Currency Wars - Perception and Reality. EICHENGREEN, Barry.

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Global Financial Institute

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Currency Wars: Perception and Reality

May 2013 Pro. Barry Eichengreen


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Author

Pro. Barry Eichengreen

George C. Pardee and Helen N.

Pardee Proessor o Economics

and Political Science

Department o Economics

University o Caliornia, Berkeley

Email:

[email protected]

Web Page:

Click here

2

Barry Eichengreen is the George C. Pardee and

Helen N. Pardee Proessor o Economics and

Proessor o Political Science at the University

o Caliornia, Berkeley, where he has taught

since 1987. He is a Research Associate o the

National Bureau o Economic Research (Cam-

bridge, Massachusetts) and Research Fellow o

the Centre or Economic Policy Research (Lon-

don, England). In 1997-98 he was Senior Policy

Advisor at the International Monetary Fund. He

is a ellow o the American Academy o Arts

and Sciences (class o 1997).

Proessor Eichengreen is the convener o the

Bellagio Group o academics and economic

ocials and chair o the Academic Advisory

Committee o the Peterson Institute o Inter-

national Economics. He has held Guggenheim

and Fulbright Fellowships and has been a


ellow o the Center or Advanced Study in the

Behavioral Sciences (Palo Alto) and the Insti-

tute or Advanced Study (Berlin). He is a regu-

lar monthly columnist or Project Syndicate.

Proessor Eichengreen was awarded the Eco-

nomic History Associations Jonathan R.T.

Hughes Prize or Excellence in Teaching in

2002 and the University o Caliornia at Berke-

ley Social Science Divisions Distinguished

Teaching Award in 2004. He is the recipient

o a doctor honoris causa rom the American

University in Paris, and the 2010 recipient o

the Schumpeter Prize rom the International

Schumpeter Society. He was named one

o Foreign Policy Magazine s 100 Leading

Global Thinkers in 2011. He is Immediate Past

President o the Economic History Associa-

tion (2010-11 academic year).
mailto://[email protected]://emlab.berkeley.edu/~eichengr/biosketch.htmlhttp://emlab.berkeley.edu/~eichengr/biosketch.htmlmailto://[email protected]


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Table of contents3

Table o contents

Introduction to Global Financial Institute

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all made relevant and reader-riendly or investment

proessionals like you.

Introduction ............................................. .............................. 04

1. History Lessons ................................................ ..................... 06

2. Reasoning by Analogy ................................................... .... 08

3. The Fog o War ................................................. ..................... 11

4. Reerences ................................................ .............................. 12



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Introduction

4

The problem o currency wars emerged as both a

major concern and a source o conusion in early 2013.

This once obscure term, rst uttered by Brazilian Finance

Minister Guido Mantega in response to the initial round

o quantitative easing in the United States, came into

widespread use ollowing the ormation o a new Japa-

nese government under Prime Minister Shinzo Abe in

late 2012. Mr. Abe indicated his intention o pursuing

more aggressively refationary monetary and exchange

rate policies. This caused the yen to all by 16% against

the dollar and 19% against the euro between the end o

September, when it became likely that Mr. Abe would

take power, and mid-February 2013, when his appoint-ment o a new Bank o Japan governor was imminent.

Both the term and the concerns to which it reerred

thereore migrated to the ront pages o the nancial

press. A host o additional policymakers some rom

emerging markets, such as Alexei Ulyukyev, rst deputy

chairman at the Russian Central Bank, and Bahk Jae-

wan, South Koreas nance minister, and others rom

advanced countries, like Bundesbank President Jens

Weidmann warned o the adverse consequences o

currency manipulation, Mr. Weidmann reerring omi-

nously to an undesirable politicisation o exchange

rates.1 The currency-war problem then became a key

topic at the meetings o the Group o Seven and Group

o Twenty this February, where it was the subject o a

careully crated set o communiques.2

But careully crated is not the same as clearly under-

stood. The conusion stems rom the act that there is

no widely accepted denition o a currency war. The

term is not ound in the leading textbooks o econom-

ics. There is the implication that a currency war is to be

understood by analogy with the concept o a trade war,

in which countries use trade policy to shit spending

toward products produced domestically at the expense

o their neighbours a process that is ultimately utile

insoar as it provokes retaliation. The only dierence is

that in the case o a currency war, it is currency policy

rather than trade policy that is being deployed. There

is, however, the analytical problem that while trade

warare destroys trade, creating a deadweight loss, o-

setting devaluations simply return bilateral exchange

rates to their initial levels with no enduring relative price

eects. It is not clear that the analogy holds water, in

other words.

