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Satyajit Das: Why the Currency Wars Matter


Just part of the larger economic conflict between nations, currency wars have significant costs.

(With apologies to The Weather Girls), it's now raining yen!

Japan has opened a new front in the "currency wars," a term coined by Brazilian Finance Minister Guido Mantega in 2010. The US, UK, and Switzerland are already enjoined, with Europe likely to take up arms shortly. Nations which constitute around 70% of world output are "at war," pursuing policies which entail devaluation and currency debasement.

Currency Battles, Economic Wars

But currency conflicts are merely skirmishes in the broader economic wars between nations. Most developed nations now have adopted a similar set of policies, to deal with problems of low economic growth, unemployment, and overhangs of high levels of government and consumer debt.

In a shift to economic isolationism, all nations want to maximize their share of limited economic growth and shift the burden of financial adjustment onto others. Manipulation of currencies as well as overt and covert trade restrictions, procurement policies favoring national suppliers, preferential financing, and industry assistance policies are part of this process.

Central banks are increasingly deploying innovative monetary policies such as zero interest rates (ZIRP), quantitative easing (QE) and outright debt monetization to try to engineer economic recovery.

Artificially low interest rates reduce the cost of servicing debt, allowing higher levels of borrowings to be sustained in the short run. Low rates and quantitative easing measures help devalue the currency, facilitating a transfer of wealth from foreign savers as the value of a country's securities denominated in the local currency falls in foreign currency terms.

A weaker currency boosts exports, driven by cheaper prices. Stronger export-led growth and lower unemployment assists in reducing trade and budget deficits.

The policies have significant costs, including increasing import prices, increasing the cost of servicing foreign currency debt, inflation, and increasing government debt levels. Eventually, when QE programs are discontinued, interest rates may increase, compounding the problems. In extreme cases, the policies can destroy the acceptability of a currency.

The policies also force the cost of economic adjustment onto other often smaller nations especially emerging countries, via appreciation of their currency, destabilizing capital inflows and inflationary pressures, for example through higher commodity prices. Given that emerging markets have underpinned tepid global economic growth, this risks truncating any recovery in developed nations.

Unequal Combat

Actions to weaken currencies risk economic retaliation. Affected nations could intervene in currency markets, try to fix its exchange rate (as Switzerland has done against the euro), lower interest rates, undertake competitive QE programs, implement capital controls, or shift objectives to targeting nominal growth or unemployment (as the US has done).

But currency wars are not conflicts between equals. Asked about a potential alliance with the Vatican, Stalin allegedly asked, "How many divisions does the pope have?" In the currency wars, major economies have large armies and superior weapons. Smaller countries and their taxpayers simply do not have the ability to bear such costs of defending themselves in the currency wars. In the worst case, large economies, like the US and Europe, have the economic size and scale to retreat into near closed economies, surviving and retooling their economies behind explicit or implicit trade barriers. This option is unavailable to nations requiring access to external markets for their products and foreign capital.

Actions to try to set a nation's currency have significant direct costs. Indirect costs include risk of inflation, domestic asset bubbles, and other distortions.
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