Currency Wars - Perception and Reality. EICHENGREEN, Barry.

www.DGFI.com

Deutsche Asset & Wealth Management

9

Global Financial Institute

Your entry to in-depth knowledge in finance

Currency Wars: Perception and Reality May 2013

Prof. Barry Eichengreen

2 Author

Global Financial Institute

Prof. Barry Eichengreen George C. Pardee and Helen N. Pardee Professor of Economics and Political Science Department of Economics University of California, Berkeley Email: [email protected] Web Page: Click here Barry Eichengreen is the George C. Pardee and

fellow of the Center for Advanced Study in the

Helen N. Pardee Professor of Economics and

Behavioral Sciences (Palo Alto) and the Insti-

Professor of Political Science at the University

tute for Advanced Study (Berlin). He is a regu-

of California, Berkeley, where he has taught

lar monthly columnist for Project Syndicate.

since 1987. He is a Research Associate of the National Bureau of Economic Research (Cam-

Professor Eichengreen was awarded the Eco-

bridge, Massachusetts) and Research Fellow of

nomic

the Centre for Economic Policy Research (Lon-

Hughes Prize for Excellence in Teaching in

don, England). In 1997-98 he was Senior Policy

2002 and the University of California at Berke-

Advisor at the International Monetary Fund. He

ley

is a fellow of the American Academy of Arts

Teaching Award in 2004. He is the recipient

and Sciences (class of 1997).

of a doctor honoris causa from the American

History

Social

Association’s

Science

Division’s

Jonathan

R.T.

Distinguished

University in Paris, and the 2010 recipient of Professor Eichengreen is the convener of the

the Schumpeter Prize from the International

Bellagio Group of academics and economic

Schumpeter

officials and chair of the Academic Advisory

of Foreign Policy Magazine ‘s 100 Leading

Committee of the Peterson Institute of Inter-

Global Thinkers in 2011. He is Immediate Past

national Economics. He has held Guggenheim

President of the Economic History Associa-

and Fulbright Fellowships and has been a

tion (2010-11 academic year).

Society.

He

was

named

one

3 Table of contents

Global Financial Institute

Table of contents

Introduction............................................................................ 04

1.

History Lessons...................................................................... 06

2.

Reasoning by Analogy........................................................ 08

3.

The Fog of War....................................................................... 11

4. References............................................................................... 12

Introduction to Global Financial Institute Global Financial Institute was launched in November

perspective, the publications span a wide variety of

2011. It is a new-concept think tank that seeks to foster a

academic fields from macroeconomics and finance to

unique category of thought leadership for professional

sociology. Deutsche Asset & Wealth Management invites

and individual investors by effectively and tastefully

you to check the Global Financial Institute website regu-

combining the perspectives of two worlds: the world

larly for white papers, interviews, videos, podcasts, and

of investing and the world of academia. While primar-

more from Deutsche Asset & Wealth Management’s

ily targeting an audience within the international fund

Co-Chief Investment Officer of Asset Management Dr.

investor community, Global Financial Institute’s publica-

Asoka Wöhrmann, CIO Office Chief Economist Johannes

tions are nonetheless highly relevant to anyone who is

Müller, and distinguished professors from institutions

interested in independent, educated, long-term views

like the University of Cambridge, the University of Cali-

on the economic, political, financial, and social issues

fornia Berkeley, the University of Zurich and many more,

facing the world. To accomplish this mission, Global

all made relevant and reader-friendly for investment

Financial Institute’s publications combine the views of

professionals like you.

Deutsche Asset & Wealth Management’s investment experts with those of leading academic institutions in Europe, the United States, and Asia. Many of these academic institutions are hundreds of years old, the perfect place to go to for long-term insight into the global economy. Furthermore, in order to present a well-balanced

4 Currency Wars: Perception and Reality

Global Financial Institute

Currency Wars: Perception and Reality Prof. Barry Eichengreen May 2013

Introduction The problem of “currency wars” emerged as both a

toward products produced domestically at the expense

major concern and a source of confusion in early 2013.

of their neighbours – a process that is ultimately futile

This once obscure term, first uttered by Brazilian Finance

insofar as it provokes retaliation.

Minister Guido Mantega in response to the initial round

that in the case of a currency war, it is currency policy

of quantitative easing in the United States, came into

rather than trade policy that is being deployed.

widespread use following the formation of a new Japa-

is, however, the analytical problem that while trade

nese government under Prime Minister Shinzo Abe in

warfare destroys trade, creating a deadweight loss, off-

late 2012.

Mr. Abe indicated his intention of pursuing

setting devaluations simply return bilateral exchange

more aggressively reflationary monetary and exchange

rates to their initial levels with no enduring relative price

rate policies. This caused the yen to fall by 16% against

effects.

the dollar and 19% against the euro between the end of

other words.

