Currency Wars

The topic of currency wars has come into the spotlight recently, particularly with the threat of Japanese devaluation, comments by French President Hollande, and the devaluation of Venezuela's currency. The G7 just put out a statement on currency devaluation and exchange rates, the full statement below.

"We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates and to consult closely in regard to actions in foreign exchange markets. We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates. We are agreed that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will continue to consult closely on exchange markets and cooperate as appropriate."

The first sentence is confusing. They affirm a commitment to market exchange rates but then are also committed to consulting closely regarding actions in exchange markets. So they do intervene in exchange markets (actions in exchange markets) and will consult (consulting closely) with each other about their actions, but they consider that fully in line with the free market (commitment to market exchange rates).

Then in the third and fourth sentences they talk about the negative effects of volatility and say that they will consult closely and cooperate as appropriate. So they're worried about exchange rate volatility (which is good for currency traders) but will consult and cooperate as appropriate(which means they'll manage exchange rates if necessary.)

This is typical of just about any government press release. Vague, confusing, contradictory. It says nothing and everything at the same time. Ignore the words on the paper, just realize that world governments are ready to intervene at a moment's notice. Switzerland has been maintaining a peg to the euro for over a year, and don't bet that other countries won't start reintroducing pegs either. With luck, maybe we'll move back to fixed exchange rates, then back to a Bretton Woods-type system, then to a 1930s-style gold exchange standard, and then back to the classical gold standard. Hey, I can dream, can't I?

But all of this is just really bringing out into the open what has been happening surreptitiously for years. Most people haven't been paying attention, but these currency wars have been fomenting for a decade or more. Japan has been keeping low interest rates for decades, hence the yen's popularity in the carry trade until the onset of the financial crisis, when the rest of the world also pushed overnight rates to zero. Brazil was thought to have engaged in competitive currency devaluation a few years ago, and of course the United States government has been ragging on China for years for pegging the yuan to the dollar.

In the case of the yuan, it was not in fact China that was the currency manipulator, but the United States. Sure, China probably shouldn't be pegging to the dollar, but put yourself in their shoes. The world's largest economy is flooding the world with debased currency, most of which is ending up in your country, to buy your exports. If you don't peg to their currency, your domestic currency appreciates, making your exports more expensive abroad, hurting the export industry upon which your country depends. So the understandable reaction is to peg your domestic currency to this debased currency, the dollar, flooding into your country. The reason the US was pissed off was because it didn't want China to maintain this peg.

Just as in the 1960s, the US wanted to create new dollars and buy goods from abroad. But then this monetary inflation would cause foreign currencies to appreciate, making US goods cheaper abroad. So you get cheap foreign goods with dollars created out of thin air plus you boost your own export sector, what could be better? But that requires other countries to play along and not depreciate their currencies along with you. China, by pegging the yuan to the dollar, essentially inflated its currency along with the dollar. Inflows of dollars were mopped up with yuan, and those dollar holdings were plowed back into purchases of Treasuries. Great for the US government, which was able to rack up huge deficits as a result, but they definitely tried to look that gift horse in the mouth. In fact, there's still pressure on to try to name China as a currency manipulator. A clearer case of the pot calling the kettle black there has never been.

But this is what happens in a world of government fiat currencies. Government fiat currencies are proxies for their national governments. As long as you have nationalized currencies, the likelihood of currency war is just as likely as that of military war. Governments seek to monopolize the monetary system specifically so they can engage in monetary policy. And by engaging in monetary policy, they attempt to achieve both domestic goals (increased employments, erosion of the value of their debts) as well as international goals (achieving a more competitive position for national exports.)

The only way to break this and eliminate the possibility of currency war is to break these national monopolies. It will have to start in one country, and hopefully that will be the domino that gets things moving. Once consumers have a choice of an actual sound, stable monetary unit, I can't see them wanting to return to monopoly money.

Now that the entire world has basically reached the zero bound, with no sign of return to growth, countries are going to strat resorting to drastic monetary measures to boost their economies. Domestic issues take precedence at this point, and if these monetary measures require beggar thy neighbor policies, then so be it. Belarus and Venezuela have already depreciated, but no large countries have yet. The fear is that one country or bloc will attempt to buck the system, and once that first country has defected from the consensus, everyone else will follow suit. Hence the fear of a hot currency war. Will a currency war be the 2010s version of Smoot-Hawley? Could very well be. And the only way to avoid it is to break national monopolies over the creation and issuance of money.