The looming currency war

January 23, 2013

Are we about to be sucked into a currency war? As the world economy continues to splutter, countries are looking for ways to break out of the mire. One way of gaining popularity is to promote growth through making exports cheap. The key to an export-led recovery is to devalue a national currency, thereby lowering the prices of exports. By allowing its currency price to slide, a nation can launch a surreptitious trade war against its commercial rivals. Western nations have for years accused China of taking an unfair trade advantage by keeping its currency, and therefore export prices, artificially low. By allowing their currencies to devalue, Western countries are fighting back.

There are indications that the early skirmishes of a currency war have begun. This is a dangerous business. If countries undercut their competitors’ prices by devaluing their currencies, the stability of the world economy is put at risk. A full-fledged currency war invites deflation, a ruinous downward spiral of prices that in turn invites a worldwide recession. The cause of the conflict lies in the failure of the chosen measure to offset a Great Recession since 2008: wave after wave of “quantitative easing” (QE) by central banks to beat stagnant growth. QE was intended to funnel cheap money into national economies to boost economic activity and increase aggregate demand, thereby creating growth and jobs. But persistent QE has had an important unintended consequence. It has removed a key measure by which traders judge sovereign interest, or the ability of a country to pay its way.

Before the financial freeze of 2008-9, traders who worried about a country’s solvency would decline to buy government bonds or insist on a punishingly high return. That mechanism became confused when, to head off a precipitous Great Recession, finance ministers from the leading industrial nations agreed to pump vast amounts of newly minted money into their economies until the danger had passed. QE, or the buying of government bonds by central banks, was intended to reduce general borrowing costs and allow businesses to borrow cheaply to invest, and thereby employ the jobless.

That did not happen. Banks — fearful of making imprudent decisions similar to the ones they made on mortgage lending that plunged the world economy into a slump in the first place — have been hoarding money, have bought other banks with it, or have awarded it as bonuses to their executives. Businesses, fearful of making large investment decisions so long as demand remains sluggish, have also sat on their cash reserves. The result is the low- to no-growth economy we are currently enduring. John Maynard Keynes thought this would happen. As he told Franklin Roosevelt, it is “like trying to get fat by buying a larger belt.” Providing endless supplies of cheap money cannot in itself lead to growth. Measures to promote demand can best do that.

Meanwhile, traders have been deprived of the way they traditionally reflect their assessment of a nation’s economic worth. When central banks furiously buy government bonds to keep interest rates low, the bond price mechanism becomes redundant. But traders can continue to express their sovereign concerns via the currency market. It appears some functions of the distorted bond market have been replaced by the currency market. As Paul Kavanagh of Killik Capital told the BBC, “The bond market is, for want of a better word, being manipulated by this QE buying at the moment, making it very hard for it accurately to express sovereign interest, where currencies maybe are.” Currency prices have always been a good reflection of a country’s worth and have become even more so since QE.

Faced with this added pressure on its currency price, and unable to raise interest rates to maintain the price of their currency for fear of making the recession worse, what is a finance minister to do? The answer, it appears, is to turn this dilemma into an advantage. Two major economies appear to be trying to break from the rest of the pack by slyly allowing their currencies to slide. The first is Japan, the world’s third-largest economy, which for decades has been lost in a deflationary economic labyrinth. Earlier this month, Japanese Prime Minister Shinzo Abe made a bolt for growth. He announced a classic Keynesian $117 billion public spending stimulus and ordered the Bank of Japan to double its conservative inflation target, to 2 per cent. Abe expects his policies will increase real growth by 2 percent and create 600,000 new jobs a year.

But that is only half of the story. Urged on by Japan’s squeezed exporters, Abe has also been letting the yen slide against the dollar – 15 percent in the past two months – and despite urgent denials from the Japanese finance minister, it is widely assumed the slippage will be allowed to continue for some time. Devaluing the yen offers a lifeline to Japan’s technology sector, which for years has been out-priced by Korea and China. A similar tacit agreement to let its currency devalue has been taken in Britain, where in recent weeks the pound sterling has slid 3½ per cent against the dollar. Stuck in a double-dip recession, which on Friday is expected to become a triple-dip recession, the Cameron government’s experiment in austerity appears to have failed. Devaluing the pound is a desperate last throw. Both Abe and Mark Carney, the incoming governor of the Bank of England, are also considering following Ben Bernanke’s example at the Fed by switching from using inflation alone as a guide to future central bank action and making employment an equally important policy goal.

Devaluation is risky. In the short run, exporters gain by cheaper prices, while imports are choked off because they are more expensive. In manufacturing countries like Japan or Britain that have few natural resources, and thus rely on imports for raw materials from which to make goods, more expensive imports soon feed into higher prices all around. Not only do exports slowly become more expensive but import-led inflation chokes off demand. But desperate times demand desperate measures and, despite anxiety among European officials that devaluations, if widespread, would lead to a destructive currency war, Japan and Britain seem prepared to gamble to haul themselves out of stagnation.