The only difference is There

It is not clear that the analogy holds water, in

September, when it became likely that Mr. Abe would take power, and mid-February 2013, when his appoint-

Similarly, there is the implication that a currency war

ment of a new Bank of Japan governor was imminent.

can be said to have broken out when one or more

Both the term and the concerns to which it referred

countries

therefore migrated to the front pages of the financial

tive currency depreciation.

press.

engages

in

beggar-thy-neighbour

competi-

But it is not clear in this

A host of additional policymakers – some from

case whether all policies that result in currency or

emerging markets, such as Alexei Ulyukyev, first deputy

exchange-rate depreciation are necessarily competitive

chairman at the Russian Central Bank, and Bahk Jae-

or beggar-thy-neighbour.

wan, South Korea’s finance minister, and others from

its exchange rate depreciate, is it necessarily engaged

advanced

in a currency war?

countries,

like

Bundesbank

President

Jens

Just because a country sees

Weidmann – warned of the adverse consequences of currency manipulation, Mr. Weidmann referring omi-

Probably the most widely accepted definition of what

nously to an undesirable “politicisation of exchange

constitutes a currency war is “what countries did in the

rates.”

1930s.”

1

The currency-war problem then became a key

Starting in 1931, one country after another

topic at the meetings of the Group of Seven and Group

depreciated

its

currency.

Since

currencies

were

of Twenty this February, where it was the subject of a

pegged to gold rather than to one another, countries

carefully crafted set of communiques.2

depreciated by abandoning their pre-existing gold parities and allowing the domestic currency price of gold

But carefully crafted is not the same as clearly under-

to rise. This consequently had the effect of also raising

stood.

the domestic currency price of foreign currencies still

The confusion stems from the fact that there is

no widely accepted definition of a currency war.

The

pegged to gold at prevailing parities.3

term is not found in the leading textbooks of economics. There is the implication that a currency war is to be

As the story is conventionally told, this enhanced the

understood by analogy with the concept of a trade war,

competitiveness of countries depreciating their curren-

in which countries use trade policy to shift spending

cies but worsened that of the remaining gold-standard

 uoted in Randow and Schneeweiss (2013). Q See Group of Seven (2013) and Group of Twenty (2013). 3 The gold parity referred to the weight of gold of specified purity in the national monetary unit as specified by law or statute of a country said to be on the gold standard. 1  2

5 Currency Wars: Perception and Reality

countries.

Global Financial Institute

This saddled the latter with overly strong

this was not well understood at the time.

As a result,

exchange rates, creating pressure for them to respond

the point is not understood today by those advancing

tit for tat, as they ultimately did. After five years of “com-

the conventional story.

petitive devaluations,” exchange rates had returned to levels very close to those prevailing in early 1931.

No

In

part,

contemporary

misunderstanding

arose

from

country succeeded in engineering a sustained improve-

the fact that interwar governments did a poor job of

ment in competitiveness or, it is argued, achieved

communicating their intentions.

faster economic growth.

the fact that they did a poor job of implementing their

other

adverse

But there were a variety of

consequences

ranging

from

height-

In part it arose from

policies; they could have done much more to accentu-

ened exchange rate uncertainty that disrupted trade

ate the positive-sum aspects.

and production to the imposition of trade barriers and

the fact that policymakers continued to view their cur-

exchange controls by countries with overvalued curren-

rent situation through the lens of past problems, failing

cies and weakened balances of payments.

to acknowledge that circumstances and therefore the

4

It is not an

exaggeration to say that popular accounts blame the

And in part it arose from

appropriate policies had changed.

currency wars of the 1930s for aggravating the political tensions that made it more difficult for countries to col-

The same factors are again present today, once more distort-

laborate in averting the military and diplomatic conflicts

ing the debate over currency policies. Policymakers have

that led ultimately to World War II.5

done a poor job communicating their intentions. They could have done more to accentuate positive-sum aspects of their

In fact, this conventional narrative is oversimplified and

actions. And, along with market participants, they have had a

misleading in important respects.

This in turn means

tendency to view policies through the distorting lens of past

that today’s debate over currency wars, because it is

problems rather than current circumstances. Understanding

heavily informed by that narrative, is itself oversimpli-

these shortcomings of the present debate and correcting the

fied and misleading.

resulting misapprehensions would go a long way toward solv-

The modern literature empha-

sises that the policy changes associated with currency

ing the currency war problem.

depreciation in the 1930s were not actually zero sum. To the contrary, those policy changes left all countries better off relative to the status quo ante, in which policy did not change and exchange rates did not move.