Similarly, there is the implication that a currency warcan be said to have broken out when one or more

countries engages in beggar-thy-neighbour competi-

tive currency depreciation. But it is not clear in this

case whether all policies that result in currency or

exchange-rate depreciation are necessarily competitive

or beggar-thy-neighbour. Just because a country sees

its exchange rate depreciate, is it necessarily engaged

in a currency war?

Probably the most widely accepted denition o what

constitutes a currency war is what countries did in the

1930s. Starting in 1931, one country ater another

depreciated its currency. Since currencies were

pegged to gold rather than to one another, countries

depreciated by abandoning their pre-existing gold pari-

ties and allowing the domestic currency price o gold

to rise. This consequently had the eect o also raising

the domestic currency price o oreign currencies still

pegged to gold at prevailing parities.3

As the story is conventionally told, this enhanced the

competitiveness o countries depreciating their curren-

cies but worsened that o the remaining gold-standard

Currency Wars: Perception and RealityPro. Barry EichengreenMay 2013

Currency Wars: Perception and Reality Global Financial Institute

1Quoted in Randow and Schneeweiss (2013).2 See Group o Seven (2013) and Group o Twenty (2013).3The gold parity reerred to the weight o gold o specied purity in the national monetary unit as specied by law or

statute o a country said to be on the gold standard.


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5 Currency Wars: Perception and Reality

countries. This saddled the latter with overly strong

exchange rates, creating pressure or them to respond

tit or tat, as they ultimately did. Ater ve years o com-

petitive devaluations, exchange rates had returned to

levels very close to those prevailing in early 1931. No

country succeeded in engineering a sustained improve-

ment in competitiveness or, it is argued, achieved

aster economic growth. But there were a variety o

other adverse consequences ranging rom height-

ened exchange rate uncertainty that disrupted trade

and production to the imposition o trade barriers and

exchange controls by countries with overvalued curren-

cies and weakened balances o payments.4 It is not an

exaggeration to say that popular accounts blame the

currency wars o the 1930s or aggravating the political

tensions that made it more dicult or countries to col-

laborate in averting the military and diplomatic conficts

that led ultimately to World War II.5

In act, this conventional narrative is oversimplied and

misleading in important respects. This in turn meansthat todays debate over currency wars, because it is

heavily inormed by that narrative, is itsel oversimpli-

ed and misleading. The modern literature empha-

sises that the policy changes associated with currency

depreciation in the 1930s were not actually zero sum.

To the contrary, those policy changes let all countries

better o relative to the status quo ante, in which policy

did not change and exchange rates did not move. But

this was not well understood at the time. As a result,

the point is not understood today by those advancing

the conventional story.

In part, contemporary misunderstanding arose rom

the act that interwar governments did a poor job o

communicating their intentions. In part it arose rom

the act that they did a poor job o implementing their

policies; they could have done much more to accentu-

ate the positive-sum aspects. And in part it arose rom

the act that policymakers continued to view their cur-

rent situation through the lens o past problems, ailing

to acknowledge that circumstances and thereore the

appropriate policies had changed.

The same actors are again present today, once more distort-

ing the debate over currency policies. Policymakers have

done a poor job communicating their intentions. They could

have done more to accentuate positive-sum aspects o their

actions. And, along with market participants, they have had a

tendency to view policies through the distorting lens o pastproblems rather than current circumstances. Understanding

these shortcomings o the present debate and correcting the

resulting misapprehensions would go a long way toward solv-

ing the currency war problem.

4These negative side eects were highlighted by Ragnar Nurkse (1944) in his infuential contemporary account, which

helped to clear the way or the Bretton Woods System o pegged-but-adjustable exchange rates. A recent, somewhat

revisionist treatment is Eichengreen and Irwin (2010).5 See or example Kennedy (1999).