All this is bad news for America. As the keeper of the world’s reserve currency, used by investors and businesses as a safe haven from the uncertainties of other currencies, the dollar’s value is not merely a reflection of what traders feel about the American economy. America is therefore unable to devalue and is prevented from competing in the looming currency war. Nor, despite the death wish of some misguided congressmen, will America, the richest country in the world, default on its debts. But a high dollar is bad news for Americans as they watch the Japanese, the British and the Europeans manipulate their currencies to make wages cheaper and more competitive. In a race to the top, America is always well-placed to use its entrepreneurial ingenuity to great effect. In a race to the bottom, however, America can never win.

Nicholas Wapshott’s Keynes Hayek: The Clash That Defined Modern Economics is published by W.W. Norton. Read extracts here.

PHOTO: A woman eats a snack near a currency exchange office in Kiev, October 27, 2012. REUTERS/Vasily Fedosenko


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All we have to do is keep printing, and we won’t have to worry about that whole reserve currency thing for long.

Posted by Jameson4Lunch | Report as abusive

The world’s reserve currency, despite the politically-motivated lowering of the US debt by Standard & Poor’s (not followed by Moody’s and Fitch), is stronger than it has ever been in United States history.

So, should we be worried about the manipulations of a few rogue countries trying to survive such as the depressed United Kingdom and the declining Japanese? Zzzzzzzzz….

Posted by ptiffany | Report as abusive

ptiffany – Yes, our currency is stronger than it’s ever been… relatively. It’s lost nearly 97% of it’s value over the last century, but when everyone is racing to the bottom, we’re the laggards. Kinda the point of the article, I think.

We’ve tripled the money supply over the last few years, and exported most of the inflation. If we lose reserve currency status, that inflation comes home. China is building up a massive gold reserve, which many speculate is to create currency to compete with the petrodollar. A currency with an intrinsic value and high availability could easily displace the dollar’s WRC status.

So, yeah, we should be worried.

Posted by Jameson4Lunch | Report as abusive

Each nation has to sell as much as they import or go into debt. Therefore WTO rules aginst traffs and export subsidies is rediculus. Particlarly expoert subsidies, what ever a nation’s government does to grow export industries can be called an export subsidy.

Rules should be when ever a nation’s difference between exports and imports exceed let day 5%, it has to tax the exceeding half of the economy (exporting activites or non-exporting) and give it to the other half, at a rate the new WTO sets.

Posted by SamuelReich | Report as abusive

Well thought and well written. Thank you for shining a little light behind the curtain.

Posted by CaptnCrunch | Report as abusive

What I like is that, in spite of the actual and evident and demonstrated failure of QE1 to accomplish its stated goal, or even to move one iota towards its stated goal, the Fed has gone ahead with more.

This shows either group insanity, as, repeating the same action with the same undesired result over and over again, or deception, as, the real goal is not the stated goal, and the action is in fact accomplishing what it sets out to do.

“Something in the water at the Fed” I reject on grounds of general implausibility — though, of course, I could be wrong.

I think that the Fed is terrified, with or without justification, that our bond prices will drift up. A few more Republican budget/debt-ceiling stunts, a revival in Germany (now underway), and rolling over our mammoth debt could start to get more expensive — and then there is the fearsome spiral. I think the Fed is willing to take money, and lots of it, from taxpayers and consumers, and give it to Jamie Dimon, to eliminate even the hint of a beginning of that process.

But I would be interested to hear alternative explanations.

Posted by acebros | Report as abusive

Btw, is Britain still “a manufacturing country”? I thought that British export earnings have been dominated by invisibles for the past 100 years at least.

Posted by acebros | Report as abusive

plan to start wallpapering your living room with dollars.

Posted by rikfre | Report as abusive

Will Walmart be selling $s on a roll for hanging in the “little boys” room?

Posted by randburg100 | Report as abusive

“America is therefore unable to devalue…” You’ve got to be kidding me, right? Bernanke acknowledged early on that a depreciated currency was one of the benefits of QE. The US, with a stronger economy than the Eurozone or Japan, would also have a much stronger currency were it not for the fact that the Fed was quick off the blocks in the currency devaluation race

Posted by Tschurin | Report as abusive

It seems to me that all of this comes back to the banks being totally out of control. They have fought tooth and nail for the deregulation of the so-called ‘financial industry’, and for what purpose? So they can engage in pseudo-warfare using our livlihood for ammunition in an escalating engagement with no rules or conventions? If the activities of any enterprise constitute a threat to stability and security on a global scale, is it not time for governments to intervene? Unless, of course, instability and insecurity are desirable outcomes… in which case, forward the currency war!

Posted by UnderRated | Report as abusive