Aggressive monetary policy moves in recent years have been accompanied by a growing fear of a currency war. In a currency war, or competitive devaluation, countries attempt to weaken their currencies to boost exports, but each devaluation leads to counter devaluations. That’s not what’s going on now. However, whether a country is purposely devaluing its currency or is merely pursuing accommodative monetary policy is irrelevant, the consequences are the same. The recent meeting of G-20 finance ministers and central bankers highlights the lack of coherent policies to boost growth.
Exchange rates are a price, dependent on supply and demand. Trade and capital flows go both ways. The latest Treasury International Capital data reported $24.2 trillion in foreign purchases of long-term U.S. securities over the 12 months ending in December and $23.7 trillion in sales. Sales and purchases of foreign securities by U.S. residents were a lot smaller, around $7.2 trillion each. Net capital inflows totaled $292 billion last year, down from $490 billion in 2011. We’re talking large numbers here. Net capital inflows roughly match net trade outflows, and the dollar moves to equate the two.
While exchange rates are generally market-determined, there are a number of factors involved, including expectations of relative growth and central bank policy. All else equal, easier monetary policy implies a weaker exchange rate. Exchange rate policy is usually the responsibility of the government, not the central bank. In the U.S., the Treasury speaks for the dollar, not the Federal Reserve. The Fed can intervene in the currency markets, but only at the request of the Treasury. Still, while exchange rate policy falls under the government’s jurisdiction, there’s relatively little it can do about it. Intervention can have an impact in the short term, but the volume of trade and capital flows are much larger than the Treasury’s ability to influence the exchange rate for more than a short period.
In a competitive devaluation, a government coerces the central bank to ease monetary policy. The drop in interest rates weakens capital inflows (and encourages capital outflows), weakening the currency. Exporters become more competitive relative to their foreign counterparties. However, imports become more expensive, adding to upward pressure on inflation. The drop in real wages boosts labor demand. In the other country, imports become cheaper, but exporters become less competitive. There is incentive to match the devaluation. If every country cuts interest rates to boost exports, inflation is higher everywhere and nobody wins. Real incomes decline.
In the last few years, the U.S. Federal Reserve, the Bank of England, and the Bank of Japan have undertaken “extraordinary” monetary policy actions. Effectively, asset purchases are not much different from conventional policy moves. In normal circumstances, when the Fed lowers short-term interest rates, there is always someone who fears that it is sowing the seeds of future inflation. Accommodative monetary policy is not undertaken with the sole purpose of weakening the currency, but that hasn’t stop critics from making that claim. The central bank is said to be “exporting inflation” or “exporting unemployment.” The fear is that other central banks will be induced to ease monetary policy as well.
These concerns have some basis in history. In the Great Depression, the countries that abandoned the gold standard earlier had an easier time. However, as Fed Chairman Bernanke, a scholar of the Great Depression, noted “pursuit of export-led growth cannot ultimately succeed if the implications of that strategy for global growth and stability are not taken into account.” Countries cannot export their way to prosperity all at the same time. Moreover, while there is much hand-wringing about the level of exchange rates, volatility or instability in exchange rates has negative consequences for global trade.
A big part of the problem is that monetary policy is the only game in town. In the early stages of the recession, fiscal policy was stimulative and coordinated across countries. However, fear about large deficits led to a reversal in fiscal policy in most countries. Austerity was meant to restore confidence. Instead, it has made recoveries worse. In the U.S., fully half of the stimulus of the $831 billion American Recovery and Reinvestment Act was offset by contractionary government policies in state and local government.
Europe’s crisis is still referred to as a sovereign debt crisis and it’s commonly seen as a morality play (the virtue of living within one’s means). However, it’s really a problem of capital flows. Capital flowed into the peripheral countries when they entered the euro, then flowed out during the crisis. If the troubled economies had their own currencies, they could devalue. Real wages would adjust. You’d take your lumps, but then you’d have a way back. With a common currency that’s not possible.
In the U.S., we have mass hysteria over the budget deficit, which is a long-term problem, not a short-term crisis. Government spending has risen as a percentage of GDP, but that’s largely because GDP is nearly 6% below its potential. Federal government outlays actually fell in FY12, and the shortfall for FY13 will be less than was forecast in 2008.
It is with great sadness that I note the passing of Ralph Bloch, who was Chief Market Technician at Raymond James for 19 years. Ralph was “old school,” but beneath the often-gruff exterior, was a real gentleman. He will be missed.
© Raymond James
