Eichengreen: Cassandras and currency wars

A guest post from Barry Eichengreen, a professor of economics and political science at the University of California, Berkeley and author, most recently, of Hall of Mirrors: The Great Depression, the Great Recession, and the Uses — and Misuses — of History.

Economic analysis, it seems, is the art of recycling old ideas under new names. So it is with the debate over currency wars, which parallels exactly the 1930s debate over competitive currency devaluation. David Woo, meet Ragnar Nurkse.

Nurkse, in his 1944 classic, International Currency Experience, argued that reflationary policies following the collapse of the 1920s-era gold standard operated by depreciating the exchange rate. Countries that pushed down their exchange rates had the greatest success at preventing further falls in prices and output, insofar as they substituted external demand, in the form of additional net exports, for deficient demand at home.

But the policy was beggar thy neighbour. One country’s additional external demand was another country’s loss. Insofar as all countries eventually followed suit, no country was able to depress its exchange rate on a sustained basis. The net effect of their uncoordinated policies was just additional currency volatility and uncertainty that depressed international trade and compounded the fall in spending. Competitive devaluation was a negative-sum game.

These are exactly the arguments made by today’s Cassandras of currency wars.

In the current environment, they warn, the only way for central banks to stave off deflation is by using conventional and unconventional monetary policies to depreciate the exchange rate. With interest rates already having been pushed to zero and in a growing number of cases below, there is no scope for monetary policies, conventional or unconventional, to push up the prices of risk assets and otherwise operate through portfolio-balance channels.

As for the expectations channel, the main way for central banks to transform expectations and credibly signal that the future will be different from the past is by actively depreciating the exchange rate, something that under normal circumstance they hesitate to do. This is precisely what a growing number of central banks, seeking to shape expectations, are now doing. And they are making no bones about it.

The problem being that not every central bank can push its currency down on the foreign exchange market at the same time. The net result is that they only neutralise one another’s signals. Their uncoordinated actions only heighten exchange rate volatility, further depressing international transactions.

Neither Nurkse, nor the many other economists and textbook writers who channeled his arguments, had a model of monetary policy. They simply observed that the main way it operated in the 1930s was by pushing down the exchange rate. Other channels of transmission, it seemed, were weak or inoperative. Had those other channels been effective, output, employment and trade would have recovered robustly once the gold standard was abandoned and central banks regained their policy autonomy.

Instead, the recovery of output and employment was lethargic, presumably because the positive effects of policy were neutralised by competitive devaluations. World trade was still more than 10 per cent below 1929 levels at the end of the 1930s, presumably reflecting the negative-sum effect of the resulting foreign exchange market volatility and uncertainty.

Subsequent scholarship shows, however, that the main reason monetary policy didn’t work more powerfully in the 1930s was that it wasn’t tried (apologies to E. Cary Brown). As I have argued here, central banks in the 1930s were reluctant to utilise their newfound monetary freedom. They were uncomfortable about making policy without an exchange rate anchor. They feared an outbreak of uncontrollable inflation even in what was a deeply deflationary environment.

Because, in this deflationary environment, they failed to make open-ended commitments to raise prices, they failed to effectively transform expectations. Because they failed to supplement the new monetary regime with supportive fiscal action, they failed to convince investors that they were committed to a fundamentally new policy regime. Because they hesitated to expand domestic credit more aggressively, they ended up relying on net exports as a way of supporting domestic demand, as argued here. And because they failed to coordinate their monetary and exchange rate policies internationally, haphazard exchange rate changes only created volatility and uncertainty, as argued here.

Today, in contrast, central banks like the Bank of Japan and European Central Bank are making open-ended commitments to do what it takes – to stick with their security-purchase programs until they produce the desired result of inflation expectations anchored at 2 per cent. The Japanese government has deferred its second VAT increase and embarked on a modest balanced-budget fiscal expansion. The Eurozone shows signs of moving, at least modestly, from fiscal consolidation to greater fiscal ease. With sufficiently aggressive monetary action and supportive fiscal steps, policy can still produce results even in this environment.

Without that action and those steps, however, the Cassandras of currency wars will be right.

Related links:
All currency war, all the time – FT Alphaville
Currency wars and central bank credibility – FT Alphaville
Positive-sum currency wars – Economist (2013)
Currency war or international policy coordination – Eichengreen (2013)