But

These negative side effects were highlighted by Ragnar Nurkse (1944) in his influential contemporary account, which helped to clear the way for the Bretton Woods System of pegged-but-adjustable exchange rates. A recent, somewhat revisionist treatment is Eichengreen and Irwin (2010). 5 See for example Kennedy (1999). 4 

6 Currency Wars: Perception and Reality

Global Financial Institute

1. History Lessons The background to the currency and exchange rate

cut interest rates to encourage borrowing and spend-

problems of the 1930s was, of course, the depression

ing.

and deflation that started in 1929. In turn, that depres-

banking system threatened to fatally weaken the cur-

sion and deflation must be understood in the context of

rency.

the gold standard, the monetary regime providing the

ited from the 1920s, that central banks would be pres-

structure for global monetary and financial affairs.6

sured to monetise public debts.

Injecting liquidity in order to support a distressed Running budget deficits rekindled fears, inherGovernments were

therefore forced to cut public spending and raise taxes The 1920s monetary regime was a gold-exchange stan-

in order to preserve confidence in their exchange rate

dard rather than a pure gold standard.

commitments.

and

governments

operated

under

Central banks

statutes

obligat-

ing them to back their monetary liabilities with gold

It might be thought that these policies of austerity, pur-

and convertible foreign exchange.7

sued in the face of depression and deflation, could not

Other than this

provision for holding reserves in the form of foreign

be sustained indefinitely.

exchange, the regime had many of the features of a text-

ain was the first major country to abandon them and

book gold standard.

depreciate its currency.

unrestricted.

International financial flows were

Indeed, they could not.

Brit-

It had a Labour government

With the capital account of the balance

that could not agree on budgetary economies and high

of payments open, domestic interest rates could not

unemployment that rendered the central bank reluctant

deviate significantly from those in the rest of the world.

to raise interest rates further in order to stem capital

If domestic policymakers sought to depress rates fur-

flight.11

ther, capital would migrate to foreign financial markets

1931, and the pound quickly fell from $4.86 to a low of

where they were higher, causing the central bank to

$3.40, from which it recovered modestly before stabi-

lose gold and foreign exchange reserves, and threaten-

lising.

ing the maintenance of gold convertibility.

members of the Commonwealth and Empire and British

standard open-economy “trilemma.”8

This is the

With exchange

It suspended gold convertibility in September

Some two dozen other economies, principally

trading partners, quickly followed suit.

The next shoe

rates pegged and capital markets open, central banks

to drop was Japan, whose finance minister Korkiyo

had limited monetary policy room for manoeuvre.

Takahashi

implemented

an

aggressively

expansion-

ary monetary policy that pushed down the yen startThe gold-exchange standard had been put back in place

ing in December.

President Franklin Delano Roosevelt

in the 1920s after roughly a decade of suspension, dur-

embargoed gold exports on March 5th, 1933, his first

ing which a number of current and former belligerents

full day in office.

had suffered high inflation.

He made that embargo permanent

That experience in turn 48

in April and actively pushed up the dollar price of gold

shaped their expectations of risks and outcomes in the

(pushed down the dollar exchange rate) from October.

event that gold convertibility was again 32 suspended.

A number of U.S. trade partners, principally in Latin

9

America, followed the dollar down.

In January 1934,

As it happened, deflation rather than inflation turned

when the dollar was again stabilised against gold, the

out to be the immediate danger.10

sterling/dollar exchange rate was back to roughly the

When it developed

after 1929, central banks and governments had little freedom of action.

level prevailing before September 1931.

As long as they remained on the

gold standard, they could not unilaterally take steps

These efforts by Britain, the U.S., and Japan to depre-

to stem the fall in prices.

ciate sterling, the dollar, and the yen made life more

They could not unilaterally

As I argued in Eichengreen (1992), on which the remainder of this section draws. Typically at ratios of 33 to 40 per cent. 8 See Obstfeld, Shambaugh and Taylor (205). 9 The hyperinflations in Germany, Austria, Hungary, and Poland being extreme cases in point. 10 Describing the origins of the global deflation would take us too far afield; in this, see Bernanke (1995) and Eichengreen (2004). 11 That Labour government was succeeded by a National government which agreed on budgetary economies in August, but by this time it was too late. 6  7 

7 Currency Wars: Perception and Reality

Global Financial Institute

difficult for countries still on the gold standard.

(That

Takahashi

supplemented

his

reflationary

monetary

these are the same three countries currently under

policy with an increase in public spending and instruc-

attack for being engaged in currency war is presum-

tions that the Bank of Japan purchase the resulting

ably a coincidence.)

increase in the public debt.

Having lost international competi-

In the U.S., FDR used his

tiveness, these so-called gold-bloc countries saw their

“bombshell message” to the World Economic Confer-

balances of payments accounts weaken and gold flow

ence of June-July 1933 to signal that he was unwilling

out of their central banks.

to restore the gold standard.

Forced to raise interest rates

He was not prepared to

to defend the reserve position rather than cutting them

privilege exchange rate stability (what he referred to in

to support the economy, their depressions deepened.

that message as “the old fetishes of international bank-

The result was not an equilibrium in either the eco-

ers”).

nomic or political sense.

