Currency spats not a war

This is my Perspective column from this week’s Fund Strategy magazine.

The financial world is aflutter with talk of prospective currency wars. There are dark mutterings about how competitive devaluations by different countries could have terrible consequences for the global economy.

Perhaps the most high-profile pronouncements so far have come from Jens Weidmann, the president of the Bundesbank. The German central banker used the annual reception of the Deutsche Börse as a platform to criticise the Japanese and Hungarian governments for trying to push down their currencies. He warned that this trend represented a “politicisation of the exchange rate”.

Contrary to many media reports, the emphasis of the speech was on central bank independence rather than currency wars themselves. Weidmann’s fundamental concern was that monetary policy should be left in the hands of unelected technocrats such as himself rather than controlled by politicians. However, in the coded language favoured by central bankers, some of the message was an implicit warning of what he saw as potential dangers ahead.

There was a kernel of truth in Weidmann’s speech. The move by the new Japanese government to stoke up mild inflation has certainly added to pressure for competitive devaluation. But before examining the currency debate it is worth considering some reasons to treat Weidmann’s pronouncement sceptically.

For a start, it is not recognised widely enough that Weidmann is underemployed. He is the president of an institution that the European Central Bank (ECB) has eclipsed as the region’s most powerful central bank. The most powerful central banker in Europe today is Mario Draghi, the ECB president, rather than the Bundesbank chief. In some respects Weidmann’s comments can be seen as carping from the sidelines. It is easy for him to talk tough since he is not a central player in implementing any policies.

Weidmann is also factually wrong, as well as undemocratic in spirit, in distancing technocrats from responsibility for the economic turmoil of recent years.

On the contrary, central bankers have played a prominent role in recent years and in many respects have made the crisis worse.

As I have argued previously in this column the eurozone itself is an entirely technocratic creation (‘Stasis hinges on lack of democracy’, 10 October 2011). It is unlikely that the European economy would be in such a mess if there were democratic control over decision-making.

Not that the America or Britain are immune to such criticism. Both the Bank of England and the Federal Reserve played a key role in economic decision-making during and before the crisis.

Weidmann, if viewed as a spokesman for Germany, is open to strong charges of hypocrisy. As Charles Dumas pointed out in a recent note for Lombard Street Research, an economic consultancy, Germany “has engaged in competitive devaluation throughout the period of the euro at the expense of the labour force’s income”. In effect Germany has used the eurozone as a way to push down its currency artificially since 1999.

None of this is meant to deny that there is constant tension over currency valuations. Only that it is wrong to see them either as the result of excess democracy or as the fault of one or two miscreant countries.

The main force for downward pressure on currencies comes indirectly from attempts to pump liquidity into national and regional economies. If everything was equal then low interest rates and quantitative easing would be expected to push a currency down against others.

However, when other countries are doing the same thing at the same time then the effects can cancel each other out. There can be a bizarre race for the bottom when everyone is trying to depress their own currency. Usually the main motivation of national authorities is to bolster their own economies rather than to boost competitiveness. However, they are no doubt aware that a weaker currency should strengthen exports by making them cheaper to foreigners. Higher import prices can also help them in their goal of curbing domestic consumption.

Not that the currency manipulation always works. From late 2007 to early 2009 the real effective exchange rate of sterling fell sharply (see graph, below). Yet Britain’s export sector is apparently too weak to make much of what should be a considerable advantage against competitors.

In any case, the ones who complain most about currency manipulation are usually those who feel most squeezed. That was what prompted Guido Mantega, Brazil’s finance minister, to complain that an “international currency war” was underway back in September 2010. At the time the Brazilian real was being pushed up against the currencies of many developed nations.

It is not accurate to describe the current tension over currencies as an all-out war. It is more akin to frequent low-level skirmishes across national borders.

No one seriously wants a genuine currency war to erupt. Such a conflict would indeed be dangerous for the global economy. But the drive to bolster national economies could inadvertently push the world in that direction.