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1. History Lessons


The background to the currency and exchange rate

problems o the 1930s was, o course, the depression

and defation that started in 1929. In turn, that depres-

sion and defation must be understood in the context o

the gold standard, the monetary regime providing the

structure or global monetary and nancial aairs.6

The 1920s monetary regime was a gold-exchange stan-

dard rather than a pure gold standard. Central banks

and governments operated under statutes obligat-

ing them to back their monetary liabilities with gold

and convertible oreign exchange.7 Other than this

provision or holding reserves in the orm o oreign

exchange, the regime had many o the eatures o a text-

book gold standard. International nancial fows were

unrestricted. With the capital account o the balance

o payments open, domestic interest rates could not

deviate signicantly rom those in the rest o the world.

I domestic policymakers sought to depress rates ur-

ther, capital would migrate to oreign nancial markets

where they were higher, causing the central bank tolose gold and oreign exchange reserves, and threaten-

ing the maintenance o gold convertibility. This is the

standard open-economy trilemma.8 With exchange

rates pegged and capital markets open, central banks

had limited monetary policy room or manoeuvre.

The gold-exchange standard had been put back in place

in the 1920s ater roughly a decade o suspension, dur-

ing which a number o current and ormer belligerents

had suered high infation.9 That experience in turn

shaped their expectations o risks and outcomes in the

event that gold convertibility was again suspended.

As it happened, defation rather than infation turned

out to be the immediate danger.10 When it developed

ater 1929, central banks and governments had little

reedom o action. As long as they remained on the

gold standard, they could not unilaterally take steps

to stem the all in prices. They could not unilaterally

cut interest rates to encourage borrowing and spend-

ing. Injecting liquidity in order to support a distressed

banking system threatened to atally weaken the cur-

rency. Running budget decits rekindled ears, inher-

ited rom the 1920s, that central banks would be pres-

sured to monetise public debts. Governments were

thereore orced to cut public spending and raise taxes

in order to preserve condence in their exchange rate

commitments.

It might be thought that these policies o austerity, pur-

sued in the ace o depression and defation, could not

be sustained indenitely. Indeed, they could not. Brit-

ain was the rst major country to abandon them and

depreciate its currency. It had a Labour government

that could not agree on budgetary economies and high

unemployment that rendered the central bank reluctant

to raise interest rates urther in order to stem capital

fight.11 It suspended gold convertibility in September

1931, and the pound quickly ell rom $4.86 to a low o

$3.40, rom which it recovered modestly beore stabi-lising. Some two dozen other economies, principally

members o the Commonwealth and Empire and British

trading partners, quickly ollowed suit. The next shoe

to drop was Japan, whose nance minister Korkiyo

Takahashi implemented an aggressively expansion-

ary monetary policy that pushed down the yen start-

ing in December. President Franklin Delano Roosevelt

embargoed gold exports on March 5th, 1933, his rst

ull day in oce. He made that embargo permanent

in April and actively pushed up the dollar price o gold

(pushed down the dollar exchange rate) rom October.

A number o U.S. trade partners, principally in Latin

America, ollowed the dollar down. In January 1934,

when the dollar was again stabilised against gold, the

sterling/dollar exchange rate was back to roughly the

level prevailing beore September 1931.

These eorts by Britain, the U.S., and Japan to depre-

ciate sterling, the dollar, and the yen made lie more

6

As I argued in Eichengreen (1992), on which the remainder o this section draws.7Typically at ratios o 33 to 40 per cent.8 See Obsteld, Shambaugh and Taylor (205).9 The hyperinfations in Germany, Austria, Hungary, and Poland being extreme cases in point.10 Describing the origins o the global defation would take us too ar aeld; in this, see Bernanke (1995) and Eichen-

green (2004).11 That Labour government was succeeded by a National government which agreed on budgetary economies in August,

but by this time it was too late.

32

48



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dicult or countries still on the gold standard. (That

these are the same three countries currently under

attack or being engaged in currency war is presum-

ably a coincidence.) Having lost international competi-

tiveness, these so-called gold-bloc countries saw their

balances o payments accounts weaken and gold fow

out o their central banks. Forced to raise interest rates

to deend the reserve position rather than cutting them

to support the economy, their depressions deepened.

The result was not an equilibrium in either the eco-

nomic or political sense. Economically, the condition

o domestic nancial institutions continued to worsen.

