Reforming Global Finance

Coordinate Currencies, or Stagnate

What can the United States, China and other nations do to prevent a wave of competitive devaluation of currencies?

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  • From a global standpoint, exchange rate devaluation is a case of robbing Peter to pay Paul.
  • The renminbi has appreciated somewhat in recent years. But it is has not been enough.
  • The principal impact of Abenomics is turning out to be yen depreciation.
  • Monetary policy must not be allowed to impact exchange rates. Cooperation by central banks can prevent that.
  • The onus of intervention must be on the country whose currency is appreciating.
  • The only silver lining to the Great Recession is it has dented Chicago School economics.

The global economy needs exchange rate coordination now. Absent that, the world is likely to be increasingly afflicted by exchange rate fluctuations and policy acrimony. These are bound to undermine the economic recovery and increase the likelihood of stagnation.

In 2010, Brazilian Finance Minister Guido Mantega warned of the possibility of “currency wars,” as countries sought to devalue their exchange rates to gain competitive advantage.

Brazil’s economy may currently be less in favor internationally, but that doesn’t change the validity of Mantega’s concerns.

In a world of demand shortage, a weaker currency can increase demand for a country’s goods — and thereby help with its own economic recovery.

The undeniable problem is exchange rate devaluation benefits the devaluing country at the expense of others. From a global standpoint, it can easily become a case of robbing Peter to pay Paul.

The Great Depression of the 1930s provides warnings along such lines.

Back then, the depression prompted competitive depreciation and trade conflict as countries sought to gain demand by increasing exports and lowering imports. That process contributed to deepening the depression.

Today, the problem of exchange rate conflict is again on the rise. One problem is China’s long-running trade surplus with the United States.

Those surpluses should long ago have fostered steep renminbi — dollar appreciation to rebalance the trade account.

Yes, the renminbi has appreciated somewhat in recent years. But it is has not been enough to prevent the United States’ trade deficit with China from steadily increasing.

Instead, China has intervened in markets to limit the scale of exchange rate appreciation. The country’s goal remains to retain both export competitiveness and attractiveness as a destination for foreign direct investment.

A second newer and much more difficult problem concerns quantitative easing (QE).

Under this process, central banks buy domestic assets on a massive scale to lower interest rates. Indeed, Mr. Mantega’s comments were actually spurred by the U.S. Federal Reserve’s QE program.

The core problem is monetary policy interventions inevitably have exchange rate impacts in a modern economy with flexible exchange rates and internationally open financial markets.

When a central bank increases the money supply by buying domestic assets and lowering domestic interest rates, some of that money is diverted offshore as investors seek other investment opportunities.

That move offshore causes the exchange rate to depreciate.

The justification for QE in the United States was strong.

The country’s economy was in deep recession, long-term interest rates were still quite high and the U.S. government was running large budget deficits.

It clearly needed assistance with financing to keep interest rate costs down.

But at this juncture, things are getting complicated.

In Japan, the new policy of Abenomics involves massive central bank purchases of Japanese government debt. Japan’s ten-year interest rate is already at 0.88%. The principal impact of Abenomics is turning out to be yen depreciation.

With the Bank of Japan buying bonds and flooding the market with cash, Japanese investors have an incentive to go overseas in search of yield. And to buy foreign assets, they must sell yen.

That has not only already triggered a wave of yen-dollar depreciation. It also promises to trigger other exchange rate changes that increasingly resemble global competitive devaluation.

The problem is that, on the surface, Abenomics looks a lot like QE. Consequently, how can the United States or other nations object?

From an international perspective, the problem is not QE — but the pursuit of QE within a flawed framework. The solution is exchange rate coordination.

What central banks can and must do

Given the global economy’s demand shortage, the world needs easy monetary policy that lowers interest rates and facilitates budget deficits.

However, such monetary policy must not be allowed to impact exchange rates. International coordination of exchange rates by central banks can accomplish that.

Such a system needs rules of exchange rate intervention. Historically, the onus of defense has fallen on countries’ whose exchange rate is weakening, which requires them to sell foreign exchange reserves.

That is a fundamentally flawed system because countries have limited reserves. Speculators therefore have an incentive to try and “break the bank” by shorting the weak currency.

They have a good shot at success, given the vast scale of low-cost leverage financial markets can muster. George Soros proved that when he successfully bet against sterling and the Bank of England in 1992.

A new, smarter international system must share the onus of intervention with the country whose currency is appreciating. Its central bank has unlimited amounts of its own currency for sale, so it can never be beaten by the market.

Consequently, speculators will back off if this intervention rule is credibly adopted, making the target exchange rate viable.

Intervening in this way will also give an expansionary tilt to the global economy.

When weak currency countries defend their exchange rate, they often raise interest rates to make their currency attractive, thereby imparting a deflationary global bias.

If strong surplus countries do the intervening, they may lower their interest rates and impart an expansionary bias.

The bottom line is a sensible coordinated exchange rate system can both stimulate the global economy and help avoid looming international economic policy conflict.

The means for such a system are at hand, but so far the politics have lagged. In the United States, discussion of exchange rate policy has been blocked by two factors.

The first is simplistic free market nostrums and the second a legacy of misunderstanding from Chicago School monetarism that claims exchange rates do not matter because induced depreciation will be offset by inflation.

The only silver lining to the Great Recession is it has dented Chicago School economics. That has created new policy space, but so far political leaders have failed to take advantage. That must change.

The September 2013 G-20 summit in St. Petersburg provides an ideal opportunity to launch an initiative for exchange rate coordination.

Not only would it address the problem of currency war, it would also build market confidence by showing that the world’s political leaders can still work together on matters of vital economic import. Carpe diem.

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About Thomas I. Palley

Thomas I. Palley is an independent economist in Washington D.C.

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