My QE is your Currency War (is someone else's revolution)
Transcript (roughly) of a talk I just gave at the Warwick Economics Summit
Movements in the exchange rate between one currency and another have become the great unmentionable in macro-economic policy. Half the world has an exchange rate policy - the other half claims not to have one.
Yet as the financial crisis has morphed into first a fiscal crisis and now in many countries a social crisis, the global currency markets have become a new stage on which the basic drama is to be played out: who pays for the crisis?
It was the Brazilian finance minister, Guido Mantegna, who declared that the world was in the midst of a currency war in September 2010.
In fact we are in the midst of several currency conflicts and I will list them:
China versus the USA: in which the US wants China to allow the RMB to rise against the dollar, weakening China's competitiveness by raising the price of Chinese exports.
There is the USA versus the Emerging Markets: in which the USA's quantitative easing policy is seen to be exporting inflation, again forcing the currencies of Brazil, South Korea and other export giants to rise against the dollar.
With the Brazilian real up 40% against the dollar in two years Brazil responded to QE2 with
a. A tax on foreign purchases of bonds, designed to suppress the flow of capital in Brazil
b. $40bn of intervention into the spot market for its own currency
c. This month, a ban on short selling of the dollar against the real in Brazil
There is the Euro versus the dollar. Analysts at Goldman Sachs estimated that the entire negative impact of European austerity programmes in 2010 could be offset by a fall in the Euro's exchange rate to parity with the dollar: to the extent that this does not happen, Europe bears the cost of its own crisis.
Then there is north Europe verus south Europe. The Eurozone is locked into one exchange rate but peripheral Europe has, over a nine year period lost competitiveness against the core industrialised and export-led countries above all Germany. Southern Europe cannot devalue, so it is being forced to impose an internal devaluation by the Eurozone authorities - which means massive austerity, wage cuts and the erosion of welfare state provision.
Then there is Japan versus America. When America did QE, so did Japan - in part justifying the move on the grounds that QE was an act of exchange rate competition.
Finally there is Britain versus the rest of the world. Sterling underwent a 25% devaluation during the Lehman crisis, stabilising at a net 20% fall against the currencies of its main trading partners. In this way Britain has offset the cost of the crisis, avoiding double-digit unemployment but amplifying the impact of the commodity price inflation that has now taken off.
The most amazing thing about these currency wars is that few ruling politicians will admit to taking part in them. But they exist - and I now want to situate them within the unfolding crisis that began in 2008.
The best metaphor I have for understanding this crisis, is the 1982 movie Alien.
In the movie, the alien is sitting on John Hurt's face, breathing on his behalf. The ship's doctor decides to cut it off. But as he makes the incision - blood spurts out and the alien's blood is acid. It burns through the floor of the ship, and the cast run down to the next floor and sure enough it's burned through the ceiling, dripped to the floor and is now burning through that as well. They run to the next level and the tension's rising - because if the acid burns thru to the ship's hull - bang! - end of the movie. But it stops. The floor holds it, or the acidic qualities burn themselves out.
In this metaphor the banks are the alien. The blood is toxic debt. The first floor burned through is the global credit market - that disintegrates. But then it burns through the real economy. Output, global trade, stock market values plummet in the final quarter of 2008 and early 09.
Then the state rescues the free market. The state, which was told to butt out of the market, that it could never play a useful function, that it could never regulate better than the two parties in a deal could. Suddenly the state steps in. Bailouts whose value in both the UK and the USA came close to totalling a year's GDP. Fiscal stimuli totalling around 12% of GDP in the USA, China. Quantitative easing in the USA, UK and Japan again totalling a similar amount. And that stabilises the crisis.
Now here's the problem. Some parts of the state formation were not strong enough to hold the toxic matter in check for ever. So it has now begun to burn through and destroy aspects of political arrangements in the world. I will list them:
- The Eurozone - where the social model in the peripheral countries has to be destroyed so the Euro can live;
- Bipartisan politics in the USA - which cannot survive the entry of the state into economic life without provoking a severe existential crisis among the population;
- British social democracy - insofar as its economic programme was based on being a conveyor belt of tax revenues from the financial and service sectors down to poor communities whose lives never got any better;
- Finally, and now spectacularly, the whole economic model in Arab north Africa based on state capitalism and patronage suddenly could not deliver rising employment to its new educated middle class and - with the return of commodity price inflation in 2010, began to be shaken by revolts and unrest.
You have to see this third phase of the crisis as the interplay between efforts to foist the cost of the crisis onto a country's own population - and efforts to offload it onto another country's population in the form of currency appreciation and inflation.
