Blog post

Currency Chaos

Publishing date
14 October 2010

What’s at stake: Leaders of the world economy failed to narrow differences over currencies over the weekend in Washington DC. Exchange rates dominated the IMF’s annual meeting in Washington on concerns that officials are relying on cheaper currencies to aid growth, risking retaliatory devaluations and trade barriers. China was accused of undervaluing the Yuan, while low interest rates in the U.S. and other rich nations were blamed for flooding emerging markets with capital.

Michael Schuman writes that it's hard to argue Guido Mantega is wrong – Brazil’s finance minister who declared that the world is already involved in "a trade war and an exchange rate war”. Though there hasn't yet been a single, sweeping event signalling a worldwide descent into protectionism -- like the passage of the notorious Smoot-Hawley tariff of 1930 – there has been mounting evidence that policymakers around the world are increasingly flirting with beggar-thy-neighbour policies. When these dots are connected, they form an arrow pointing in a very dangerous direction for the entire world economy.

Alphaville has the number of countries intervening: we’re now at 23! They count everything including actual intervention, de facto intervention via such measures as quantitative easing, suspected intervention and talk of intervention. They are not counting countries that have always pegged their currencies. As a reminder they note that nothing quite comparable with this has ever happened before in the history of the world, except right after WWII.

Nouriel Roubini argues that the trouble is that not all currencies can be weak at the same time: if one is weaker, another must, by definition, be stronger. Likewise, not all economies can improve net exports at the same time: the global total is, by definition, equal to zero. So the competitive devaluation war in which we find ourselves is a zero-sum game: one country’s gain is some other country’s loss. Currency wars eventually lead to trade wars, as the recent US congressional threat against China shows. With US unemployment and Chinese growth both at almost 10%, the only mystery is that the drums of trade war are not louder than they are.

Ryan Avent writes the right way to understand the current situation is not as a war, which it isn't (yet) but as a crisis, which it is. In a crisis, everyone understandably looks out for their own interest and places the greater, international good second. But if this self-interested management is talked through and loosely coordinated, it can be prevented from spiralling into something explicitly zero sum. Each step of the way, there will be costs that are not evenly shared. That doesn't mean the process must become adversarial. It's in the world's interest to avoid evolution toward that adversarial outcome, even if it would make for snappier headlines. The language of war is attractive because it is dramatic and evocative, and because it seems appropriate to the issue of international imbalances. But it risks injecting unnecessary belligerence into the discussion, and it obscures critical aspects of the currency dynamic.

Could a currency war actually help?

Barry Eichengreen argues that what's missing from the war framing of the issue is that it can actually bring about the policy easing that the world needs. The conventional wisdom that we’re playing a zero-sum game is a misreading of both the 1930s and the current situation. It is a misunderstanding to believe that the current policies pursued by the BOJ, the Fed, and the Bank of England come at one another's expense. What we are seeing, in all three cases, is not exchange rate manipulation but what is known as quantitative easing, actual or incipient. This, of course, is precisely what is needed in a world where deflation has again become a problem. So it is not a "beggar thy neighbour race to the bottom." If anything it is a race to the top. In the 1930s, monetary easing achieved through a process of "competitive devaluation" was better than no monetary easing. It would be better to achieve monetary easing in a coordinated way (as argued here) since the process can be disorderly and disruptive but monetary easing achieved through a “currency war”" is better than no monetary easing.

Paul Krugman writes that the Eichengreen argument does not work, at least not as phrased. The hypothesized currency war in which the Fed buys euros and the ECB buys dollars might not do any harm, but it probably wouldn’t help, either. Why? In the 1930s, competitive devaluation mattered largely because a number of countries were still on the gold standard, and were keeping interest rates well above the zero lower bound in an attempt to preserve their gold reserves. Devaluation relaxed this constraint by making the gold worth more in domestic currency, and hence was expansionary. Today there’s nothing like that, and rates are pretty much at zero. And in that case, it’s hard to see what mutual intervention accomplishes.

Martin Wolf writes that the US wants to inflate the rest of the world, while the latter is trying to deflate the US. The US must win, since it has infinite ammunition: there is no limit to the dollars the Federal Reserve can create. What needs to be discussed is the terms of the world’s surrender: the needed changes in nominal exchange rates and domestic policies around the world.

From currency to trade war

Michael Pettis argues that retaliation is likely. In 1930, following France’s very successful 1928 devaluation and Britain’s tightening of trade conditions within the Commonwealth, the world’s leading trade-surplus nation passed the Smoot-Hawley tariffs in a transparent attempt to gain a greater share of dwindling global demand. This would have been a great strategy for the US had no one noticed or retaliated, but of course the rest of world certainly noticed, and all Smoot-Hawley did was accelerate a collapse in global trade which, not surprisingly, hurt trade surplus countries like the US most. We seem to be following the same path, and in a beggar-thy-neighbor world any country that does not participate in retaliatory policies will suffer. The only question is which retaliatory policy.

