A new currency war?

To students of the Great Depression, the current discussion about a currency war should come as no surprise. In the ‘30s, the world had a fixed exchange rate system, based on a US-centered gold standard. It made it obvious for all that a series of competitive devaluations were taking place as countries turned their attention to exports as a way of boosting domestic growth.


This time around it is a bit different. We do not have a global fixed exchange rate. We have dollar, we have the euro, and the yen. Until the outbreak of the crisis, we also had two currency blocs, the Euro and the US dollar bloc. By the latter I refer to the fact that a number of South American and in particular Asian exporters unilaterally kept their currencies largely stable against the dollar.

We are now in a situation where competitive devaluations are off the table, since there is no fixed exchange rate system. This has opened the floodgates for something far more insidious, quiet and discrete manipulation of the currencies. And there is a sneaking feeling that the US of A is actually the main culprit. The US allegedly want to weaken the dollar in order to redress the huge hole in the trade balance. Doing this is so not kosher.

It is very easy to come to that conclusion when looking at the weakening of the USD since in the past months. Several currencies have appreciated significantly against the USD. I talk about the euro, the ASEAN currencies, the yen. And even the Chinese yuan also increased a bit. For all practical purposes the implicit dollar bloc has gone and the USA appear to be exporting its economic trouble to everybody else.

It always makes good headlines to accuse somebody else of currency manipulation. US lawmakers are specialists in that discipline as they pound the Chinese in order to obtain a significant appreciation of the CHY.

I am sure that everybody in the US economic policy circles welcomes a weaker USD. It was the same in Euroland in the first half of the year. But I am equally sure that the current dollar depreciation is the result of what I described in my previous post. Namely the current situation of the USA being caught in a liquidity trap.

There is a near universal expectation that the Federal Reserve will resume its asset purchasing programme within weeks. Such a program increases reserves in the banking system, but so far it does not lead to an increase in the money stock. Banks do not lend money and consumers and businesses do not borrow. Banks have a tendency to increase deposits at the central banks in that situation. It could however also happen that they help finance investments in securities. In other words, the main consequence is to inflate the value of financial assets.

To the extent that investments are not made exclusively in dollar-denominated assets, this liquidity flow will tend to weaken the dollar and to drive up assets in the “host” countries. In other words, the side effect of the US monetary policy is to drive the dollar down and financial assets upwards, also outside the USA.

Obviously, there is nobody complaining about the asset inflation, since it is supposed to lead to consumers feeling better and increasing demand. Eventually, that is.

But the falling dollar is obviously provoking a lot of politicians in other countries, from China to Brazil. A lot of noise is now audible and it is fully understandable. The weakening dollar makes US exports more competitive. The country that triggered the financial crisis through a disastrous combination of private and public sector deficits, a debt explosion and a terminally weak regulatory regime are now trying to export their way out of the crisis. At least according to the critics. I am sure that US policy makers would prefer to be in a situation where they could indeed push a string – using the monetary policy to get the economy growing faster.

Eventually the US economy will pull out of the liquidity trap, but nobody knows the timing of this. In the meantime the trends in the financial markets will continue, no matter how contradictory they are.

And in the meantime, we can all marvel at the best manipulators in town, the Chinese. Following months of increasing pressure from the Western World, the crawling peg regime from the pre-crisis years was reinstated. Not that CNY has moved a lot against the USD. But the change came virtually at the same moment as the USD began to weaken against the EUR and the JPY. So the net effect has been a weakening of the CNY in trade-weighted terms. Not bad for presumed novices in the noble art of waging a currency war.