No real currency yet in talk of 'currency wars'

The worst that has happened to date has been the odd currency skirmish

Within weeks of the earthquake that struck the western world’s financial system in September 2008, observers quickly saw parallels with the 1930s. That decade ended in war, such was the severity of the recession that followed the crash of 1929 and the bank failures that started in 1931.

In the early months of 2009, some indicators were pointing to the economies of the rich world following the same trajectory as the early 1930s. Could the bloody history of that time repeat itself in our era, it was asked?

Thankfully, the prospect of armed conflict among democratic states remains next to non-existent.

Currency wars

But if actual conflict is not breaking out, there has been much talk of “currency wars”.

Since the Brazilian finance minister coined the term in 2010, accusations have been flying that governments and monetary authorities are seeking to steal a competitive march on trading partners by deliberately depressing the value of their currencies. The debate re-ignited recently as G20 finance ministers prepare to meet in Moscow at the weekend.

The proximate cause of the renewed flaring up of the debate has been recent developments in Japan. That economy has never fully shaken off the effects of its crash more than 20 years ago.

One manifestation of the malaise has been deflation – consumer and many asset prices are lower now than they were in 1990.

During Japan’s recent general election campaign, the role of the central bank in ending this protracted deflationary slump was a central issue. Shinzo Abe, the leader of the main opposition party, campaigned for a radical change in the way the Bank of Japan (BoJ) addresses the problem.

He won the election, is now prime minister and calls the installation of new leadership at the BoJ next month “regime change”.

The incoming BoJ boss has signalled a widening in the scope of the authority’s money printing activities (known as “quantitative easing”) and a raising of its inflation target from 1 to 2 per cent. That has led to a sharp depreciation of the yen, and charges of currency manipulation.

When currencies float against each other – as those of almost all large developed economies do – their relative value is set by supply and demand, just as is the case for the price of any asset in a normal market.

Demand for a currency is based on the relative returns to be earned by holding assets denominated in a given currency. Most fundamentally, the state of the economy and rates of growth determine long-run returns. But many other factors also affect the demand for a currency, including the political system’s long-term record on macroeconomic management and the level of interest rates set by the central bank.

On the supply side, in a paper money system central banks have most influence on money supply. Since the crash, economic conditions have been so severe that the current generation of central bankers has had to resort to measures once considered highly unorthodox as a means of stimulating their flagging economies. Now commonplace, quantitative easing is designed to provide a stimulus to the economy by lowering different market interest rates across the economy. But a by-product is that it increases the supply of money, which pushes down the external value of the currency, all other things being equal.