Currency Wars

By: Frank_Hollenbeck

The current Japanese monetary printing orgy and European Central Bank threats of massive QE are both aimed at primarily boosting exports to kick start their moribund economies. The yen has dropped nearly 12% against the dollar since the Japanese announcement in October and the Euro has dropped over 10% against the dollar in the last six months.

Previously, Secretary of the Treasury Jack Lew has warned Japan, China and Europe against competitive devaluations. This is clearly the pot calling the kettle black! The current unwritten rule on exchange rate policy is that direct intervention is frowned on, but indirect intervention is acceptable since the exchange rate was not the initial objective of policy. This is the equivalent of dropping a thousand pound bomb on a terrorist and wiping out a preschool and saying “no problem since our primary target was the terrorist and not the preschool.”

It is simply irresponsible to look only at the direct and not indirect effects of economic policies. The US quantitative easing over the last six years has forced emerging market countries to impose capital controls and other currency restrictions, and ramp up their own printing presses. Current Japanese monetary policy, which is driving down the yen, is causing serious consternation to its Chinese and Korean neighbors.

We are in a currency war, and have been since 2008. Our current global monetary system is deeply flawed, although the IMF was supposedly created to foster monetary cooperation and financial stability. Yet, the IMF has been eerily silent. It is now clear to everyone who butters the IMF’s bread.

Let’s not be naïve into thinking that the current ECB action is to save Europe from dreaded deflation. A key reason for the ramp up of the printing presses is to reduce the value of the euro. Of course, these actions are based on another popular misconception promulgated by economists, even Austrian economists, that a depreciating currency will boost exports and therefore help the domestic economy. The corollary is that an appreciating currency does just the opposite. For some reason, many economists still have their theoretical minds stuck in the 1950s.

The standard argument is that a depreciating currency will allow exporters to reduce their prices overseas, helping them capture market share, boosting profits with positive ramifications for the domestic economy. It is standard “beggar thy neighbor” policy. If instead the currency appreciates, exporters will be forced to raise foreign currency prices to cover costs, reducing their competitive position in oversea markets. The mistake in this logic is that it looks at the direct effects while totally ignoring the indirect effects.

A simple example will make this clear. Suppose the exchange rate is $1 for 1 euro. The European exporter is selling his product for $100 in the US which he converts into 100 euros to cover his production cost of 80 euros, ensuring a 25% profit. Now suppose the euro depreciates so that it takes 1.5 Euros to get $1. The exporter can now lower his prices to $66.66 since this will bring in the same amount of euros as before the depreciation. He has gained a competitive advantage over his foreign rivals, with benefits to the domestic economy.

The first problem with this story is that with new financial instruments such as swaps and financial futures many exporters can hedge their foreign exchange risk long term, and may have already committed themselves to the rate they swap dollars for euros. The second problem with this story is that many exporters today import many of their inputs. A BMW has parts coming from all over the world. Its engines may come from the UK. The leather seats may come from China and the steel may come from Brazil. If the depreciation causes input prices to rise from 80 Euros to 120 euros, the exporter will be unable to lower his dollar prices, and, therefore will not gain in competitiveness. Of course, not all costs are imported inputs. This, however, highlights how depreciations really help exporters. If domestic cost, mostly labor, does not adjust to the higher import prices resulting from the depreciation, exporters will gain, but this gain comes from reducing the real income of domestic workers. If these workers ultimately negotiate an increase in nominal wages to bring their real wages back up to before the depreciation, the gain to exporters will disappear. The depreciation has created only a temporary gain.

Furthermore, there are many other indirect effects that make depreciating your currency a very bad policy objective. Mises indicated that standard balance of payment accounting cannot be used when the exchange value of the measuring stick, money, is changing. Even if exporters are more profitable, this is not something to cheer if a higher nominal profit means lower real profit since depreciation would raise the prices of foreign products. Of course, other economic actors are also hurt by such a policy. Consumers will bear the brunt of the higher prices on foreign products. Domestic firms who import their inputs and sell on the domestic market will also likely be hurt.

A depreciating currency reflects a country’s central bank printing money faster than its neighbors. Yet, this printing hurts all firms, including exporters. Try building a house when the length of a meter is constantly changing. Printing money alters absolute and relative prices. It interferes with the critical signals prices send across time about what and how society wants goods and services to be produced.

This same logic can be applied to exporters. They are not necessarily hurt by a stronger currency. Suppose the US exporter is selling his product for 200 euros which converts into $200 that covers his $160 cost of production, thus ensuring a 25% profit. Now suppose we get the same depreciation of the euro or appreciation of the dollar. According to standard theory, the exporter will now have to raise his prices to 300 euros to make the same dollar profits. Higher prices means less sales, layoffs, and a slumping economy. That is the standard Keynesian story, and one you will find in many textbooks.

Yet, an appreciating currency will also lower the prices of an exporter’s inputs. If they go from $160 to $106.66 then our exporter need not raise his euro prices since his 200 euros will give him $133.33 –the same 25% profit.

Here, again, the indirect effects are more important than the direct effects. An appreciating currency is really reflecting the irresponsible monetary policy of a country’s neighbors. Better to let the currency appreciation and ensure stability of the money supply which is critical for price to function correctly in a capitalist economy. With stable money, all firms gain.

What Europe needs is not a weaker euro but significant structural reform. Today, Europe is heading in the wrong direction. The role of the public sector keeps getting larger as European economies head toward communist Cuba instead of Singapore. Europe should learn from Latvia’s experience with reform. In 2009-2010, the Latvia cut government spending from 44 percent of GDP to 36 percent. It fired 30 percent of the civil servants, closed half the state agencies, and reduced the average public salary by 26 percent in one year. Government ministers took personal wage cuts of 35 percent. The Latvian economy initially dropped 24 percent, but rebounded sharply with yearly real growth of nearly 5 percent over the last three years. Yet, Latvia did this while keeping its former currency, the Lats, fixed against the euro.

Frank Hollenbeck, PhD, teaches at the International University of Geneva. See Frank Hollenbeck's article archives.

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