Currency Wars: Causes and Consequences

Marc To Market's picture

The Realist understanding of international affairs is that it is a realm of competition.  The competition is multi-faceted, taking place in politics and economics.  It has a cultural dimension.  It take place even in the writing of history. 

This competition spills over into the foreign exchange market.  It did not begin with the unorthodox pursuit of monetary policy in high income countries beset with crisis.  Even at Bretton Woods countries were jockeying for advantage.  From the time that the dollar-gold standard of Bretton Woods became operational, the foreign exchange market was politicized. The US wanted the German mark and Japanese yen, for example, to be adjusted higher, rather than devalue the dollar.  The attempt to re-start Bretton Woods with the Smithsonian Agreement was shaped by the conflict of national interest.

This has also been the history of the floating rate era.  The hot capital flows into Germany and Switzerland resulted in a policy response of intervention and negative interest rates in the 1970s.  Some observers attribute the 1987 equity market crash in part to Treasury Secretary James Baker threatening dollar depreciation if Germany did not stimulate its domestic economy.   When he was Treasury Secretary Llyod Bentsen threatened to allow the dollar to fall against the yen unless the Japanese government opened its markets more to US goods. 

At times, the high income countries coordinated intervention such as under the 1985 Plaza Agreement.  At other times, countries, such as Japan, were forced to act alone.  Western European countries have repeatedly sought to minimize the intra-European currency fluctuations; from the Snake, through the ERM to finally getting rid of national currencies altogether. 

Very few countries in the world seem to have ever felt completely comfortable with the  prices that the foreign exchange market set.  Indeed from Mexico's Tequilla Crisis in 1995/95 through the Asian financial crisis in 1997-1998, a number of semi-fixed exchange rates were broken after numerous and costly attempts to defend them.  The large build up of reserves in emerging market countries is largely, though not solely, a reflection of resistance to currency appreciation and the pursuit of neo-mercantilist developmental strategies. Most of the wealthy Mideast countries retain pegged currency regimes. 

These days, it has become fashionable to talk of this pursuit of national self-interest over foreign exchange prices as a "currency war".    Although many seem to think it began with the unorthodox monetary policies pursued by the high income countries since the onset of the crisis, the tale of the tape tells a different story.   

Many observers are confused by the metaphor.  They think it is real.  Currency warfare devolves into outright protectionism and, viola, Smoot-Hawley-esque protectionism, a trade war.  Then a real shooting war.  Q.E.D. 

Typically central banks want the external value of their currencies to move in the same direction as monetary policy.  Given the synchronized economic downturn in the high income countries, it is not surprising that monetary policy has become synchronized and that most officials want weaker currencies.  And this is at loggerheads with the many of the leading emerging market currencies that are not willing to accept substantial currency appreciation.

At the same time that Bank of England Governor King warned against competitive devaluations this week, he suggested that sterling's relative strength has not done the UK any favors.  The Bank of Canada, whose governor will soon replace King at the helm of the BOE, noted that the persistent strength of the Canadian dollar has hurt exports.   Norway and Sweden have indicated that the strength of their respective currencies could influence the course of monetary policy decisions.  Switzerland, with one of the largest current account surpluses, has effectively capped its currency.

The rhetoric, much more than the action, of the new Japanese government, explicitly seeking a weaker yen, has irked many.  Former Eurogroup head Juncker was off-message when he recently said the euro was dangerously high.  German officials have been quick to clarify. First it was Finance Minister Schaeuble who was critical of Japan's "false understanding" of monetary policy.  Then is was BBK's Weidmann who warned of the risks of politicizing the exchange rate.  This was followed by Deputy Chairman of Merkel's CDU who expressed concern not just at Japan's competitive devaluation but also that if other countries follow, it could lead to a downward spiral. 

