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.
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.
While those central banks engaged in the practice are quick to say they are not seeking currency depreciation, suspicions linger that they are not unhappy with the positive impact on competitiveness of a weaker exchange rate.
If the central bankers who are engaging in quantitative easing (QE) can just about maintain a level of plausible deniability on exchange rate manipulation, the Swiss central bank cannot. It has taken the most radical action to date.
As the Alpine state became a safe haven from the euro crisis, money flooded into Switzerland, causing its currency to appreciate (the “price” of a currency rises if demand for it rises, just like any other price).
Not only was this threatening the export-dependent economy, but the effect on import prices risked triggering a deflationary spiral (just as a stronger currency makes exports uncompetitive in trading partners’ currencies, it makes imports cheaper in local currency).
In order to prevent the franc rising any further, the Swiss central bank announced in 2011 that it would engage in unlimited intervention in currency markets to maintain a ceiling of €1.20 to the franc.
Despite the explicit nature of the move, Switzerland has come in for little criticism and has certainly not been accused of currency warfare, given that the Swiss authorities were not trying to weaken their currency as much as trying to stop its destructive strengthening in the midst of a crisis in the euro area by which it is surrounded.
But if the Swiss have been excused their interventions, no monetary authority is more in the clear on currency manipulation than the European Central Bank.
Although it has certainly engaged in actions that are very far from orthodox, such as buying government bonds, it remains the most conventional of all the major central banks.
Thus far at least, it has eschewed the QE option and has maintained a purist position on markets determining exchange rates. The decision not to use instruments that cause currency weakening is very likely to have played a big part in keeping the external value of the euro strong against most other currencies even at times of existential crisis for the euro.
But for all the talk of currency wars, it remains largely just talk. If monetary authorities around the world were truly engaged in acts hostile to their neighbours and trading partners, foreign exchange markets would be showing much bigger movements in prices and volumes. The truth is that central bankers know that engaging in competitive devaluations is a beggar thy neighbour tactic, which can be easily and quickly copied by neighbours. A tit for tat cycle of ploys to push down currencies would end in the beggaring of all, as happened in the 1930s.
Sometimes the lessons of history are well learned. They appear to have been in this case. The worst that has happened to date has been the occasional currency skirmish. It is very unlikely that more serious hostilities will break out.
Exchange rate regimes Fixed, floating, managed and unified
Until 1971, governments controlled their currencies’ value against others because the economic consensus held that exchange rate volatility negatively affected economic activity generally, and international trade most specifically.
Following the acrimonious breaking apart of the post second World War fixed exchange rate system, a period of turmoil ensued and the intellectual consensus fragmented. While many economists continued to favour government managing exchange rates in various ways, other believed that market forces should determine rates.
Europeans set up their own fixed exchange rate mechanism in order to limit the negative effects of exchange rate volatility. That eventually led to the abolition of most of the continent’s national currencies and their replacement with the euro.
At the other extreme, the US allowed the dollar to float freely against other currencies and, with the exception of a period in the 1980s, Washington has never explicitly sought to influence the external value of the greenback.
With varying degrees of success, countries have attempted regimes between the two extremes of monetary union and a free float. From setting wide bands within which the currency can fluctuate to pegging the currency rigidly or within very narrow bands and to a “currency board” arrangement, which is the closest thing to full monetary union short of abolishing one’s currency, there are no shortage of options for governments.
If there is any consensus at all on exchange rates among economists today, it is that there is no such thing as a perfect regime.
All arrangements, including monetary union itself, come with sizeable costs and downsides.
Ups and downs Euro's value
Since its launch in 1999, the euro’s value against other currencies has often confounded expectations. In the months before it was introduced, the consensus among traders and economists was that it would appreciate against other currencies. It did the opposite, quickly losing a third of its value against the dollar.
By 2002, as the euro languished, one investment banker famously described it as a “toilet currency”. But just as there were no obvious reasons for its protracted initial depreciation, nor was it obvious what changed around 10 years ago to drive the euro higher. But appreciate it did, against the dollar at any rate. The euro-sterling exchange rate was much more stable.
By the crash of September 2008, an almost uninterrupted appreciation led to its near doubling in value in dollar terms from the lows of 2002.
But despite the epicentre of that crash being in the US, such was the panic at the time that investors felt relatively less at risk in the dollar. The euro fell sharply as a result.
By the end of 2009, it had recovered most of the ground lost post-Lehman. But the outbreak of Europe’s sovereign debt crisis around that time triggered another euro sell off. Since then, the single currency has yo-yoed, driven largely by the waxing and waning of the crisis. Perhaps the most confounding thing about the euro’s value is how high it remains despite very real concerns for its future.