Guido Mantega, Brazil’s Finance minister, in 2010 revived the charge that some countries are relying on currency depreciation to improve their balance of trade, using it to revive their economic fortunes. Economists also refer to this as a ‘beggar thy neighbour’ policy. There are a number of interesting features associated with the currency war argument. First, in spite of attempts by politicians and, possibly, the media, to whip up sentiment from time to time in support of the view of an imminent currency war, the news headlines appear to fade away almost as quickly as they appear. Either few actually believe that countries are deliberately using the exchange rate as a policy tool or identifying the culprits, and their motivation, is much more difficult than it might seem, leading to skepticism about the accusation of resorting to deliberate exchange rate manipulation to gain domestic economic advantage.
Appearances to the contrary, countries may have little stomach for deliberately engaging in depreciating their exchange rate in the manner claimed by some politicians. For example, it would seem odd, to say the least, for the euro zone to resort to a policy of deliberately depreciating the euro when the European Central Bank (ECB) is unable to influence the fundamentals, at least not directly, that might contribute to a change in the exchange rate. These are, to a significant extent, still a function of the domestic policies set by sovereign member states. Besides, EU finance ministers have done a marvellous job of creating large movements in the exchange rate on their own thanks to their innate inability to help the single currency area escape from the ongoing sovereign debt crisis (keep an eye out for a future post on this).
Even if direct intervention in foreign exchange markets is deemed appropriate, the ECB would have to explain why it is acceptable to influence the external value of the euro to gain an artificial economic advantage while insisting that some euro zone economies must undergo an ‘internal’ devaluation since member states’ nominal exchange rate cannot be changed (the real exchange rate does, of course, change). Together with some euro zone politicians who insist that economic salvation is only possible through structural reforms, underpinned with a strong dose of fiscal austerity, one can only imagine the uproar that would follow an ECB attempt, perhaps with some political pressure thrown in, to justify a policy of trying to depress the euro’s value against its major trading partners. Charges that this benefits the big exporters (i.e., Germany) but not others would not take long to appear.
The Chinese might also have to deal with the fallout from reversing a course towards a more flexible exchange rate if it were clear that the yuan was again subject to more concerted intervention to improve the external balance of trade. Since the Chinese government has also come to the realization that their economy’s future lies with a more open capital account, together with an orientation towards more domestically driven demand, participating in a currency war would not be in its self-interest. In fact, such action would prompt politicians from around the world to claim that the Chinese government was talking out of both sides of its mouth.
As for the US, fiscal policy remains in the grip of a stalemate between the Obama administration and Democrats in Congress on the one side and Republicans on the other. The latter continue to block any initiative that might end uncertainty about the direction of fiscal policy. Meanwhile, the Fed is focused on applying multiple instruments and policies to guarantee that the domestic economy returns to some semblance of normality. Tying the return of higher interest rates to an economic threshold rather than to a calendar one, as was the case until very recently, does not suggest a deliberate attempt to devalue the US dollar against other currencies but is rather a recognition that a broad set of sectors of the US economy are in need of any relief and support that monetary policy can provide. The exchange rate, whatever direction it takes, is a ‘residual’ element in the Fed’s calculation.
Finally, the attempt to drum up fury over deliberate exchange rate manipulation must confront two other important developments in the world economy over the past two decades or so, neither of which has been mentioned in the recent debate. First, there is clear evidence that the link between changes in the exchange rate and domestic prices, known as pass-through effects, have substantially declined. Therefore, an economic shock of some kind that leads to variability in the nominal exchange rate no longer produces an effect as strong as the one portrayed in textbooks, namely a rise in domestic prices, in the event of a currency depreciation, or a fall in domestic prices when the exchange rate appreciates. Moreover, the integration of goods and financial markets, together with the global the supply chain, also reduces the size of any export boost following a depreciation. Adding to the difficulty is that, as much of the advanced economies are in the midst of deleveraging and aggregate demand remains soft, it is unclear that any currency depreciation is the economic salvation it once, if ever, was. The UK government and the Bank of England, for example, both of whom once rejoiced at a weaker pound have lately changed their message in part to stymie international reaction but also because no export boost is able to offset the likelihood of another recession.
Regardless, the tonic of exchange rate depreciation as a means of stimulating exports is no longer seen as effective as it once was. Even if an economy is somehow inoculated against fluctuations in the nominal exchange rate, the global financial crisis has taught us that, in the trade of goods, services and in the flow of capital, contagion can step in when fundamentals might otherwise predict that shocks from abroad have few consequences for the domestic economy. For all of these reasons the periodic worry that a currency war will break out imminently is not to be taken too seriously. It is a more of a phoney war than a real one.