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

Leave a comment


  1. Ben Southwood

     /  February 12, 2013

    Lars – I’ve read a few posts on this topic but I don’t fully understand or know exactly what I think. I’d appreciate if you’d help me understand.

    Imagine the Bank of England buys gilts, and sterling depreciates. One effect this has is adding to demand, which helps overcome nominal rigidities suffered since we fell off our NGDP growth path.

    Surely another effect this has is makes exports cheaper and imports more expensive, putting pressure on those in the obvious directions (although the overall effect may not be in those obvious directions, due to the improved demand picture). Would this not lead to a demand injection from net trade? (Coming from other countries, though not entirely if the demand boost applies upward pressure on imports, against the exchange rate’s downward pressure). Therefore a devaluation would be positive-sum, but would still detract from foreign demand and have some competitiveness about it.

    OR: Is it the case that this boost cheapens sterling to exactly the same extent as it boosts prices? (e.g. total output = 10 widgets, stock of money is £100, widgets sell for £10, £=$ as US output is 100 and there are $1,000; BoE boosts money supply by £10, widgets sell for £110, £1.10=$). But if this is the case surely THIS is the main counterargument to be made to the currency war worriers?

    • Ben, thanks for the question.

      Well, I think your first shot at the story is the right one – at least for the short-term. However, I would stress that the primary boost from monetary easing in the case of the UK – even if it leads to a weaker pound – will be increased domestic demand – higher private consumption and investment growth. In that regard it is important to note that the impact on the trade balance not necessarily is positive as stronger domestic demand will boost imports and that might very well “outpace” the gains made on exports through improved competitiveness. That actually happened in the US in 1933-34 and in Argentina in 2002.

      Your second point is valid as well and very well illustrates what is wrong with the currency war argument – even if prices and wages increase as much as the currency weakened then it would boost domestic demand, but certainly not improve competitiveness. That is basically the point that Hawtrey made in 1933.

      I should of course stress that a depreciation of the currency cannot increase REAL GDP in the long run (the Phillips curve is vertical), but might very well do it in the short-run particularly in a situation like the present with strong depressed domestic demand.

      • Ben Southwood

         /  February 12, 2013

        Lars – but if my story is true then it’s at least possible that there is some element of war – in the short run – in currency devaluations. Net trade is zero-sum by definition. Assuming there is some boost to imports through the overall demand boost, it’s still possible (notwithstanding your two historical examples) that there’s a net trade shift from the non-inflater to the inflater.

        So an attack on the idea of currency wars would need to be a good deal more measured (e.g. “just balance them out”; “the effect could go either way”; “in the long run prices will adjust and the effect will disappear”; and “why do we trade anyway? to get stuff, not to get foreign currency for our toil and use of stuff”).

        Correct me if I’ve mis-stepped somewhere – it seems to me like net trade still MIGHT shift and therefore the fears of, e.g., Weidmann are at least on their terms somewhat justified.

  2. I think all this talk of currency wars is just a side effect of certain editors trying to sell more newspapers. Sadly, this is how bad memes are born. Currency war sounds like something you should know about! but a one percentage point increase in trend Japanese NGDP, not so interesting outside Asia. It is shocking how many macro analyst types fly blind and just parrot the papers. Though I still can’t grasp how Japan—if we were in a currency war—could be deemed an aggressor, after the jarring appreciation the JPY has seen since 2008. If anything the EMU is the aggressor, carefully engineering a near collapse in Spain to sell a few more BMWs!

  3. Benjamin Cole

     /  February 13, 2013

    Great blogging…and I hope the major central banks of the world keep printing a lot more money, for years and years into the future. Bring on currency wars, I say.

  1. I am sick and tired of hearing about “currency war” | Fifth Estate
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  3. The New York Times joins the ‘currency war worriers’ – that is a mistake | Fifth Estate

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