Exchange rates should be co-ordinated
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The global economy needs exchange rate co-ordination now. Absent that, the world is likely to be increasingly afflicted by exchange rate fluctuations and policy acrimony. These are bound to undermine the economic recovery and increase the likelihood of stagnation.
In 2010 Brazilian Finance Minister Guido Mantega warned of the possibility of “currency wars”, as countries sought to devalue their exchange rates to gain a competitive advantage. In a world of demand shortage, a weaker currency can increase demand for a country’s goods – and thereby help with its own economic recovery.
But exchange rate devaluation benefits the devaluing country at the expense of others. It can easily become a case of robbing Peter to pay Paul.
The Great Depression of the 1930s provides warnings along such lines. It prompted competitive depreciation and trade conflict as countries sought to gain demand by increasing exports and lowering imports. That process contributed to deepening the depression.
Today, exchange rate conflict is again on the rise. One problem is China’s long-running trade surplus with the US. Those surpluses should long ago have fostered steep renminbi–dollar appreciation to rebalance the trade account. Yes, the renminbi has appreciated in recent years. But it is has not been enough to prevent the US trade deficit with China from steadily rising.
Instead, China has intervened in markets to limit the scale of exchange rate appreciation. Its goal remains to retain export competitiveness and attractiveness as a destination for foreign direct investment.
A newer and much more difficult problem concerns quantitative easing (QE). Under this process, central banks buy domestic assets on a massive scale to lower interest rates. Indeed, Mantega’s comments were spurred by the US Federal Reserve’s QE programme.
The core problem is that monetary policy interventions inevitably affect exchange rates. When a central bank increases the money supply by buying domestic assets and lowering interest rates, some of that money is diverted offshore as investors seek other opportunities, causing the exchange rate to depreciate.
The justification for QE in the US was strong. The economy was in recession, long-term interest rates were quite high and the government was running large budget deficits. It clearly needed help with financing to keep interest rate costs down.
But things are getting complicated. In Japan, the new policy dubbed Abenomics involves massive central bank purchases of Japanese government debt. Japan’s 10-year interest rate is already at 0.88 percent. The principal impact of Abenomics is turning out to be yen depreciation.
By buying bonds and flooding the market with cash, Japanese investors are being spurred to go overseas in search of yield. And to buy foreign assets, they must sell yen. That has not only already triggered a wave of yen depreciation against the dollar. It also promises to trigger other exchange rate changes that increasingly resemble global competitive devaluation.
The problem is that, on the surface, Abenomics looks a lot like QE. Consequently, how can the US or other nations object? From an international perspective, the problem is not QE, but the pursuit of QE within a flawed framework. The solution is exchange rate co-ordination.
Given the global economy’s demand shortage, the world needs easy monetary policy that lowers interest rates and facilitates budget deficits. But it must not be allowed to affect exchange rates. Co-ordination by central banks can accomplish that.
Such a system needs rules of intervention. Historically, the onus of defence has fallen on countries whose exchange rates are weakening, which requires them to sell foreign exchange reserves. That is a fundamentally flawed system because countries have limited reserves. Speculators therefore have an incentive to try to “break the bank” by shorting the weak currency.
They have a good shot at success, given the vast scale of low-cost leverage financial markets can muster. George Soros proved that when he successfully bet against sterling and the Bank of England in 1992.
A new, smarter international system must share the onus of intervention with the country whose currency is appreciating. Its central bank has unlimited amounts of its own currency for sale, so it can never be beaten by the market.
Speculators will back off if this intervention rule is credibly adopted, making the target exchange rate viable. It will also give an expansionary tilt to the global economy. When weak currency nations defend their exchange rate, they often raise interest rates to make their currency attractive, imparting a deflationary global bias.
If strong surplus countries do the intervening, they may lower their interest rates and impart an expansionary bias. A sensible co-ordinated exchange rate system can stimulate the global economy and help avoid looming economic policy conflict.
The Group of 20 summit in St Petersburg in September provides an ideal opportunity to launch an initiative for exchange rate co-ordination. Carpe diem.
Thomas Palley is a senior economic policy adviser to US trade union AFL-CIO and a regular contributor to The Globalist, where this article initially appeared. © The Globalist