Richard Baldwin points out that the US has a long history of fighting what it perceives as currency manipulations with trade sanctions. You’ll want to watch the YouTube of Nixon announcing, on 15 August 1971, 10% tariffs on all goods. The goal was to force Germany and Japan to appreciate their currency; it worked. In the mid 1980s, the US’s aggressive unilateralism – especially the Super 301 bill – forced Japan to appreciate its currency in the Plaza Accord and open its market via a series of talks called the Structural Impediments Initiative. In East Asia, the resulting sharp movement of the yen is often viewed as the beginning of the end of Japan’s long post-war boom. Today, the US Congress is in a fighting mood, Americans are angry, unemployed and looking for someone to blame. And the sitting US President is not sure whether to resist these pressures.

Proposals to reverse the coming war

Harold James argues that the real lesson of the 1980’s is that exerting massive pressure for exchange-rate adjustment and looser monetary and fiscal policy won’t work – especially since China now, like Japan then, is already running substantial budget deficits. The resulting monetary expansion in the second half of the 1980’s fuelled Japan’s massive asset-price bubble, the collapse of which seemed to lead directly to the country’s “lost decade” of stagnation. As debate about Japanese economic decline intensified, a consensus emerged in Japan that outside pressure had forced the country into adopting a dangerous and ultimately destructive course. Models and Agents disagrees with that view and writes that of all the factors cited in the literature as contributing to the asset price boom and then bust, the yen’s move is at best an incidental one.

Scott Summer argues that a grand meeting to coordinate currency policy would be unwise, as it would almost certainly end up pressuring China to revalue, instead of encouraging the Fed, ECB and Bank of Japan to depreciate their currencies. A similar attempt at coordinating exchange rates was unexpectedly sabotaged in June 1933 by President Roosevelt. Most respectable pundits were outraged by FDR’s decision to pursue unilateral dollar devaluation, but Keynes called his decision “magnificently right”.

Daniel Gros proposes a reciprocity requirement that would stem currency manipulation. The US (and Japan) could easily prevent the Chinese Central Bank from continuing its intervention policy without breaking any international commitment. The US and Japan only need to invoke the principle of reciprocity and declare that they will limit sales of their public debt henceforth to only include official institutions from countries in which they themselves are allowed to buy and hold public debt. Instead of the “moral suasion”, tried in vain by the Japanese, the Chinese authorities would just be told that they can buy more US T-bills Japanese bonds only if they allow foreigners to buy domestic Chinese debt. Imposing such a “reciprocity” requirement on capital flows would be perfectly legal – although the US (and Japan and all EU member countries) have notified the IMF that they have liberalised capital movements under Article VIII of the IMF. Yet, in contrast to the area of trade, there are no legal constraints on the impositions of capital controls.

Paul Krugman does not understand what Martin Wolf, Fred Bergsten and Daniel Gros are saying. Bergsten calls for countervailing intervention that when China or Japan buy dollars to keep their currency substantially undervalued, the United States would sell an equivalent amount of dollars to push back. But how can this be done? China has capital controls (which is why its intervention is so effective). Gros then proposes that we limit Chinese purchases of our assets instead. But how can we do that? We can exclude China from buying US government debt at debt auctions — but how do you stop it from buying it on the secondary market? Even if you pass a rule to that effect — which would be very hard to enforce — why can’t they just launder the money through offshore hedge funds? Absent broad-based US capital controls, which would be a bigger step than a countervailing trade duty, I just don’t understand the mechanics.

Gérard Roland has a creative solution that would show genuine international leadership on the part of Chinese leaders: start imposing a green tax on Chinese exports. This would have the same effect as an import tariff imposed on the US side but the revenue would instead go to the Chinese government. If they use the tariff revenues solely for green investments to reduce Chinese carbon emissions, they would achieve two goals at the same time: 1) reduce the international currency tensions that risk leading to dangerous trade wars while saving face, 2) show international leadership in adjustment to climate change.

It’s the IMS, stupid!

Harold James writes that we’re seeing a shift in the character of the global financial crisis, away from concern with banking problems and toward a focus on the world’s dysfunctional exchange-rate system – or, rather, its current lack of one.

Fred Bergsten argues that this crisis exposes a glaring gap in today's international monetary system: the absence of effective discipline on surplus countries. All adjustment pressures fall on those with deficits—resulting in an inherent deflationary bias that is especially acute during global slowdowns. The International Monetary Fund (IMF) was set up to stop the competitive devaluations that deepened the Great Depression, but it has never been given the tools to do so.

Tim Duy notes the collapse of Bretton Woods 2 might be coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve. And at the moment, the collapse looks likely to turn disorderly quickly. If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US. Perhaps Bretton Woods does not end because foreign governments are unwilling to bear ever increasing levels of currency and interest rate risk or due to the collapse of private intermediaries in the US, but because it has delivered the threat of deflation to the US, and that provokes a substantial response from the Federal Reserve. A side effect of the next round of quantitative easing is an attack on the strong dollar policy. The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.

About the authors

  • Jérémie Cohen-Setton

    Jérémie Cohen-Setton is a Research Fellow at the Peterson Institute for International Economics. Jérémie received his PhD in Economics from U.C. Berkeley and worked previously with Goldman Sachs Global Economic Research, HM Treasury, and Bruegel. At Bruegel, he was Research Assistant to Director Jean Pisani-Ferry and President Mario Monti. He also shaped and developed the Bruegel Economic Blogs Review.

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