Don’t Mention the War!

February 18, 2013

–Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own.–

Modern wars have no clear start and no clear end, leaving politicians free to deny their existence when it suits them and to claim victory even in the face of obvious defeat.

The same seems to be true of currency wars, judging by the reports from the meeting of the world’s finance ministers in Moscow, who, according to the FT, asserted that “central banks should not target their exchange rates, but added that monetary easing which had the side-effect of weakening a country’s currency was allowed”. This is a bit like saying that bombing civilians is OK as long as you’re actually aiming at terrorists – which, come to think of it, is more or less what we do say.

If you think it is only in the Economics 101 textbook that currency depreciation follows monetary easing as night follows day, then read on: “Shorting the Japanese yen ….hedge funds [have been] reaping billion dollar profits … in January.” The hedge funds had got the message.

The background to this saga goes back to the dark days immediately following the collapse of Lehman Bros in September 2008, when the US authorities hastily embarked on a campaign of so-called Quantitative Easing (again, as in all modern wars, uncomfortable realities have to be camouflaged in specially-invented newspeak – QE is simply what used to be called printing money). Britain did the same. True, neither the US administration nor the Labour Government of Gordon Brown actually took aim at the exchange rate – at least, not publicly – but the Americans were at the very least unconcerned about the effect on the dollar, and on this side of the Atlantic there was quiet satisfaction when the pound duly fell by 20% against the dollar and 30% against the euro.

However, as the crisis progressed, the euro zone began to unravel, partly because the rise in the relative value of the euro made its struggling periphery even less competitive on world markets than it had been before the 2008 crisis. It was obviously only a matter of time before the ECB cracked under the pressure and started to print euros – yes, of course, Governor Draghi was ostensibly acting to save ClubMed from default, but the collateral damage was bound to be a lower value for the euro.

While all this was going on, global investors – hedge funds, sovereign wealth funds, internationally-minded pension funds – were engaged in an increasingly desperate search for a safe haven where they could park the trillions of dollars under their care. The Swiss Franc is the traditional bolt-hole in such circumstances, and it duly rose against the dollar by more than 10% in 2008, and by 2011 had doubled in value in only ten years. Not surprisingly, Swiss industry was feeling the strain and demanded action, and their central bank has responded by agreeing to print as many Swiss Francs as necessary to stop any further appreciation. Outside Europe, the new darlings of the emerging markets – Brazil, Korea, Mexico and others – were taking similar measures to ensure they were not swamped in the flood of dollars and pounds.

By last year, the only major currency being allowed to appreciate was the ten. Although Japan had invented (or, rather, re-invented) QE back in the 1990’s, when its own long recession began, the pace of its monetary expansion had remained fairly constant, thanks to a residual sense of responsibility and integrity in the higher reaches of its central bank. This fact, combined with the largely-outdated perception in global markets that the Japanese are still in thrall to Confucian thrift and self-denial, meant that the more the rest of the world printed money, the greater the demand for yen. As the exchange rate dipped below 80 to the dollar, the resistance to accelerated monetary easing began to buckle, and with a general election looming, it was clear from the opinion polls in 2012 that the LDP was going to return to power on a platform of printing enough money to bring the value of the yen back down.

Markets do not wait for politics, however, so selling the yen was a no-brainer in the run-up to the election of Mr Abe last December, which the hedge funds, including (it is said) George Soros, exploited. (And why on earth shouldn’t they)?

So much for background. My amazement at the comments emanating from the G20 is because, if the sequence of events in this potted history of the last five years is not an ongoing global currency war, I invite suggestions as to which additional ingredient is missing.

Yet Christine Lagarde who heads up the IMF remains a politician first and foremost: “The talk of currency wars is overblown. Yes, the euro has appreciated and yes, the yen has depreciated but that is the result of good policies in the euro zone and looser policy in Japan.” (Note the contrast between “good” and “looser” policies).

In the 1930’s, countries followed beggar-my-neighbour policies of competitive devaluation backed up by trade protection. We should be grateful that, so far at least, politicians have withstood the clamour for tariffs or quotas, but the danger is that as the currency war becomes fiercer, they will find it impossible to resist the pressure for escalation.

In the meantime, they obviously calculate that admitting they are in a war will only make it harder for them to withstand the pressure. Maybe they are right, but my fear is that many of them actually believe the nonsense coming out of G7 and G20 meetings, based as it is on an imaginary distinction between monetary expansion for domestic purposes (good) and for external competitiveness via exchange rate depreciation (bad). The former is OK, according to Mme. Lagarde, when “there is no major deviation from the fair value of the currencies.”

This may be good politics, but it is the economics of the madhouse.  Economists have never arrived at an unambiguous definition of the fair value of an exchange rate, and even if they did agree on one, it could never logically involve a simultaneous depreciation of all the world’s currencies unless the Martians agreed to let their currency appreciate.

Maybe there’s a hidden logic here – after all, these meetings do seem sometimes to take place on another planet.


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