CHAPTER 3
Reflections on a Golden Age
“We’re in the midst of an international currency war.”
Guido Mantega, Finance Minister of Brazil,
September 27, 2010
“I don’t like the expression . . . currency war.”
Dominique Strauss-Kahn, Managing Director, IMF,
November 18, 2010
Acurrency war, fought by one country through competitive devaluations of its currency against others, is one of the most destructive and feared outcomes in international economics. It revives ghosts of the Great Depression, when nations engaged in beggar-thy-neighbor devaluations and imposed tariffs that collapsed world trade. It recalls the 1970s, when the dollar price of oil quadrupled because of U.S. efforts to weaken the dollar by breaking its link to gold. Finally, it reminds one of crises in UK pounds sterling in 1992, Mexican pesos in 1994 and the Russian ruble in 1998, among other disruptions. Whether prolonged or acute, these and other currency crises are associated with stagnation, inflation, austerity, financial panic and other painful economic outcomes. Nothing positive ever comes from a currency war.
So it was shocking and disturbing to global financial elites to hear the Brazilian finance minister, Guido Mantega, flatly declare in late September 2010 that a new currency war had begun. Of course, the events and pressures that gave rise to Mantega’s declaration were not new or unknown to these elites. International tension on exchange rate policy and, by extension, interest rates and fiscal policy had been building even before the depression that began in late 2007. China had been repeatedly accused by its major trading partners of manipulating its currency, the yuan, to an artificially low level and of accumulating excess reserves of U.S. Treasury debt in the process. The Panic of 2008, however, cast the exchange rate disputes in a new light. Suddenly, instead of expanding, the economic pie began to shrink and countries formerly content with their share of a growing pie began to fight over the crumbs.
Despite the obvious global financial pressures that had built up by 2010, it was still considered taboo in elite circles to mention currency wars. Instead international monetary experts used phrases like “rebalancing” and “adjustment” to describe their efforts to realign exchange rates to achieve what were thought by some to be desired goals. Employing euphemisms did not abate the tension in the system.
At the heart of every currency war is a paradox. While currency wars are fought internationally, they are driven by domestic distress. Currency wars begin in an atmosphere of insufficient internal growth. The country that starts down this road typically finds itself with high unemployment, low or declining growth, a weak banking sector and deteriorating public finances. In these circumstances it is difficult to generate growth through purely internal means and the promotion of exports through a devalued currency becomes the growth engine of last resort. To see why, it is useful to recall the four basic components of growth in gross domestic product, GDP. These components are consumption (C), investment (I), government spending (G) and net exports, consisting of exports (X) minus imports (M). This overall growth definition is expressed in the following equation:
GDP = C + I + G + (X − M)
An economy that is in distress will find that consumption (C) is either stagnant or in decline because of unemployment, an excessive debt burden or both. Investment (I) in business plant and equipment and housing is measured independently of consumption but is nevertheless tied closely to it. A business will not invest in expanded capacity unless it expects consumers to buy the output either immediately or in the near future. Thus, when consumption lags, business investment tends to lag also. Government spending (G) can be expanded independently when consumption and investment are weak. Indeed, this is exactly what Keynesian-style economics recommends in order to keep an economy growing even when individuals and businesses move to the sidelines. The problem is that governments rely on taxes or borrowing to increase spending in a recession and voters are often unwilling to support either at a time when the burden of taxation is already high and citizens are tightening their own belts. In democracies, there are serious political constraints on the ability of governments to increase government spending in times of economic hardship even if some economists recommend exactly that.
In an economy where individuals and businesses will not expand and where government spending is constrained, the only remaining way to grow the economy is to increase net exports (X − M) and the fastest, easiest way to do that is to cheapen one’s currency. An example makes the point. Assume a German car is priced in euros at €30,000. Further assume that €1 = $1.40. This means that the dollar price of the German car is $42,000 (i.e., €30,000 ×
$1.40/€1 = $42,000). Next assume the euro declines to $1.10. Now the same €30,000 car when priced in dollars will cost only $33,000 (i.e., €30,000 × $1.10/€1 = $33,000). This drop in the dollar price from $42,000 to $33,000 means that the car will be much more attractive to U.S. buyers and will sell correspondingly more units. The revenue to the German manufacturer of €30,000 per car is the same in both cases. Through the devaluation of the euro, the German auto company can sell more cars in the United States with no drop in the euro price per car. This will increase the German GDP and create jobs in Germany to keep up with the demand for new cars in the United States.
Imagine this dynamic applied not just to Germany but also to France, Italy, Belgium and the other countries using the euro. Imagine the impact not just on automobiles but also French wine, Italian fashion and Belgian chocolates. Think of the impact not just on tangible goods but also intangibles such as computer software and consulting services. Finally, consider that this impact is not limited solely to goods shipped abroad but also affects tourism and travel. A decline in the dollar value of a euro from $1.40 to $1.10 can lower the price of a €100 dinner in Paris from $140 to $110 and make it more affordable for U.S. visitors. Take the impact of a decline in the dollar value of the euro of this magnitude and apply it to all tangible and intangible traded goods and services as well as tourism spread over the entire continent of Europe, and one begins to see the extent to which devaluation can be a powerful engine of growth, job creation and profitability. The lure of currency devaluation in a difficult economic environment can seem irresistible.