Russia has recently taken exception and has threaten to raise the issue at upcoming international meetings.   South Korea has threatened to take action.  The industry association for US auto makers protests (as they have since there were more than 300 yen to the dollar).  It is unusual for Fed officials to comment on the foreign exchange market, but the St. Louis Fed President Bullard recently expressed his concern.

Following the war metaphor, we have often found it helpful to understand intervention as an escalation ladder.  The lower rungs may be different ways to verbally express displeasure at market prices.  Most of the time officials stay on the lower rungs.  Despite desire for weaker currencies, neither the Bank of Canada nor the Bank of England are about to intervene materially in the foreign exchange market, for example.  And if some countries cut interest rates to offset their currencies' strength, well, that is how the adjustment process is supposed to work.

The World Trade Organization also helps act like a circuit breaker of sorts.  It offers a conflict resolution mechanism to prevent trade disputes from leading to exactly the downward spiral that many observers rightly fear.  There is no sign that this firewall has been threatened.

When officials talk about currencies reflecting fundamentals, they often mean external balances.  Japan has swung from a trade surplus to a trade deficit.  In fact, on a seasonally adjusted basis, it has not recorded a monthly trade surplus  since Feb 2011.  Exports have fallen on year-over year basis since May 2012 (and the December report due out first thing in Tokyo on Thurs is expected to show more of the same).  The OECD calculation of purchasing power parity has the yen about 14.6% over-valued at current levels. 

Besides the relative size of the economies, it is not clear why the Swiss capping their currency has not drawn the same ire as the Japanese.    Indeed, one could argue that the Swiss move deflected more pressure to Japan and if the SNB had not pegged its currency, the new LDP government in Japan would not be talking the yen lower.

While we do think Japanese officials would welcome a weaker yen, we see in the rhetoric an attempt to ease concern  that it is seeking an endless or even protracted decline.  The upcoming G20 meeting may reaffirm the commitment to market-based foreign exchange rates.  The push back may impact LDP policy intentions may making it less likely that it will seek to buy foreign bonds, which would be too close to material intervention. 

A real currency war remains a remote possibility.  The recent clash is largely in the realm of rhetoric and does not appear substantially different than what has been seen through the floating rate area.  The synchronized crisis and economic weakness has produced synchronized easing of monetary policy.  Officials typically want currency to be supporting not contradicting monetary policy signals.  Lastly, it is particularly noteworthy  that Japan's largest trading partner and regional rival China, appears not to have publicly protested the yen developments.

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otto skorzeny's picture

"Endless money forms the sinews of war"-Marcus Tullius Cicero

Orly's picture

Dude, that's ancient history.


captcorona's picture

Am I the only one who finds the irony of a unified and socialist Europe in which Germany is the dominate power 70 years after WWII? Kind of makes you wonder what all the fuss was back then and why the U.S. got involved. Sure seems like a wasted effort to me.

hooligan2009's picture

you should not believe for one minute that Germany is immune from the pressures facing other countries. Its welfare budget is off balance sheet and it enjoys "success" only because it still carries a huge guilt complex and its citizens live in fear of a renewal of its huge underbelly of bigotry against race, homosexuality and dysmorphophobia.

maybe when the third generation (grandsons and granddaughters) of war criminals have passed the psychology of the country might change. the germans bail out the PIIGS and the French because they still feel guilty about Hitler.

Orly's picture

Adding another monkey in the wrench, UK PM David Cameron said in the overnight that unless the EU shapes up and initiates real reforms that include less stringent rules on sovereign countries for participation the EU (their level of participation should be variable...), as well as a more democratic mechanism for participation, he would seek a referendum to have the UK vote for withdrawal from the EU by 2017.

Von Rumpuy and fellows have had practical dictatorial powers over the inner workings of European economics across borders for over a decade and only now are the British recognising this problem?