Politically, opposition welled up against policies o aus-

terity. The remaining members o the gold bloc pro-

gressively ell by the wayside. Czechoslovakia and Italy

devalued in 1934, Belgium in 1935, Poland, France, the

Netherlands, and Switzerland in 1936, returning their

exchange rates to roughly the same levels against the

dollar and sterling that prevailed beore 1931. These

competitive devaluations gave rise to a good deal o

damaging exchange rate and nancial volatility, but atthe end o the day, it is said, they changed nothing.

Such is the conventional narrative. The modern litera-

ture on exchange rate policy in the 1930s, beginning

with Eichengreen and Sachs (1985), disputes this view

that the exchange rate policies o the 1930s were with-

out positive eect. While currency depreciation did

switch demand toward domestic goods and away rom

their oreign substitutes, this was not its exclusive or

even its principal impact. Rather, abandoning the com-

mitment to peg the exchange rate allowed countries

to replace the defationary measures o the preceding

period with refationary monetary policies. Going o

the gold standard was a credible way o signaling this

commitment to prioritise price stability over exchange

rate stability.

Thus, six months ater abandoning the gold standard,

the Bank o England began cutting interest rates; by

July 1932 these had reached the historically low level

o 2%, inaugurating a new era o cheap money. The

Swedish government and Riksbank replaced the gold

standard with an explicit price level target. In Japan,

Takahashi supplemented his refationary monetary

policy with an increase in public spending and instruc-

tions that the Bank o Japan purchase the resulting

increase in the public debt. In the U.S., FDR used his

bombshell message to the World Economic Coner-

ence o June-July 1933 to signal that he was unwilling

to restore the gold standard. He was not prepared to

privilege exchange rate stability (what he reerred to in

that message as the old etishes o international bank-

ers). The bombshell message may have made interna-

tional cooperation on trade policy, security policy, and

other matters more dicult, but it was a strong signal

o a durable change in the monetary regime.

These new policies had other important eects apart

rom their impact on exchange rates. Lower inter-

est rates encouraged interest-rate sensitive orms o

spending, in the U.K. or example, where the literature

reers to the housing boom o the 1930s. 12 They put

upward pressure on asset prices which, other things

equal, stimulated investment spending. By haltingdefation, they stemmed the rise in debt burdens and

squeeze on prots. By creating expectations o higher

uture prices, they encouraged households to shit

consumption rom the uture to the present. By giv-

ing central banks more reedom o action, they allowed

them to intervene as lenders o last resort to limit bank

distress.13 And insoar as the policies had these stabi-

lising eects on the initiating country, they encouraged

residents to spend more on oreign as well as domestic

goods. Currency devaluation by an individual country

may have had negative spillovers on its neighbours via

the exchange rate channel, but it had positive spillovers

via these interest rate, asset price, and expectations

channels. Even i the negative exchange rate spillovers

dominated when a single policy was taken in isolation,

once the entire round o exchange rate changes was

complete those negative spillovers were gone and only

the positive interest rate, asset price, and expectation

eects remained.

These conclusions are, o course, inconsistent with the

presumption that monetary policy was impotent in the

1930s because interest rates were at the zero lower

12 See Middleton (2010) or reerences.13 The cross-country evidence can be ound in Grossman (1994).



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bound.14 Cross-country comparisons, calibration exer-

cises, and national case studies, all using data rom the

1930s, have combined to overturn this presumption.15

These studies highlight that interest rates were still

signicantly above zero prior to the change in policy

regime; the change thereore gave central banks ur-

ther room to cut. They remind us that even when nomi-

nal interest rates are near zero, central banks can still

aect the real interest rates on which allocation deci-

sions depend through the expectations channel by

using orward guidance and asset purchases to create

expectations o infation rather than defation. FDRs

gold purchases and Takahashis government bond pur-

chases can be thought o as analogous to quantitative

easing, while the Bank o Englands commitment to

keep interest rates low and the Riksbanks commitment

to target the price level can be thought o as orward

guidance.

Modern studies thus conclude that countries abandon-

ing the gold standard and allowing their currenciesto depreciate recovered most quickly rom the 1930s

depression. Recovery was, however, less than vigor-

ous. Countries abandoning the gold standard and

depreciating their currencies were reluctant to imple-

ment aggressively refationary policies. In Britain, or

example, the Bank o England, concerned that the ster-

ling exchange rate could collapse in the absence o its

golden anchor, took three ull quarters to convince itsel

that cheap money was sae and to cut interest rates to

2%. Even then it remained reluctant to cut them ur-

ther. FDR, although depreciating the dollar by 50%, put

the U.S. back on the gold standard at the now higher

gold price in January 1934, contrary to the advice o

John Maynard Keynes and others. In the subsequent

period, the Treasury repeatedly sterilised gold infows,

limiting the growth o money and credit. Central banks

and governments could not ree themselves o the

specter o the 1920s infations and thus were reluctant

to make ull use o their newound monetary room or

manoeuvre.