However, the problems and unintended consequences of these actions appear almost immediately. To begin with, very few goods are made from start to finish in a single country. In today’s globalized world a particular product may involve U.S. technology, Italian design, Australian raw materials, Chinese assembly, Taiwanese components and Swiss-based global distribution before the product reaches consumers in Brazil. Each part of this supply and innovation chain will earn some portion of the overall profit based on its contribution to the whole. The point is that the exchange rate aspects of global business involve not only the currency of the final sale but also the currencies of all the intermediate inputs and supply chain transactions. A country that cheapens its currency may make final sales look cheaper when viewed from abroad but may hurt itself as more of its cheap currency is needed to purchase various inputs. When a manufacturing country has both large foreign export sales and also large purchases from abroad to obtain raw materials and components to build those exports, its currency may be almost irrelevant to net exports compared to other contributions such as labor costs, low taxes and good infrastructure.
Higher input costs are not the only downside of devaluation. A bigger immediate concern may be competitive, tit-for-tat devaluations. Consider the earlier case of the €30,000 German car whose U.S. dollar price drops from $42,000 to $33,000 when the euro is devalued from $1.40 to $1.10. How confident is the German manufacturer that the euro will stay down at $1.10? The United States may defend its domestic auto sector by cheapening the dollar against the euro, pushing the euro back up from $1.10 to some higher level, even back up to $1.40. The United States can do this by lowering interest rates—making the dollar less attractive to international investors—or printing money to debase the dollar. Finally, the United States can intervene directly in currency markets by selling dollars and buying euros to manipulate the euro back up to the desired level. In short, while devaluing the euro may have some immediate and short-term benefit, that policy can be reversed quickly if a powerful competitor such as the United States decides to engage in its own form of devaluation.
Sometimes these competitive devaluations are inconclusive, with each side gaining a temporary edge but neither side ceding permanent advantage. In such cases, a more blunt instrument may be required to help local manufacturers. That instrument is protectionism, which comes in the form of tariffs, embargoes and other barriers to free trade. Using the automobile example again, the United States could simply impose a $9,000 duty on each imported German car. This would push the U.S. price back up from $33,000 to $42,000 even though the euro remained cheap at $1.10. In effect, the United States would offset the benefit of the euro devaluation for the Germans with a tariff roughly equal to the dollar value of that benefit, thereby eliminating the euro’s edge in the U.S. market. From the perspective of an American autoworker, this might be the best outcome since it protects U.S. industry while allowing the autoworker to take an affordable European holiday.
Protectionism is not limited to the imposition of tariffs but may include more severe trade sanctions, including embargoes. A notable recent case involving China and Japan amounted to a currency war skirmish. China controls almost all of the supply of certain so-called rare earths, which are exotic, hard-to-mine metals crucial in the manufacture of electronics, hybrid automobiles and other high-tech and green technology applications. While the rare earths come from China, many of their uses are in Japanese-made electronics and automobiles. In July 2010, China announced a 72 percent reduction in rare earth exports, which had the effect of slowing manufacturing in Japan and other countries that depend on Chinese rare earth supplies.
On September 7, 2010, a Chinese trawler collided with a Japanese patrol ship in a remote island group in the East China Sea claimed by both Japan and China. The trawler captain was taken into custody by the Japanese patrol while China protested furiously, demanding the captain’s release and a full apology from Japan. When the release and apology were not immediately forthcoming, China went beyond the July reduction in exports and halted all rare earth shipments to Japan, crippling Japanese manufacturers. On September 14, 2010, Japan counterattacked by engineering a sudden devaluation of the Japanese yen in international currency markets. The yen fell about 3 percent in three days against the Chinese yuan. Persistence by Japan in that course of devaluation could have hurt Chinese exports to Japan relative to exports from lower-cost producers such as Indonesia and Vietnam. China had attacked Japan with an embargo and Japan fought back with a currency devaluation while both sides postured over a remote group of uninhabited rocks and the fate of the imprisoned trawler captain. Over the next few weeks the situation stabilized, the captain was released, Japan issued a pro forma apology, the yen began to strengthen again and the flow of rare earths resumed. A much worse outcome had been avoided, but lessons had been learned and knives sharpened for the next battle.
A prospective currency warrior always faces the law of unintended consequences. Assume that a currency devaluation, such as one in Europe, succeeds in its intended purpose and European goods are cheaper to the world and exports become a significant contributor to growth as a result. That may be fine for Europe, but over time manufacturing in other countries may begin to suffer from lost markets leading to plant closures, layoffs, bankruptcy and recession. The wider recession may lead to declining sales by Europeans as well, not because of the exchange rate, but because foreign workers can no longer afford to buy Europe’s exports even at the cheaper prices. This kind of global depressing effect of currency wars may take longer to evolve, but may be the most pernicious effect of all.
So currency devaluation as a path to increased exports is not a simple matter. It may lead to higher input costs, competitive devaluations, tariffs, embargoes and global recession sooner rather than later. Given these adverse outcomes and unintended consequences, one wonders why currency wars begin at all. They are mutually destructive while they last and impossible to win in the end.
As with any policy challenge, some history is instructive. The twentieth century was marked by two great currency wars. The first, Currency War I, ran from 1921 to 1936, almost the entire period between World War I and World War II including the Great Depression, with which it is closely associated. The second, Currency War II, ran from 1967 to 1987 and was finally settled by two global agreements, the Plaza Accord in 1985 and the Louvre Accord in 1987, without descending into military conflict.
Currency wars resemble most wars in the sense that they have identifiable antecedents. The three most powerful antecedents of CWI were the classical gold standard from 1870 to 1914, the creation of the Federal Reserve from 1907 to 1913, and World War I and the Treaty of Versailles from 1914 to 1919. A brief survey of these three periods helps one to understand the economic conflicts that followed.