It seems rather hypocritical of Cameron and Sir Merv to now wring their hands over something Nigel Farage has been on about this entire time.  Cameron knows that a vote today would mean that the UK would pull out of the EU, as the British people are tired of being bossed around from Brussels.  To appease the British people, he said he would put it to a vote within four years, all the while hoping that the European Commision gets off their high horse and stops treating the EU and ECB like a throne.

If anywhere in the Western nations where a throw-the-bums-out attitude can foment into real unrest it is in Great Britain.  They're getting pretty sick of being raked over the coals in what used to be England, so that ire will probably extrapolate to all the foreigners who have "ruined British culture."  It seems ironic that this more-or-less passive people may vocally, then forcefully reject their banking masters on the Continent.

Interesting times, indeed.


Toolshed's picture

What I find absolutely amazing is that Cameron seems to actually believe that the EU will still exist in 2017. Talk about optimistic!

Orly's picture

Hedging his bets, Marc Chandler-style!


DR's picture

Where would the UK economy be without the Eurodollar financial industry? They would be just another peripheral European country trying to make ends meet with nothing special to offer to the global economy. The UK is very, very dependent on the Euro succeeding..

LawsofPhysics's picture

Yes, but they very much need another greece to extort.  hence they want the U.S. to be able to join in.  The united states of europe if you will.  That would be very profitable for the tiny island and the banksters in london.

Orly's picture

Which is why for all the fluster and bluster, nothing will happen.  The propo-machine will be out in force in the next four years, touting the money-making London.

If it ever did come to a vote, it should be remembered that the people in Hucknall, Notts couldn't care less about The City.


Marc To Market's picture

Really ?  Qaddafi was overthrown because he was a threat to dollar hegemony ?  Really ?  And all the currency wars are the US fault ?  An incredbily jaundiced reading of modern history.  A closer reading of the history of the Plaza, you'll find that Europe was getting frustrated with the strength of the US dollar.  The policy mix under Reagan-Volcker of tight monetary policy and loose fiscal policy led to an overshoot.  US strong armed Europe and Japan ?  Is there really much evidence for that claim ?  My friends on both the left and right blame the US first for everything that happens in the world that they do not like.  The main point of my note is that like international affairs more broadly, the fx market has always been a realm in which nation-states jockey for advantage.  Can what is dubbed a currency war lead to a worse outcome?  Sure.  Is it partcularly likely, no. 

bank guy in Brussels's picture

Currency 'wars' ongoing may be much more real and devastating than the above article suggests. Especially when you consider that heads of state Sadam Hussein and Muammar Qaddafi both died horrible violent deaths, and had the regimes of their nations changed, after becoming threats to dollar hegemony and the petro-dollar.

Though sometimes currency war is more subtle, though still brutal, as re US modern economic aggression upon the Japanese.

Interesting to recall the 'Plaza Accord' of 1985, as mentioned above, where the US strong-armed both Japan and Germany into appreciating their currencies, in order to help keep the USA and the US dollar afloat.

What is thought by many - and very significantly, by many Chinese, and with some justification - is that the Plaza Accord was an extortion by the US against both Japan and the Europeans - and though Germany survived the extortion, Japan was devastated by it.

Older folks can remember the talk back in the 1980s, that Japan was going to 'take over the world' economically ... According to some, it was the Plaza Accord extortion by the US against Japan, that basically destroyed that possibility.

After the Plaza Accord destroyed the value of Japanese foreign investments, their forced currency appreciation created a domestic internal Japanese real estate bubble for four years, and domestic banking over-leveraging, which then led to the huge Japanese crash starting circa 1990 ... with whose consequences Japan is still suffering more than two decades later ... Though Japan perhaps managed the consequences reasonably well. Although it is fashionable to bash Japan today for sovereign mega-debt, they have nonetheless avoided major depression for 23 years.

Japan's share market stock values never again saw those highs, still marking about one-fourth of the pricing at the market top. And Japan's real estate values declined about 70% as well, also never to recover.

And that all might be the result of the aggression of the Americans in 'currency wars'.