As a result, the beggar-thy-neighbour eect o currency

depreciation tended to dominate the positive spillovers

transmitted through now lower interest rates and infa-

tionary expectations. And the ailure o policymakers

to more clearly explain their intentions which were

not to beggar their neighbours but to stabilize their own

prices, economies, and nancial systems caused their

motives to be widely misunderstood.

Thus, to the extent that there was a currency problem

in the 1930s, it stemmed not rom the decision o coun-

tries abandoning the gold standard to refate, but rom

the ailure o the countries o the gold bloc to do like-

wise. That ailure was rooted, as noted above, in ear-

lier experience with high infation in France, Belgium,

Poland, and the Central European countries that now

clung to the gold standard with the help o exchange

control.16 Policymakers and their constituents contin-

ued to perceive current economic and nancial circum-

stances through the lens o past problems, with pro-

oundly negative consequences.

The problem in the 1930s, then, was not too much cur-

rency warare, but too little.

Many o these points have analogues in the current

debate. First, there is the view, implicit in the critiques

o emerging market policymakers, that the unconven-

tional monetary policies o advanced-country central

banks are ineectual. Monetary policy, they allege, has

lost its potency now that interest rates are at the zero

lower bound, just as it allegedly lost its potency in the

1930s. Only the negative side-eects, it ollows, are

let.

While there is less than ull consensus on the ecacy

o unconventional monetary policies at the zero lower

bound, a growing body o literature studying dierent

episodes suggests that such policies are not entirely

without eect. Oda and Ueda (2005) and Ugai (2006)

14 A presumption that is popularly cited as explaining Keyness discovery o the importance o using activist scalpolicy in a liquidity trap.15 See, respectively, Bernanke and James (1991), Eggertsson (2008), and Romer (1992) or examples.16 In the cases o Switzerland and the Netherlands, an additional motive was the desire not to jeopardise the position o

Zurich and Amsterdam as international nancial centres and the power o the banking lobby.


2. Reasoning by Analogy


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analyse the impact o the Bank o Japans experience

with quantitative easing between 2001 and 2006 and

conclude in avor o small but noticeable impacts on

medium- and long-term interest rates. Gagnon, Raskin,

Remarche, and Sack (2011) report evidence, derived

using a variety o methodological approaches, o posi-

tive eects o quantitative easing in the United States.

Krishnamurthy and Vissing-Jorgensen (2010) look at

low requency variations in the supply o long-term

Treasury bonds like those that would ollow rom quan-

titative easing and identiy eects on interest rates on

other relatively sae assets. Krishnamurthy and Vissing-

Jorgensen (2011), disaggregating urther, nd evidence

o a signaling channel, an expected infation channel,

and a demand-or-long-term-sae-assets channel trans-

mitting eects o both the rst and second rounds o

quantitative easing by the Federal Reserve. Looking

back at Operation Twist in the 1960s, Swanson (2011)

nds a small but signicant impact on long-term inter-

est rates operating through the portolio rebalancing

channel. Joyce, Lasaosa, Stevens, and Tong (2010)similarly nd evidence o the operation o the porto-

lio rebalancing channel in the response o gilt prices

to large-scale asset purchases by the Bank o Eng-

land starting in March 2009. In a companion paper,

Kapetanios, Mumtaz, Stevens, and Theodoridis (2010)

conclude that those Bank o England purchases had an

eect on the level o real GDP o around 1 % and

raised the annual rate o CPI infation by about 1 per-

centage points at its peak. Dierent studies consider

dierent episodes and arrive at dierent point esti-

mates, but as a group they are inconsistent with the

view that unconventional monetary policies are with-

out eect. This casts doubt on the assertion by some

observers based in emerging markets that such policies

should simply be abandoned.

