Currency wars are best fought quietly

The identity of the true warriors might come as a surprise 

Few issues in economics are more susceptible to political misrepresentation than exchange rates. The past few days have provided another perfect illustration of this point.

On Tuesday, in response to pressure from Shinzo Abe, the country’s new prime minister, the Bank of Japan voted to increase its inflation target from 1 to 2 per cent and to hit that target “at the earliest possible date”. To that end, starting a year from now, the BoJ will buy Y13tn ($140bn) of mostly short-term government debt each month.

The Japanese move triggered a flurry of warnings of an imminent “currency war”. Alexei Ulyukayev, first deputy chairman of Russia’s central bank, led the charge, closely followed by Jens Weidmann, Bundesbank president, and Bahk Jae-wan, South Korea’s finance minister.

Mr Weidmann referred darkly to “alarming infringements” and an “end to central bank autonomy”. The Japanese were not slow to respond. “Germany is the country whose exports have benefited most from the euro area’s fixed exchange rate system,” shot back Akira Amari, the country’s economy minister. “He’s not in a position to criticise.”
Before the beer glasses start flying in Davos (fat chance), let’s put this in historical perspective. Consider four things.

Back in the 1930s, it was obvious who was waging a currency war. Before the Depression, most countries had been on the gold standard, which had fixed exchange rates in terms of the yellow metal. When Britain abandoned gold in September 1931, it unleashed a wave of competitive devaluations. As economist Barry Eichengreen argues, going off gold was the essential first step towards recovery in the Depression. Floating the pound not only cheapened British exports; more importantly, it allowed the Bank of England to pursue a monetary policy focused on domestic needs. Lower interest rates helped generate recovery via the housing market.

Today, however, we live in a world of fiat money and mostly floating rates. The last vestige of the gold standard was swept away in August 1971, when Richard Nixon suspended the convertibility of the dollar into gold. For one country to accuse another of waging a currency war in 2013 is therefore absurd. The war has been going on for more than 40 years and it is a war of all against all.

Secondly, we should reflect on just how dire things are in Japan. The country has been in a near stationary state since the end of the 1980s. Nominal gross domestic product in yen terms is about where it was 20 years ago. Its public debt is unsustainably large. Japan’s demographics are the world’s worst. So give them a break.

Thirdly, the BoJ’s move is hardly revolutionary. Governor Masaaki Shirakawa offered no new asset purchases in 2013 and the net impact of the purchases promised for 2014 will be limited since most of the money will be used to buy short-term debt close to maturity. The net increase in asset purchases for 2014 will be only Y10tn, equivalent to about 2 per cent of GDP.
Compare that with the policy of the US Federal Reserve, which has consistently been more aggressive than its Japanese counterpart since the beginning of the financial crisis. Last week the Fed’s balance sheet exceeded $3tn for the first time ever. If the Fed keeps buying assets at the current pace of $85bn a month for the rest of 2013, it will accumulate another trillion in long-term assets: between 6 and 7 per cent of GDP. And that’s this year, not next.

Fourthly, and most importantly, the tendency of politicians and the public to focus on short-term movements in nominal exchange rates generates much more heat than light. True, Japan’s nominal rate in terms of the dollar has weakened markedly since September. Back then, a dollar was worth just Y77. Today it’s above Y90. But that 17 per cent depreciation looks less impressive when you remember that the dollar was worth Y158 back in early 1990 and apart from a brief period in 1995 it has traded below Y90 only since the summer of 2010.
In any case, it’s not a single nominal exchange rate that really matters. The Bank for International Settlements calculates far more meaningful real effective exchange rates, which take into account all the different economies with which a country trades and, crucially, changes in relative prices.

Put in these terms, Japan’s story looks very different. Since the early 1990s, the effects of deflation have weakened the real effective exchange rate. Between 1994 and the summer of 2007, this rate declined by more than a third. But with the onset of the global financial crisis, Japan had to give back some of its gains in competitiveness. Between August 2007 and October 2011 the real effective exchange rate strengthened by 27 per cent. Recent Japanese policy has only partly reversed that.
On the basis of the Bis data, the most aggressive currency warriors of the past 5½ years have been South Korea (a 19 per cent real effective depreciation since August 2007) and the UK (minus 17 per cent). So the Koreans win this week’s prize for hypocrisy. As for the Brits, small wonder Prime Minister David Cameron regards the crisis of the European Monetary Union as a huge political opportunity. He was one of those wise Conservatives who opposed British membership of the euro. And it has been the BoE’s easy monetary policy that has eased the pain of his government’s austerity.

Mr Cameron has been called many things in the past week but not “currency warrior”. Yet part of the plan since he entered Number 10 has been to discreetly weaken the pound. Sir Mervyn King, BoE governor, has been obliging. Mark Carney, his successor, will be even more so.

Naive commentators have portrayed Mr Cameron’s promise of an “in-out” referendum on EU membership after the next general election as reckless. But it not only makes political sense. It also makes economic sense as part of a covert devaluation strategy.