Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared at Project Syndicate.
May 26, 2022 — The value of the US dollar is up 14 % against the euro, over the last year from 1.21 $/€ in May 2021. At 1.05 $/€, it is approaching one-to-one parity for the first time. If you think that prices for oil and other commodities are now high in terms of dollars, you should see what they look like in terms of euros! Get ready for “reverse currency wars.”
The regular sort of currency wars were characterized by countries feeling aggrieved that their trading partners were deliberately pursuing policies to weaken their own currencies. The feared motive would be gaining unfair advantage in international trade. The original phrase “currency wars” was a colorful description of what international economists had more informatively long called “competitive devaluations” or, when exchange rates float, “competitive depreciation” .
A reverse currency war, then, is the symmetric situation of “competitive appreciation,” in which countries feel aggrieved that their trading partners are deliberately pursuing policies to strengthen the values of their currencies. The motive would be putting downward pressure on their CPIs.
Competitive depreciation arises in a context where everyone’s main macroeconomic goals, in addition to maximizing growth in GDP and employment, include also boosting their trade balances. This generally describes the last few decades in the world economy. Competitive appreciation arises in a context where everyone’s main macroeconomic goals, in addition to maximizing growth, include also disinflation, that is, reducing their inflation rates (without hurting growth, to the extent possible). This context could describe the period that began in 2021, when inflation has returned as a serious problem in most countries. The global inflation problem, a return to the 1970s, is likely to persist for some time.
In both cases, competitive depreciation and competitive appreciation, it is of course impossible for everyone to achieve their goals — because it is, by definition, impossible for everybody to move their exchange rates in the same direction. Both cases represent circumstances often perceived as a lack of international cooperation to achieve exchange rates stability, sometimes leading to calls for a new Bretton Woods.
The IMF Articles of Agreement, agreed in 1944 at Bretton Woods, New Hampshire, were written to avoid the competitive devaluations of the 1930s. As amended in 1976, Article IV(1) iii bans each country from “manipulating exchange rates…to gain an unfair competitive advantage over other members…”.
The US has been quick to allege that other currencies are unfairly undervalued. Congress has since 1988 required the Treasury to send semi-annual reports on whether major trading partners are manipulating their currencies. China and other Asian countries are the most frequent targets. But Switzerland has also been under suspicion, notwithstanding that the Swiss franc is by far the most expensive major currency in the world by other criteria.
In February 2013, the US Treasury spearheaded an agreement among G7 countries that they would refrain from taking steps to depreciate their currencies. The 2013 agreement is little known; but it worked, in the sense that the members over the last decade have refrained from intervening to sell their own currencies on the foreign exchange market.
The phrase “currency wars” was coined by Brazilian leaders in 2010, while complaining about the monetary policies of the US, Japan, and other countries. The accusation this time was not explicit devaluation of the dollar or yen, nor even intervention in the foreign exchange market to drive down the prices of these currencies. The allegation was, rather, that the Fed, Bank of Japan, and other central banks had adopted excessively loose monetary policies, which began by cutting their interest rates to zero and then went further with Quantitative Easing, and that it had the deliberate intent of depreciating their currencies, boosting their net exports, and exporting unemployment to their neighbors.
Similarly, nobody today accuses the US authorities of using foreign exchange intervention to strengthen the dollar. The allegation of 2022, rather, is that, the Fed’s current upward interest rate path attracts a capital inflow and appreciates the dollar. Thus, an alternative perspective on reverse currency wars is that (in today’s non-cooperative equilibrium), the Fed is forcing up interest rates internationally and so holding back global growth from where it could be.
There is ample historical precedent for fears of competitive devaluation, most notably the 1930s, when major powers in sequence each devalued against gold and thereby against each other. Is there historical precedent for competitive appreciation?
It has been argued that the early 1980s were such an example. When the Fed, under Chair Paul Volcker, raised interest rates sharply to fight inflation, it knew that it would be aided by an appreciation of the dollar. But the corresponding depreciation of trading partners’ currencies worsened their inflation rates and forced them to raise interest rates as well. The worry was that the world ended up with higher interest rates than were desirable. The 1985 Plaza agreement to bring down the dollar ended this period of competitive appreciation.
Today, the most likely victims of a strengthening dollar are not other major Advanced Economies, but rather Emerging Market and Developing Economies. Many of them have substantial dollar-denominated debts (exacerbated by the fiscal spending necessary to fight the pandemic in 2020-21). When the dollar appreciates, the cost of servicing their debts goes up in terms of their own currencies. This “balance sheet effect” is contractionary for the economy. The combination of rising interest rates and a rising dollar can trigger debt crises, as it did in Mexico in 1982 and 1994.
Not all fears of competitive appreciation are justified (just as not all fears of competitive depreciation in the past have been justified) or merit a reform of the international currency system. Unlike most central banks, the Bank of Japan has kept its monetary policy very loose into 2022, in a continued attempt to raise inflation, which is running at approximately 1 % per annum, up to the elusive 2 % target Its interest rates are still below zero (negative 0.1%, for the policy rate). This, at a time when the US is raising interest rates in its attempt to reduce inflation. As one would predict from the widening US-Japan interest differential, the yen has depreciated 14 % over the last year against the dollar from 109 yen/$ in May 2021, to 126 now.
Is this big change in the exchange rate a problem? Not really, on net. The movement has allowed upward pressure on Japanese inflation, at the same time that it has allowed downward pressure on US Inflation. That is what both countries want, given their respective current cyclical positions. In this light, floating currencies serve the useful purpose of allowing each country to pursue the monetary policy that suits its own circumstances.
This post written by Jeffrey Frankel.