Second, there is the view that unconventional monetary

policies operate only by pushing down currencies, with

beggar-thy-neighbour consequences or other coun-

tries. To be sure, the exchange rate channel can be

important or switching expenditure toward domestic

goods. Insoar as this channel dominates, the eect

will be to beggar thy neighbour. Just as in the 1930s, to

the extent that central banks ail to complement open

mouth operations pushing down the real exchange rate

with open market operations and other asset purchases

pushing down real interest rates, their neighbours will

have correspondingly more reason to complain about

the spillover eects on output and employment in other

countries.

But the exchange rate channel can also be important

or signaling the policy authorities commitment to

do what it takes to hit their infation target. Svensson

(2003) reers to the combination o a price-level target

path, a zero interest rate commitment and, importantly,

currency depreciation and a commitment to maintain-

ing a level or the exchange rate as the oolproo way

o ending defation. Insoar as ending the defation and

avoiding the extended period o economic stagnation to

which it can give rise is good not just or the initiating

country but also its trade and nancial partners, posi-

tive spillovers on other countries rom depreciation o

its exchange rate may still dominate.

The studies reerred to earlier in this section suggest

that unconventional monetary policies also operate

through the portolio rebalancing channel that leads

to changes in the term structure o interest rates. IMF

(2011) nds that portolio-rebalancing-related interest-

rate eects dominated the other negative cross-border

spillover eects o QE1 and QE2 in other words, that

the spillover impact on oreign output was positive on

balance, the complaints o emerging market policymak-

ers notwithstanding.

Third, there are complaints about other negative side

eects o unconventional monetary policies. The worry

is that quantitative easing is encouraging renewed

nancial excesses in advanced countries and emerg-

ing markets alike. Risks are being allowed to build up.

Equity markets in the United States are becoming richly

valued as investors acing near-zero interest rates on

sae assets stretch or yield by purchasing riskier instru-

ments. The natural process o deleveraging by the

household and nancial sectors needed to produce a

saer and more stable economy is being rustrated, the



10/14


implication ollows.

This view has an analogue in the liquidationist

response to the Great Depression.17 U.S. policymak-

ers inside and outside the Fed worried that monetary

accommodation would cause the development o an

even larger Wall Street boom and bubble, leading sub-

sequently to an even larger crash. Herbert Hoovers

Treasury Secretary Andrew Mellon amously argued

that restraint was necessary to teach speculators

a lesson and purge the rottenness out o the sys-

tem.18 Similar views were advanced by Austrian and

other Continental European economists rom Hayek to

Schumpeter.

The modern literature on the Great Depression and on

nancial crises generally acknowledges that activism

has risks but suggests that inaction in the ace o cri-

sis also has a downside. And to the extent that pol-

icy activism in response to crisis encourages nancial

excesses, these are best addressed by tightening super-vision and regulation o nancial markets, not by pre-

mature abandonment o supportive monetary policies.

Some recent studies have questioned this separation

principle they have questioned whether there exists

an adequate array o monetary and regulatory instru-

ments, so that monetary policy can be assigned to infa-

tion and growth while regulation is assigned to nancial

stability.19 Maybe not, but i not the call should be or

policymakers to develop a wider array o instruments,

not or central banks and governments to abandon the

pursuit o all other valid goals in the interest o nancial

stability.

The same goes or the complaint that unconventional

monetary policies in the advanced countries are eed-

ing nancial excesses in emerging markets. The worry

itsel is not without oundation: As Chen, Filardo, He

and Zhu (2011) show, quantitative easing in the United

States has had a strong impact on credit growth,

asset prices, and capital infows in emerging markets.

But the rst-best response or policymakers in those

countries is not to jawbone the Federal Reserve and

Bank o Japan to abandon quantitative easing, which

would make or slower global and even possibly slower

emerging-market growth, but to tighten their own

supervision and regulation o nancial markets. And to

the extent that conventional regulatory instruments are

not up to the task, emerging market policy makers can

resort to capital infow taxes and controls as a second

line o deence against nancial excesses resulting rom

oreign policies.20

Similarly, to the extent that low interest rates in the

advanced countries encourage capital infows into

emerging markets that an infation, result in currency

overvaluation, and create worries o overheating, the

rst-best response is not or ocials there to pressure

advanced country central banks to abandon their low

interest rate policies but to adjust their own policies

appropriately. The rst-best response is or emerging

markets to tighten scal policy. Tightening scal policy

puts downward pressure on domestic spending. It putsdownward pressure on asset valuations. It means less

infation, other things equal. It means lower interest

rates and, thereore, smaller capital infows and less

pressure or real exchange rate appreciation. By reduc-

ing sovereign debt burden, it puts the economy in a

stronger position going orward.