The bombshell message may have made interna-

Economically, the condition

tional cooperation on trade policy, security policy, and

of domestic financial institutions continued to worsen.

other matters more difficult, but it was a strong signal

Politically, opposition welled up against policies of aus-

of a durable change in the monetary regime.

terity.

The remaining members of the gold bloc pro-

gressively fell by the wayside.

Czechoslovakia and Italy

These new policies had other important effects apart

devalued in 1934, Belgium in 1935, Poland, France, the

from their impact on exchange rates.

Netherlands, and Switzerland in 1936, returning their

est rates encouraged interest-rate sensitive forms of

exchange rates to roughly the same levels against the

spending, in the U.K. for example, where the literature

dollar and sterling that prevailed before 1931. These

refers to the “housing boom” of the 1930s.12

competitive devaluations gave rise to a good deal of

upward pressure on asset prices which, other things

damaging exchange rate and financial volatility, but at

equal, stimulated investment spending.

the end of the day, it is said, they changed nothing.

deflation, they stemmed the rise in debt burdens and squeeze on profits.

Such is the conventional narrative.

The modern litera-

Lower inter-

They put By halting

By creating expectations of higher

future prices, they encouraged households to shift

ture on exchange rate policy in the 1930s, beginning

consumption from the future to the present.

with Eichengreen and Sachs (1985), disputes this view

ing central banks more freedom of action, they allowed

that the exchange rate policies of the 1930s were with-

them to intervene as lenders of last resort to limit bank

out positive effect.

distress.13

While currency depreciation did

By giv-

And insofar as the policies had these stabi-

switch demand toward domestic goods and away from

lising effects on the initiating country, they encouraged

their foreign substitutes, this was not its exclusive or

residents to spend more on foreign as well as domestic

even its principal impact.

goods.

Rather, abandoning the com-

Currency devaluation by an individual country

mitment to peg the exchange rate allowed countries

may have had negative spillovers on its neighbours via

to replace the deflationary measures of the preceding

the exchange rate channel, but it had positive spillovers

period with reflationary monetary policies.

via these interest rate, asset price, and expectations

Going off

the gold standard was a credible way of signaling this

channels.

commitment to prioritise price stability over exchange

dominated when a single policy was taken in isolation,

Even if the negative exchange rate spillovers

rate stability.

once the entire round of exchange rate changes was complete those negative spillovers were gone and only

Thus, six months after abandoning the gold standard,

the positive interest rate, asset price, and expectation

the Bank of England began cutting interest rates; by

effects remained.

July 1932 these had reached the historically low level of 2%, inaugurating a new era of “cheap money.”

The

These conclusions are, of course, inconsistent with the

Swedish government and Riksbank replaced the gold

presumption that monetary policy was impotent in the

standard with an explicit price level target.

1930s because interest rates were at the zero lower

12  13

In Japan,

See Middleton (2010) for references. The cross-country evidence can be found in Grossman (1994).

8 Currency Wars: Perception and Reality

bound.14

Global Financial Institute

Cross-country comparisons, calibration exer-

depreciation tended to dominate the positive spillovers

cises, and national case studies, all using data from the

transmitted through now lower interest rates and infla-

1930s, have combined to overturn this presumption.

tionary expectations.

These studies highlight that interest rates were still

to more clearly explain their intentions – which were

significantly above zero prior to the change in policy

not to beggar their neighbours but to stabilize their own

regime; the change therefore gave central banks fur-

prices, economies, and financial systems – caused their

ther room to cut. They remind us that even when nomi-

motives to be widely misunderstood.

15

And the failure of policymakers

nal interest rates are near zero, central banks can still affect the real interest rates on which allocation deci-

Thus, to the extent that there was a currency problem

sions depend through the expectations channel – by

in the 1930s, it stemmed not from the decision of coun-

using forward guidance and asset purchases to create

tries abandoning the gold standard to reflate, but from

expectations of inflation rather than deflation.

the failure of the countries of the gold bloc to do like-

FDR’s

gold purchases and Takahashi’s government bond pur-

wise.

chases can be thought of as analogous to quantitative

lier experience with high inflation in France, Belgium,

That failure was rooted, as noted above, in ear-

easing, while the Bank of England’s commitment to

Poland, and the Central European countries that now

keep interest rates low and the Riksbank’s commitment

clung to the gold standard with the help of exchange

to target the price level can be thought of as forward

control.16

guidance.

ued to perceive current economic and financial circum-

Policymakers and their constituents contin-

stances through the lens of past problems, with proModern studies thus conclude that countries abandon-

foundly negative consequences.

ing the gold standard and allowing their currencies to depreciate recovered most quickly from the 1930s

The problem in the 1930s, then, was not too much cur-

depression.

rency warfare, but too little.

ous.

