Serious Money:Fears of an imminent currency war have resurfaced following the Bank of Japan's decision last month, under pressure from freshly elected prime minister Shinzo Abe, to increase its infla- tion target from 1 to 2 per cent and expand its purchases of bonds and other assets next year, in order to achieve the new objective "at the earliest possible date".
The international response to the Japanese central bank’s announcement was immediate, as finance ministers in both emerging and developed economies warned that the action could trigger a series of competitive devaluations that mimic the worst of the “beggar-thy-neighbour” policies that followed Britain’s decision to abandon the gold standard in the autumn of 1931.
The growing concern among policy- makers stems from the observation that Britain’s exit from the prevailing international monetary regime – in the face of the financial panic across Europe following the collapse of Austria’s largest bank, Creditanstalt, in May of the same year – unleashed a wave of counterproductive, tit-for-tat policies that compounded the misery of the Great Depression.
The facts speak for themselves, and the protectionist policies that followed the rational move by the British to free themselves from the restrictions of the gold standard contributed to a precipitous decline in world trade that would prove long lasting.
The retaliatory tactics adopted by other beleaguered nations virtually assured a breakdown in world trade. The disharmonious international relations stood in sharp contrast to the prosperous regime that had persisted from 1871 until the outbreak of war in 1914.
Efforts to put the failed monetary system back together during the inter-war years proved misguided – most notably Britain’s decision to return to the gold peg at a vastly overvalued exchange rate.
The rest is history as one might say, and the collapse in world trade which saw volumes languish more than 20 per cent below their pre-depression two decades later is often traced to the 1931 devaluation of sterling.
Fast-forward to today and competitive devaluations continue to be viewed in a negative light. Indeed, a potential currency war has ranked high on the list of risks that has troubled the world’s political leadership since the global economy sank into the Great Recession five years ago. The G-20 felt compelled to declare at the height of the crisis that “we will not repeat the historic mistakes of protectionism of recent eras”.
Unfortunately, the emphatic statement did not allay concerns for long, as the unconventional monetary policies adopted in the US and elsewhere in the developed world, were greeted with disdain by the emerging world’s elite. The upward pressure on exchange rates and, subsequent attempts to limit currency appreciation compromised central banks’ flexibility with respect to the appropriate monetary stance in the face of intensifying inflationary pressures.
A slowdown in economic growth saw the tension ease through most of 2012, but the rhetoric remained the same, as the US Federal Reserve continued to be accused of unleashing a “monetary tsunami” upon the rest of the world.
The latest episode of currency hysteria is somewhat different, however, insofar as Japan’s prime minister has urged monetary policymakers to expand the monetary base more aggressively than previously, and to purchase foreign bonds in an effort to push the exchange rate lower.
It is not clear why such a move is viewed so negatively, as it could well provide an important boost to world growth.
Policymakers should recognise that it was the imposition of tariffs and exchange by countries that remained on the gold standard which was largely responsible for the collapse in world trade during the 1930s, and not the competitive devaluations that followed other countries’ decision to abandon the monetary regime. Indeed, the economist Barry Eichengreen wrote as far back as 1984: “One country’s devaluation need not beggar the remaining countries, and a series of devaluations can easily leave all countries better off.”
A paper published by the Bank for International Settlements last year analysed the foreign exchange interventions conducted by the Japanese against the dollar in 2003 and 2004, and concluded that the actions lowered bond yields not only in the US, but also in a number of other countries due to a global portfolio rebalancing.
In effect, Japan’s large-scale currency interventions eased monetary conditions in most of the developed world.
Fears are growing that the world might on the verge of a currency war, but a more realistic assessment reveals that the measures proposed by Japan’s new prime minister would provide an important boost to a global economy that is struggling to sustain a satisfactory pace of growth. Investors should take note.
