Business World, 22 February 2015


The air is thick with rumors of currency wars. And why not? The Euro has weakened against the dollar further in anticipation of the ECB’s conversion to quantitative easing (QE). The German economy’s export sector is humming again, fueling the German economy out of recession which in turn drags the Euro area out of recession. The Japanese yen has gone from ¥78 per US dollar to ¥118 to a dollar on the strength of the BOJ QE and Japanese exports are scoring those of South Korea. The Chinese yuan has also depreciated in the wake of the Chinese authorities’ monetary pushback on its own brand of economic slowdown. The Swiss National Bank scrapping its Swiss franc floor and allowing the Swiss franc to appreciate 20% seems an exception but for the fact that it lowered its interest rate further to -.75%: yes you heard it right, you pay Switzerland 3/4th of a percent interest rate for the privilege of parking money in this safe haven! The emerging economies’ — including the PHL’s — currencies have as a result appreciated.

The February 10 G-20 Meeting in Istanbul endorsed “accommodative monetary policies” to jumpstart the global economic recovery. Observes Simon Johnson of the Sloan School of Management: “The side-effect of this pursuit of domestic growth is depreciation of currencies which may look like, sound like, and smell like ‘competitive devaluations’ or ‘currency wars.’” One view that has become popular among commentators and pundits is that currency wars are now front row in the global landscape. This is hardly compelling.

The naughty edge of expansionary monetary policy is its exchange rate effect. This however makes it all the more effective for fighting downturns in open economies with gaping underemployed capacities. The Mundell-Fleming model tells us that under a flexible exchange rate regime and mobile capital (Japan, the Eurozone and the US are exemplars), expansionary monetary policy directly raises output and, as Johnson correctly observes, leaves a depreciated currency, which boosts exports and further boosts output. Germany’s response to the weakening Euro seems illustrative. Because Germany is the largest economy in the Eurozone, its growth has pulled the aggregate Eurozone out of recession, even though recession still grips many individual Euro member countries.

A depreciated Euro should however be good for the Eurozone generally over the longer term and, if it ignites a stronger tourism in Greece and elsewhere in the Eurozone, it will be a boon even in the shorter run. It was, after all, the strength of the Euro that decimated the non-German Eurozone’s traded goods capacity.

Fiscal stimulus, on the other hand, does not have the same expansionary magic under a flexible exchange rate regime nor does it have the other virtue of QE. Money creation via QE has the added attraction of pushing back the stubborn and threatening deflationary pressure. The oil price collapse has made deflation a distinct reality. France has just slid into deflation and Great Britain is about to fall in.

The special circumstance that supports the G-20 position on accommodative monetary policy is excess capacity and unemployment in most Eurozone and OECD countries. When all in the QE fraternity are in economic doldrums, a concerted monetary expansion, nee QE, will spur domestic growth and will be helped along by a depreciated currency. But the “beggar thy neighbor” effect among concert members themselves will hardly be felt since relative prices will not change and so neither benefits nor harms. The domestic expansionary effects will, however, be marked (perhaps the US economy as exhibit) and will do the world economy much good. The G-20 construes, and with reason, concerted monetary expansion as a Prisoner’s Dream Game where everyone within the QE concert benefits as opposed to a Prisoner’s Dilemma Game where all will lose.

It is a bit different with non-QE countries. Countries like Great Britain, South Korea, Scandinavia, and Switzerland will suffer the brunt of currency depreciations in QE countries, these being their export competitors. The emerging economies who have benefited from the currency-carry trade and foreign investment effects of close to zero interest rate in the OECD can hope for more of the same. Emerging markets’ exports to the QE countries will also slow down further as the price effect kicks in on top of the already depressed (recessionary) income effect. But if QE succeeds in pump priming OECD recovery, the income effect will reverse in its favor. So they are probably wise to overlook the currency depreciation effect of QE the OECD. What is clear is that economic recovery in QE countries is paramount and will benefit the world economies, QE or not. It is probably as close to a win-win solution as one can get in the real world.

Currency war mongers even in non-QE countries can easily overstate their case. Countries outside the QE fraternity which have some monetary independence (most of them have flexible exchange rates or practice inflation targeting), especially those experiencing growth slowdowns, may indeed decide to follow the QE path not as an act of war but as an act of solidarity. Singapore and Indonesia are cutting interest rates to stimulate their economies and at the same time relieve the appreciation pressure. The collapse of the oil price has given them room for policy flexibility as the threat of inflation recedes.

One fact remains: currency wars or not, the dominant strategy on the emerging global currency space today is a weaker currency.