monetary easing from the Fed and the BoJ. It is not an hostile act. In fact it is very helpful in easing the European crisis.

If the more easy monetary stance in Japan and US was an hostile act then one should have expected to see the European markets take a beating. That have, however, not happened. In fact both the European fixed income and equity markets have rallied strongly on particularly the new Japanese government’s announcement that it want the Bank of Japan to step up monetary easing.

So it might be that some financial journalists and policy makers are scare about the prospects for currency war, but investors on the other hand are jubilant.

If you don’t need monetary easing – don’t import it

Concluding, I strongly believe that a global “currency war” is very good news given the quasi-deflationary state of the European economy and so far Prime Minister Abe and Fed governor Bernanke have done a lot more to get the euro zone out of the crisis than any European central banker has done and if European policy makers don’t like the strengthening of the euro the ECB can just introduce quantitative easing. That would curb the strengthening of the euro, but more importantly it would finally pull the euro zone out of the crisis.

Hence, at the moment Europe is importing monetary easing from the US and Japan despite the euro has been strengthening. That is good news for the European economy as monetary easing is badly needed. However, other countries might not need monetary easing.

As I discussed in my recent post on Mexico a country can decide to import or not to import monetary easing by allowing the currency to strengthen or not. If the Mexican central bank don’t want to import monetary easing from the US then it can simply allow the peso strengthen in response to the Fed’s monetary easing.

Currency war is not a threat to the global economy, but rather it is what could finally pull the global economy out of this crisis – now we just need the ECB to join the war.

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