Recovery was, however, less than vigor-

Countries abandoning the gold standard and

depreciating their currencies were reluctant to implement aggressively reflationary policies.

In Britain, for

example, the Bank of England, concerned that the sterling exchange rate could collapse in the absence of its

2. Reasoning by Analogy

golden anchor, took three full quarters to convince itself

Many of these points have analogues in the current

that cheap money was safe and to cut interest rates to

debate.

2%.

First, there is the view, implicit in the critiques

Even then it remained reluctant to cut them fur-

of emerging market policymakers, that the unconven-

ther. FDR, although depreciating the dollar by 50%, put

tional monetary policies of advanced-country central

the U.S. back on the gold standard at the now higher

banks are ineffectual.

gold price in January 1934, contrary to the advice of

lost its potency now that interest rates are at the zero

John Maynard Keynes and others.

lower bound, just as it allegedly lost its potency in the

In the subsequent

period, the Treasury repeatedly sterilised gold inflows,

1930s.

limiting the growth of money and credit.

left.

Central banks

Monetary policy, they allege, has

Only the negative side-effects, it follows, are

and governments could not free themselves of the specter of the 1920s inflations and thus were reluctant

While there is less than full consensus on the efficacy

to make full use of their newfound monetary room for

of unconventional monetary policies at the zero lower

manoeuvre.

bound, a growing body of literature studying different episodes suggests that such policies are not entirely

As a result, the beggar-thy-neighbour effect of currency

without effect.

Oda and Ueda (2005) and Ugai (2006)

A presumption that is popularly cited as explaining Keynes’s “discovery” of the importance of using activist fiscal policy in a liquidity trap. 15 See, respectively, Bernanke and James (1991), Eggertsson (2008), and Romer (1992) for examples. 16 In the cases of Switzerland and the Netherlands, an additional motive was the desire not to jeopardise the position of Zurich and Amsterdam as international financial centres and the power of the banking lobby. 14

9 Currency Wars: Perception and Reality

Global Financial Institute

analyse the impact of the Bank of Japan’s experience

the extent that central banks fail to complement open

with quantitative easing between 2001 and 2006 and

mouth operations pushing down the real exchange rate

conclude in favor of small but noticeable impacts on

with open market operations and other asset purchases

medium- and long-term interest rates.

Gagnon, Raskin,

pushing down real interest rates, their neighbours will

Remarche, and Sack (2011) report evidence, derived

have correspondingly more reason to complain about

using a variety of methodological approaches, of posi-

the spillover effects on output and employment in other

tive effects of quantitative easing in the United States.

countries.

Krishnamurthy

and Vissing-Jorgensen

(2010)

look

at

low frequency variations in the supply of long-term

But the exchange rate channel can also be important

Treasury bonds like those that would follow from quan-

for signaling the policy authorities’ commitment to

titative easing and identify effects on interest rates on

do what it takes to hit their inflation target.

other relatively safe assets.

Krishnamurthy and Vissing-

(2003) refers to the combination of a price-level target

Jorgensen (2011), disaggregating further, find evidence

path, a zero interest rate commitment and, importantly,

of a signaling channel, an expected inflation channel,

currency depreciation and a commitment to maintain-

and a demand-for-long-term-safe-assets channel trans-

ing a level for the exchange rate as the “foolproof way”

mitting effects of both the first and second rounds of

of ending deflation. Insofar as ending the deflation and

quantitative easing by the Federal Reserve.

Svensson

Looking

avoiding the extended period of economic stagnation to

back at Operation Twist in the 1960s, Swanson (2011)

which it can give rise is good not just for the initiating

finds a small but significant impact on long-term inter-

country but also its trade and financial partners, posi-

est rates operating through the portfolio rebalancing

tive spillovers on other countries from depreciation of

channel.

its exchange rate may still dominate.

Joyce, Lasaosa, Stevens, and Tong (2010)

similarly find evidence of the operation of the portfolio rebalancing channel in the response of gilt prices

The studies referred to earlier in this section suggest

to large-scale asset purchases by the Bank of Eng-

that

land starting in March 2009.

through the portfolio rebalancing channel that leads

In a companion paper,

unconventional

monetary

policies

also

operate

Kapetanios, Mumtaz, Stevens, and Theodoridis (2010)

to changes in the term structure of interest rates.

IMF

conclude that those Bank of England purchases had an

(2011) finds that portfolio-rebalancing-related interest-

effect on the level of real GDP of around 1 ½ % and

rate effects dominated the other negative cross-border

raised the annual rate of CPI inflation by about 1 ¼ per-

spillover effects of QE1 and QE2 – in other words, that

centage points at its peak.

Different studies consider

the spillover impact on foreign output was positive on

different episodes and arrive at different point esti-

balance, the complaints of emerging market policymak-

mates, but as a group they are inconsistent with the

ers notwithstanding.

view that unconventional monetary policies are without effect.

