A War without Winners

Three years into the global economic crisis, it is easy to be overcome by an uncomfortable sense of déjà-vu. Once again, governments are contemplating new stimulus measures with disappointingly little sign of the much-awaited rebound, at least in the West. Problematically, much of the ammunition has already been used up. Interest rates in most Western economies are at zero and talk of fiscal consolidation has dampened some of the previous enthusiasm for Keynesian stimulus spending. In search of new weaponry, the economic stimulus efforts have shifted focus to quantitative easing and, partly as a result, to efforts to manipulate exchange rates in order to protect or boost external competitiveness.

The next phase of the crisis has been appropriate dubbed ‘currency wars’ and there is a great risk that it will bring us little closer to a solution than previous tactics. The frustrating reality remains that, in spite of massive stimulus measures, most of the structural problems that triggered and perpetuated the crisis remain firmly in place. Normal financial intermediation is at a standstill and property markets weak in many Western economies, further depressed by persistent high levels of unemployment. International imbalances are little different from the pre-crisis period with China now controlling a third of all global reserves, just shy of $2.5 trillion.

The long-standing and increasingly acrimonious dispute between China and the US is at core of also the latest phase of the crisis. Have bought itself a respite through a commitment to greater flexibility in June, China has subsequently once again enraged its critics by Washington by moving forward with extreme caution. This lack of progress led the US House of Representatives recently to passing a measure to levy tariffs on Chinese imports, a troubling sign of things to come even this particular bill is never likely to be signed into law. Although a Chinese revaluation by itself would do little to help the US, it would trigger a desirable rebalancing of the Chinese economy. The case for this is obvious given that the current reserves equal 50% of the country’s GDP.

In recent months, a new front has been opened up in the currency wars, led by relative ‘safe haven’ currencies, the Swiss Franc and the Japanese Yen, which have been under particular upward pressures as investors have sought safety. South Korea has been forced to follow suit and Brazil is faced with a similar challenge. The Euro itself is subject to very powerful conflicting forces. The policy stance and rhetoric of the ECB remain among the most orthodox among major central banks and the impression of credibility is further boosted by the ongoing fiscal consolidation in a number of Euro-zone economies. The Euro has benefited from the recent show of support for Greece by China, which has indicated a desire to bolster the value of the Euro even as the Europeans, concerned about the fragility of their export-led recovery, have echoed American calls for a gradual appreciation of the Renminbi. On the other hand, however, the sovereign debt crisis is far from over, with for instance the Irish deficit now exceeding 30 per cent of GDP. This means that potentially sharp corrections remain likely at times.

As understandable as the temptation of boosting external competitiveness through devaluation is, it almost always invites responses in kind. The fundamental problem with the current situation is that not all countries can bring down their exchange rates at the same time. Nor can every country export its way to recovery, given the global demand weakness. Even a temporary victory by one participant in the currency wars produces losers at a time when few economies have significant room for maneuver. Moreover, what successes are achieved will likely prove temporary with even individual central banks relatively small players in the international currency markets.

It is obvious that only internationally coordinated moves in the currency markets can hope to be successful and the Institute of International Finance called for a new currency pact to bring the increasingly volatile situation under control. Problematically, there may not be any quick fixes. In 1985 when the Plaza accords succeeded in weakening the Dollar, they brought about other imbalances. In particular, Japan, faced with a loss of export competitiveness, engaged in monetary stimulus measures that significantly contributed to the bubble of the 1980s which ultimately burst and paved the way for the ‘lost decade,’ a major warning example for the Chinese.

Regrettably, the lack of a prospect of success has not always deterred people from trying. In the absence of some measure of international coordination, unilateral efforts are likely to continue. Moreover, the recent House bill reflects the willingness to consider protectionist measures and even capital controls, potentially turning the currency war into a trade war. The end result could well be at least a partial reversal of the wave of liberalization that swept the world during the past two decades. Currency market volatility is likely to remain elevated while quantitative easing threatens to debase currencies, which explains the growing appetite for hedges such as gold.

The decoupling between the West and the emerging economies is another risk. On the one hand, the extremely loose monetary policy of Western central banks is creating an unparalleled carry trade opportunity between the West and the East as emerging central banks are typically tightening policy. On the other hand, efforts by emerging market central banks to contain currency appreciation threatens to create domestic inflationary pressures (in the absence of full sterilisation) while supporting an unsustainable fiscal situation in the US as the Dollar acquisitions are converted in US Treasuries. These trends can easily result in a major emerging market bubble even if Western investors are still significantly underexposed to these economies and their underlying long-term growth prospects favorable. The approach of investors to emerging economies is showing signs of becoming less discriminating, always a warning sign.

The uncomfortable reality facing the generals of these currency wars is that the effort expended on exchange rate manipulation will likely prove a costly diversion. But above all, it will be a distraction. What the world need now is a belated focus on the structural imbalances holding back the recovery. Delaying this process by seeking ‘quick fixes’ is folly, the appearance of action with potential political dividends but little by way of economic results to show for it. As the belated post-oil crisis recovery in the 1980s showed, the only way to bring about sustainable growth is to create favorable economic fundamentals conducive to it, however painful this may be in the short term. Is there an alternative? The Japanese example inspires little confidence.

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