Korea, the Phillipines, Indonesia, Colombia and South Korea are all engaged in some very public thinking about the same kind of capital controls as Brazil imposed. And currency manipulation spills very easily over into trade sanctions.
The US Congress passed the Currency Reform for Free Trade Act authorising the government to take punitive trade sanctions against any country whose currency was deemed to be undervalued by more than 5%.
Here's a graph of undervalued currencies: most of them in Asia, as proposed by HSBC's forex team. (ref Cline and Williamson, Petersen Institute/HSBC).
American policymakers make continued and resolute statements that they have no intention of weakening the dollar through loose monetary policy. Mervyn King has, in private been more frank: a senior and reliable source inside the bank told me Mervyn "was very proud of himself for talking down sterling" during the 2007/8 crisis.
When I studied the political economy of the Great Depression, in the early 1980s, we tended to focus on the Keynesian and Marxist explanations - falling effective demand; disequilibrium; the rate of profit. Everyone agreed that the money supply had collapsed and that prices had fallen but Keynesians tended to see this as a consequence, not a cause.
One of the fruits of the rise of neoliberal economics in the 1980s is that everyone is much more enlightened as to the monetary and forex explanations for why the stock market crash turned into an output sliump. Indeed the greatest contributor on this subject is Ben Bernanke himself. He argues that US monetary contraction was a result of faulty institutions and bad policy and that the bad policy was a result of the USA's determination to stick to the Gold Standard, at a time when many of its competitors were leaving: that is, to maintain an unviably high price for the dollar against gold.
"To an overwhelming degree the evidence shows that countries that left the Gold Standard recovered from the Depression more quickly than countri that remained on gold."
Those that devalued first, like France or Belgium, recovered first. This, to me, despite all the public statements, is the logic behind the policies of all the major economies.
China struggles to maintain its undervalued currency. The USA struggles to devalue causing a secondary conflict with Emerging Asia and Latam; ditto the UK; the Eurozone is caught in the middle - but the Bernanke law forces peripheral Europe into an internal devaluation.
One school of thought sees this all leading to a resolution of the global imbalances - on capital flows, on trade, on current account. I don't. It is already leading to disorder - in North Africa rising food prices are just one factor in the unrest but they are a factor and they are in part the result of the wall of money flowing from the developed world into the Ems.
Premier Wen Jia-Bao has with disarming frankness explained what the impact would be of the desired change in the Yuan-Dollar rate:
"If the yuan isn't stable, it will bring disaster to China and the world. If we increase the yuan by 20-40 percent as some people are calling for, many of our factories will shut down and society will be in turmoil."
There is an other reason why the "orderly rebalancing thru currency war" story does not stack up - and it's been pointed out by HSBC's forex analysis team. (Currency Wars: What are they good for? November 2010, Bloom D et al)
Looking at the Plaza Accord of 1985 - designed to rebalance the current account situation between the USA, German and Japan, and to cure high US unemployment - HSBC concludes:
- The scale of the changes needed to address current account imbalances is too large to do in the medium term;
- Even if you achieve a big exchange rate adjustment, the trade imbalances are very sticky - they don't easily respond: you don't get in other words a bunch of toy factories opening up in Tennessee
- And finally there are unintended consequences. The Plaza Accord laid the basis for the loose monetary policy in Japan that fuelled its property boom and bust - a bust which, lets remind ourselves, Japanese property prices have never recovered, even 20 years later.
So what to do?
China has proposed a new global reserve currency; America proposed and withdraw a voluntary cap on current account surpluses at the Seoul G20. [There's been some scant movement on this actually at the G20 meeting this week but nothing spectacular]
But the two proposals would have to be seen as elements of a much bigger global restructuring of capitalism that is beyond the scope of this discussion.
I will finish with a warning. I recently played the excellent mega wargame Hearts of Iron III, which stretches from 1936 to 1947. It models internal politics, espionage, resource allocation and of course trade. But by 1936 - if you are a country like France, Britain or the USA you do not have much to worry about: nearly all your trade is with your own currency bloc. Its an affront to the modern mind to propose - as France - a perfectly economically equal trade between Chile and yourself only to be rebuffed with the reminder: "Chile is a puppet of the United States".
By the mid-1930s the Gold Standard had been replaced by near hermetic trade and currency blocs. Soon another one would be formed, around the Reichsmark.
That is what happens when, to go back to the Alien analogy, the acid burns through to the hull of the spaceship.