This casts doubt on the assertion by some

Third, there are complaints about other negative side

observers based in emerging markets that such policies

effects of unconventional monetary policies.

should simply be abandoned.

is that quantitative easing is encouraging renewed

The worry

financial excesses in advanced countries and emergSecond, there is the view that unconventional monetary

ing markets alike.

policies operate only by pushing down currencies, with

Equity markets in the United States are becoming richly

beggar-thy-neighbour

coun-

valued as investors facing near-zero interest rates on

To be sure, the exchange rate channel can be

safe assets stretch for yield by purchasing riskier instru-

tries.

consequences

for

other

Risks are being allowed to build up.

important for switching expenditure toward domestic

ments.

The natural process of deleveraging by the

goods.

Insofar as this channel dominates, the effect

household and financial sectors needed to produce a

will be to beggar thy neighbour. Just as in the 1930s, to

safer and more stable economy is being frustrated, the

10 Currency Wars: Perception and Reality

Global Financial Institute

implication follows.

countries is not to jawbone the Federal Reserve and Bank of Japan to abandon quantitative easing, which

This

view

has

an

analogue

in

response to the Great Depression.17

the “liquidationist”

would make for slower global and even possibly slower

U.S. policymak-

emerging-market growth, but to tighten their own

ers inside and outside the Fed worried that monetary

supervision and regulation of financial markets.

accommodation would cause the development of an

the extent that conventional regulatory instruments are

even larger Wall Street boom and bubble, leading sub-

not up to the task, emerging market policy makers can

sequently to an even larger crash.

Herbert Hoover’s

resort to capital inflow taxes and controls as

famously

line of defence against financial excesses resulting from

Treasury that

Secretary

restraint

was

Andrew

Mellon

necessary

to

teach

argued

speculators

And to

a second

foreign policies.20

a lesson and “purge the rottenness out of the system.”18

Similar views were advanced by Austrian and

Similarly, to the extent that low interest rates in the

other Continental European economists from Hayek to

advanced

Schumpeter.

emerging markets that fan inflation, result in currency

countries

encourage

capital

inflows

into

overvaluation, and create worries of overheating, the The modern literature on the Great Depression and on

first-best response is not for officials there to pressure

financial crises generally acknowledges that activism

advanced country central banks to abandon their low

has risks but suggests that inaction in the face of cri-

interest rate policies but to adjust their own policies

sis also has a downside.

appropriately.

And to the extent that pol-

The first-best response is for emerging

icy activism in response to crisis encourages financial

markets to tighten fiscal policy.

Tightening fiscal policy

excesses, these are best addressed by tightening super-

puts downward pressure on domestic spending.

vision and regulation of financial markets, not by pre-

downward pressure on asset valuations.

mature abandonment of supportive monetary policies.

inflation, other things equal.

Some recent studies have questioned this “separation

rates and, therefore, smaller capital inflows and less

principle” – they have questioned whether there exists

pressure for real exchange rate appreciation.

an adequate array of monetary and regulatory instru-

ing sovereign debt burden, it puts the economy in a

ments, so that monetary policy can be assigned to infla-

stronger position going forward.

It puts

It means less

It means lower interest By reduc-

tion and growth while regulation is assigned to financial stability.19

Maybe not, but if not the call should be for

The objection here is that political constraints make

policymakers to develop a wider array of instruments,

it difficult to adjust fiscal policy, which is even more

not for central banks and governments to abandon the

politicised than monetary policy.

pursuit of all other valid goals in the interest of financial

the call should be to make it easier to implement opti-

stability.

mal adjustments of fiscal policy in emerging markets

Maybe so, but then

by strengthening automatic stabilisers or delegating The same goes for the complaint that unconventional

aspects of fiscal policy to an independent fiscal council,

monetary policies in the advanced countries are feed-

not to insist that advanced country central banks aban-

ing financial excesses in emerging markets.

don the pursuit of price stability and recovery.

The worry

itself is not without foundation: As Chen, Filardo, He and Zhu (2011) show, quantitative easing in the United

The European Central Bank, spokesmen for which have

States has had a strong impact on credit growth,

complained about how the policies of other central

asset prices, and capital inflows in emerging markets.

banks have produced an uncomfortably strong euro

But the first-best response for policymakers in those

exchange rate, is in a different position.

