Who is afraid of currency wars?

At the Central Bank of Chile conference the other day, talk naturally turned to the threat of what the Brazilian finance minister Guide Mantega called "currency wars" -- the danger that the world is headed for major conflict over currency movements. All of this is coming from a) unease about the exchange rate of the Chinese currency, which many American politicians feel is too low b) fear in the rest of the world that American pump-priming in the form of quantitative easing will put undue upward pressure on their currencies. On the bus over to the conference restaurant, I had the good fortune of chatting with Olivier Blanchard, currently chief economist of the IMF, and as we talked (without attributing anything specific to him or the IMF) it occurred to me that the current discussion is quite similar to what we used to think about the end of the gold standard during the Great Depression. The standard story used to say - everyone devalued against gold, i.e. against each other, in a bid to improve the competitiveness of their economies. By the end, relative rates were not much changed -- but you had tremendous turmoil in between, and world trade collapsed. That's saying currency wars in the 1930s were really bad, and the implication is gloomy -- we are at it again.

The new view, pioneered by Barry Eichengreen and others, holds that devaluing against gold was good because it broke the grip of deflation. Relative exchange rates may not have moved much, but that wasn't the point -- reflating by getting the money supply up was. In that sense, if we all did a bit of quantitative easing, a bit of "currency war" might be a good thing. It's also an interesting way of aligning incentives. The standard problem in an open economy is that we want our neighbor to stimulate his economy (especially if there is a risk of inflation) - much better than to do it at home. Because QE likely has an impact on exchange rates, this "free rider" problem is mitigated - you may still benefit from your neighbor's QE, but you will pay a price through a higher exchange rate if you don't move as well. In that sense, the non-cooperative policy setting that Mantega described may be a good "second best", provided you believe that Europe is being a bit conservative in terms of monetary policy... The part of the world that really does have a problem is epitomized by Mantega's Brazil, which as been booming and certainly doesn't need more stimulus. But then, perhaps it can live with a higher exchange rate as a price for equilibrating growth around the world.

Bad news is good news ... again

Why do I have this sense of deja vu? No, it's not because I am heading to the airport tomorrow for another conference in far-flung lands (the Central Bank of Chile is having what promises to be a good one). It's that strange sensation I get from seeing stock markets rallying hard because Bernanke and friends are promising us more quantitative easing. So let's get this right. QE 2 is being discussed because a) output growth is slowing b) unemployment is high c) the US housing market is in the doldrums d) which means that the banks will have even more problems in the future e) which all sums up to a good chance of deflation. One can debate whether more money printing by the Fed is the right answer. As for the wisdom of bidding up stocks... either it works, which means that we will have anaemic growth plus rising prices, and then we have to worry about inflation (which has traditionally been bad for stocks). Or it doesn't, and we are getting something between the Great Depression and the Japanese lost decades. Neither prospect seems much of a cause for cheer. Now, when was it when I saw this last? That's right, in the fall of 2007, when increasingly bad news led markets to expect interest rate cuts from the Fed. For a few months, the bad news was accumulating, and the markets continued to move higher. Back then, people had complete confidence in the Fed's powers to make any recession disappear in... and when people realized it wasn't quite true, things really collapsed hard. It made for a good show back then. Given how untested QE is compared to good old interest rate tools, I wouldn't be surprised if we get a rerun in a stockmarket near you before long...