The objection here is that political constraints make

it dicult to adjust scal policy, which is even more

politicised than monetary policy. Maybe so, but then

the call should be to make it easier to implement opti-

mal adjustments o scal policy in emerging markets

by strengthening automatic stabilisers or delegating

aspects o scal policy to an independent scal council,

not to insist that advanced country central banks aban-

don the pursuit o price stability and recovery.

The European Central Bank, spokesmen or which have

complained about how the policies o other central

banks have produced an uncomortably strong euro

exchange rate, is in a dierent position. In contrast to

17 See DeLong (1990).18 As quoted in Hoover (1952).19 See Committee on International Economic Policy and Reorm (2011).20This is the justication o capital infow restrictions as a second-best orm o nancial regulation rst developed, i I

am correct, in Eichengreen and Mussa (1998).



11/14


emerging markets, spokesmen or which have similarly

complained that their exchange rates are uncomort-

ably strong, the Eurozone does not currently suer rom

excessive infation, rothy asset markets, or risk o eco-

nomic overheating to the contrary. Eurozone infation

ell to 2% in January in line with the ECBs target, while

core infation at 1.2% is running below that. The ourth

quarter o 2012 saw Eurozone GDP shrink by 0.6%.

The standard policy prescription or a central bank

engaged in fexible infation targeting and worried by

an overly strong exchange rate would be to join the cur-

rency wars. In the event, the ECB is not a conventional

infation-targeting central bank. It has a mandate to

hold infation at or below its target o 2% but not to pur-

sue other goals. The European public, whose approval

lends the ECBs policies political legitimacy, continues

to worry about infation, which was yesterdays prob-

lem but is less obviously todays or even tomorrows.

The analogy with the defationary 1930s when central

banks were haunted by the spectre o infation in anearlier decade, in turn eeding their reluctance to take

more aggressive monetary action is direct. How the

ECB squares this circle will have implications not just

or the global currency wars, but or the uture o the

Eurozone itsel.

A nal analogy with the 1930s is the ailure o policy

makers in countries ollowing unconventional monetary

policies to adequately communicate their goals and

strategies. In late December, Japans incoming prime

minister made a series o comments about the desir-

ability o resisting a strong yen that were interpreted

in terms o the desirability o a weaker yen exchange

rate. By ocusing on the exchange rate rather than

on measures to push up the price level, reduce inter-

est rates, and encourage spending, those comments

anned ears that the strategy was intentionally beggar

thy neighbour. In its rst policy statement or 2013,

the Bank o Japan then signaled its responsiveness to

the new governments desires, but announced that it

would consider urther ramping up its programme o

asset purchases only in 2014. By creating expectations

that it might acquiesce to a weaker yen exchange rate

but that it would only take additional steps to oster

expectations o higher prices, lower real interest rates,

and more spending 12 or more months in the uture,

that statement urther heightened ears abroad that the

new strategy was exchange-rate-centered and beggar

thy neighbour.

It may be that the essence o Japans new monetary

policy strategy is the higher infation target o 2% and

that the Bank o Japan will make a concerted eort to

achieve it, creating expectations o a higher uture price

level and encouraging additional spending by Japanese

consumers something that would be more likely to

have positive spillovers or other countries. I so, this

act needs to be conveyed more clearly to avoid anning

ears o currency war.

Currency war is now a standard trope in journalis-

tic accounts o monetary policy. But what exactly

constitutes currency warare remains unclear. Not

every economic policy that is associated with a weaker

exchange rate is undesirable, and not every domestic

policy associated with a weaker exchange rate nec-

essarily redounds to the disavor o other countries.

Ocials warning o currency wars would do better to

distinguish positive rom negative eects o the oreign

monetary policies o which they complain. They would

do well to consider the alternatives. Would emerging

markets really be better o i advanced countries at

risk o defation and recession abandoned their uncon-

ventional policies? Policymakers in emerging markets

could spend less time complaining about advanced

country policies and more time identiying and imple-

menting an appropriate policy response. Policymakers

in advanced countries, or their part, need to do a better

job o communicating the intent o their policies. Only

then are we likely to see our way through the og o war.


3. The Fog o War


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