See DeLong (1990). As quoted in Hoover (1952). 19 See Committee on International Economic Policy and Reform (2011). 20 This is the justification of capital inflow restrictions as a second-best form of financial regulation first developed, if I am correct, in Eichengreen and Mussa (1998). 17 18

In contrast to

11 Currency Wars: Perception and Reality

Global Financial Institute

emerging markets, spokesmen for which have similarly

but that it would only take additional steps to foster

complained that their exchange rates are uncomfort-

expectations of higher prices, lower real interest rates,

ably strong, the Eurozone does not currently suffer from

and more spending 12 or more months in the future,

excessive inflation, frothy asset markets, or risk of eco-

that statement further heightened fears abroad that the

nomic overheating – to the contrary.

new strategy was exchange-rate-centered and beggar

Eurozone inflation

fell to 2% in January in line with the ECB’s target, while

thy neighbour.

core inflation at 1.2% is running below that. The fourth quarter of 2012 saw Eurozone GDP shrink by 0.6%.

It may be that the essence of Japan’s new monetary policy strategy is the higher inflation target of 2% and

The standard policy prescription for a central bank

that the Bank of Japan will make a concerted effort to

engaged in flexible inflation targeting and worried by

achieve it, creating expectations of a higher future price

an overly strong exchange rate would be to join the cur-

level and encouraging additional spending by Japanese

rency wars.

consumers – something that would be more likely to

In the event, the ECB is not a conventional

inflation-targeting central bank.

It has a mandate to

have positive spillovers for other countries.

If so, this

hold inflation at or below its target of 2% but not to pur-

fact needs to be conveyed more clearly to avoid fanning

sue other goals.

fears of currency war.

The European public, whose approval

lends the ECB’s policies political legitimacy, continues to worry about inflation, which was yesterday’s problem but is less obviously today’s or even tomorrow’s. The analogy with the deflationary 1930s – when central banks were haunted by the spectre of inflation in an earlier decade, in turn feeding their reluctance to take more aggressive monetary action – is direct.

How the

3. The Fog of War “Currency war” is now a standard trope in journalis-

ECB squares this circle will have implications not just

tic accounts of monetary policy.

But what exactly

for the global currency wars, but for the future of the

constitutes “currency warfare” remains unclear.

Eurozone itself.

every economic policy that is associated with a weaker

Not

exchange rate is undesirable, and not every domestic A final analogy with the 1930s is the failure of policy

policy associated with a weaker exchange rate nec-

makers in countries following unconventional monetary

essarily redounds to the disfavor of other countries.

policies to adequately communicate their goals and

Officials warning of currency wars would do better to

strategies.

distinguish positive from negative effects of the foreign

In late December, Japan’s incoming prime

minister made a series of comments about the desir-

monetary policies of which they complain.

ability of resisting a strong yen that were interpreted

do well to consider the alternatives.

in terms of the desirability of a weaker yen exchange

markets really be better off if advanced countries at

rate.

risk of deflation and recession abandoned their uncon-

By focusing on the exchange rate rather than

They would

Would emerging

on measures to push up the price level, reduce inter-

ventional policies?

est rates, and encourage spending, those comments

could spend less time complaining about advanced

fanned fears that the strategy was intentionally beggar

country policies and more time identifying and imple-

thy neighbour.

menting an appropriate policy response.

In its first policy statement for 2013,

Policymakers in emerging markets

Policymakers

the Bank of Japan then signaled its responsiveness to

in advanced countries, for their part, need to do a better

the new government’s desires, but announced that it

job of communicating the intent of their policies.

would consider further ramping up its programme of

then are we likely to see our way through the fog of war.

asset purchases only in 2014.

By creating expectations

that it might acquiesce to a weaker yen exchange rate

Only

12 Currency Wars: Perception and Reality

Global Financial Institute

4. References Bernanke, Ben (1995), “The Macroeconomics of the

IMF Occasional Paper no.172, Washington, D.C.: IMF

Great Depression: A Comparative Approach,” Journal

(August).

of Money, Credit and Banking 27, pp.1-28. Eichengreen, Barry and Jeffrey Sachs (1985), Bernanke, Ben and Harold James (1991), “The Gold

“Exchange Rates and Economic Recovery in the

Standard, Deflation and Financial Crisis in the Great

1930s,” Journal of Economy History 49, pp.924-946.

Depression,” in R. Glenn Hubbard (ed.), Financial Markets and Financial Crises, Chicago: University of Chi-

Gagnon, Joseph, Mathew Raskin, Julie Remache, and

cago Press, pp.33-68.

Brian Sack (2011), “The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases,” Inter-

Chen, Qianying, Andrew Filardo, Dong He, and Feng

national Journal of Central Banking 7, pp. 3-43.

Zhu (2011), “International Spillovers of Central Bank Balance Sheet Policies,” BIS Paper no.66, pp.230-274.

Grossman, Richard (1994), “The Shoe that Didn’t Drop: Explaining Banking Stability During the Great Depres-

Committee on International Economic Policy and

sion,” Journal of Economic History 54, pp.654-682.

Reform (2011), Rethinking Central Banking, Washington, D.C.: Brookings Institution.

