Satyajit Das: Why the Currency Wars Matter
Just part of the larger economic conflict between nations, currency wars have significant costs.
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.
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.
In 2012, the Swiss National Bank (OTCMKTS:SWZNF) was forced to build record foreign exchange reserves to maintain the euro at Swiss Franc 1.20 in an effort to shield Switzerland from an economic downturn, driven in part by an appreciating currency. Its reserves of over Swiss Franc 427 billion ($453 billion) are over 75% of Switzerland’s annual gross domestic product. The SNB purchased Swiss Franc 188 billion francs ($199 billion) in foreign currencies in 2012, more than 10 times the Swiss Franc 17.8 billion ($18.9 billion) it spent in 2011. The SNB’s intervention resulted in losses totaling Swiss Franc 27 billion in 2010.
In Australia, where a rising currency is creating economic problems, policy makers have tacitly acknowledged their powerlessness.
Recent disclosures from the Reserve Bank of Australia show that on their foreign currency holdings, a 10% appreciation in the Australian dollar results in an unrealized loss of about $3.43 billion. Similarly, an increase in interest rates of 1% would result in a valuation loss of $0.66 billion on these securities. Intervention to bring down the value of the Australian would require the RBA to sell the Australian dollar and use the proceeds to buy and hold additional foreign currency securities, increasing these risks.
This restricts the policy options available to smaller economies, limiting their capacity to influence exchange rates and economic activity in practice. Responding to a question about New Zealand’s approach, Finance Minister Bill English stated the obvious with disarming honesty: “To influence the exchange rate you need a couple of hundred billion US in the bank so they take you seriously. We’d be out in the war zone with a peashooter.”
Enriching Thy Neighbor?
The US and Japan defend their actions, claiming that they are not seeking to devalue their currencies but only trying to boost their domestic economy. In a recent speech, Federal Reserve Chairman Ben S. Bernanke refused to countenance that the US was involved in “beggar-thy-neighbor” policies, arguing that America had adopted an “enrich-thy-neighbor” strategy. He did not elaborate on how this would work, beyond the homily that a strong US economy was good for the world.
Speaking on April 10, 2013, Australia Treasurer Wayne Swan expressed support for American and Japanese reflation policy via QE and currency devaluation. He stated puzzlingly: “Expansionary monetary policy can bring about a depreciation of the currency, but that doesn’t mean it is manipulation.” He was effusive in his praise of the action of the US: “Thank god for the Fed.” Given the effects of the high Australian dollar on Australia’s export and competitiveness, the Treasurer’s position is curious, especially given increasing American and European disquiet at Japanese actions to weaken the yen.
Ultimately, a policy of devaluation to attain prosperity is flawed, especially when all major nations implement similar policies. Everybody cannot, by definition, have the cheapest currency. In the words of one central bank official, it is like peeing in bed to keep warm; while it might feel good at first, it soon becomes messy and difficult to clean up.
But to expect nations not to use fiscal and monetary policy to manipulate currencies is disingenuous. Circumstances now dictate the use of every available policy tool to serve individual national interests.
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