Group of Seven (2013), “Statement by G7 Finance Ministers and Central Bank Governors” (12 February),

DeLong, J. Bradford (1990), “‘Liquidation’ Cycles:

http://www.g8.utoronto.ca/finance/index.htm .

Old-Fashioned Real Business Cycle Theory and the Great Depression,” NBER Working Paper no.3546

Group of Twenty (2013), “Communique of Meeting of

(December).

Finance Ministers and Central Bank Governors, Moscow, 15-16 February 2013,” http://en.g20russia.ru/

Eggertsson, Gauti (2008), “Great Expectations and the

documents/.

End of the Depression,” American Economic Review 98, pp.1476-1516.

Hoover, Herbert (1982), The Memoirs of Herbert Hoover: The Great Depression, New York: Macmillan

Eichengreen, Barry (1992), Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, New

International Monetary Fund (2011), “United States:

York: Oxford University Press.

Spillover Report – 2011 Article IV Consultation,” Washington, D.C.: IMF (22 July).

Eichengreen, Barry (2004), “Understanding the Great Depression,” Canadian Journal of Economics 37,

Joyce, Michael, Ana Lasaosa, Ibrahim Stevens, and

pp.1-27.

Matthew Tong (2010), “The Financial Market Impact of Quantitative Easing,” Bank of England Working Paper

Eichengreen, Barry and Douglas Irwin (2010), “The

no.393 (August).

Slide to Protectionism in the Great Depression: Who Succumbed and Why?” Journal of Economic History

Kapetanios, George, Haroon Mumtaz, Ibrahim Stevens,

70, pp.871-897.

and Konstantinos Tehodoridis (2012), “Assessing the Economy-wide Effects of Quantitative Easing,” Eco-

Eichengreen, Barry and Michael Mussa, with Giovanni

nomic Journal 122, pp.F316-F347.

Dell’Arricia, Enrica Detagiache, Gian Maria MilesiFerretti, and Andrew Tweedie (1998), “Capital Account

Kennedy, David (1999), Freedom from Fear: The Ameri-

Liberalization: Theoretical and Practical Aspects,”

can People in Depression and War, 1929-1945, New

13 Currency Wars: Perception and Reality

York: Oxford University Press.

Global Financial Institute

Paper no.06-E-10, Monetary Affairs Department, Bank of Japan (October).

Krishnamurthy, Arvind and Annette Vissing-Jorgensen (2011), “The Effects of Quantitative Easing on Interest

Svensson, Lars (2003), “Escaping from a Liquidity Trap

Rates: Channels and Implications for Policy,” NBER

and Deflation: The Foolproof Way and Others,” Journal

Working Paper no.17555 (October).

of Economic Perspectives 17, pp.145-166.

Krishnamurthy, Arvind and Annette Vissing-Jorgensen

Swanson, Eric T. (2011), “Let’s Twist Again: A High-

(2010), “The Aggregate Demand for Treasury Debt,”

Frequency Event-Study Analysis of Operation Twist

unpublished manuscript, Northwestern University.

and Its Implications for QE2,” Brookings Papers on Economic Activity, Spring, pp. 151-88.

Middleton, Roger (2010), “British Monetary and Fiscal Policy in the 1930s,” Oxford Review of Economic Policy 26, pp.414-441. Nurkse, Ragnar (1944), International Currency Experience, Geneva: League of Nations. Obstfeld, Maurice, Jay Schambaugh, and Alan Taylor (2005), “The Trilemma in History: Tradeoffs Among Exchange Rates, Monetary Policies and Capital Mobility,” Review of Economics and Statistics 87, pp.423-438. Oda, Nobuyuki and Kazuo Ueda (2005), “The Effects of the Bank of Japan’s Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach,” Bank of Japan Working Paper no. 05-E-6, Monetary Affairs Department, Bank of Japan (April). Randow, Jana and Zoe Schneeweiss (2013), “Weidmann Says Exchange Rates Should be Determined by Markets,” Bloomberg Business Week (15 February), http://www.businessweek.com/news/2013-02-15/weidmann-says-exchange-rates-should-be-determined-bymarkets. Romer, Christina (1992), “What Ended the Great Depression?” Journal of Economic History 52, pp.757-784. Ugai, Hiroshi (2006), “Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses,” Working

14 Disclaimer

Global Financial Institute

Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. This material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither Deutsche Bank AG nor any of its affiliates, gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the Deutsche Bank Group, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The opinions and views presented in this document are solely the views of the author and may differ from those of Deutsche Asset & Wealth Management and the other business units of Deutsche Bank. The views expressed in this document constitute the author’s judgment at the time of issue and are subject to change. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. Any forecasts provided herein are based upon the author’s opinion of the market at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. Investments are subject to risks, including possible loss of principal amount invested. Publication and distribution of this document may be subject to restrictions in certain jurisdictions.

© Deutsche Bank · May 2013

R-31183-1 (4/13)