Global: The Perils of Competitive Currency Devaluation
Stephen Roach (New York)
Guns are blazing on the anti-deflation front. Policy makers in Japan and the United States have elevated deflation to their number one concern. Even European authorities have finally joined the game, as evidenced by an aggressive 50 bp ECB easing, with the euro-zone inflation rate still above the so-called price-stability threshold. The full force of the global policy arsenal now seems aimed at arresting deflation. And that’s very good news.
The bad news is that there’s no guarantee the medicine will work. Policy traction is most difficult to achieve at low levels of inflation and nominal interest rates. Just ask Japan. In the case of the US economy, stabilization policies typically work their charm on three sectors – consumer durables, homebuilding, and business capital spending. With all three sectors having gone to excess in recent years, any response to policy stimulus could be surprisingly muted. In Europe, monetary stimulus is being offset by the combined headwinds of fiscal consolidation and lingering structural rigidities, especially in the labor market. History tells us that deflationary remedies must be administered early and aggressively. Only time will tell if it already isn’t too late.
But there’s another piece of bad news on the deflation watch – the risk that a policy clash gets played out in foreign exchange markets. That’s especially the case with respect to Japan and the United States, where senior officials in both countries have lately hinted at playing the currency-devaluation trump card in the battle against deflation. Haruhiko Kuroda, the Japanese MOF vice minister for international affairs, has become quite vocal in recent days attempting to manage the yen lower – first with an opinion piece in the Financial Times (see "Time for a Switch to Global Reflation" published on 1 December 2002) and now with a rhetorical salvo implying that the Japanese currency has only just begun to fall from a position of "excessive strength." At the same time, Fed Governor Ben Bernanke has introduced the possibility of dollar devaluation as an anti-deflation remedy as one option in a broad array of "non-traditional" actions that the US central bank could take against deflation (see his 21 November 2002 speech before the National Economists Club, "Deflation: Making Sure ‘It’ Doesn’t Happen Here"). While the coexistence of a weaker yen and a weaker dollar seems highly unlikely, just the mere suggestion by authorities in both countries to reflate through currency depreciation conjures up the perils of competitive currency devaluation – a highly disruptive outcome for the global economy and world financial markets.
It’s times like this that bring out the worst in xenophobic policies. When faced with the perils of deflation, it’s "every man for himself!" Yet since foreign exchange rates are relative prices, it is mathematically impossible for all of the major economies in the world to embrace currency devaluation as a tactic to stave off deflation. The case for a weaker dollar is especially compelling, in my view. As seen through the lens of the real effective exchange rate, the dollar is more than 30% above its 1995 level, whereas the yen is off about 15% over the same period. In that regard, and in the context of America's massive current-account deficit (an estimated -4.6% of GDP in 2002) and Japan's outsize external surplus (an estimated +3.3% of GDP in 2002), it’s hard to argue on the basis of economic fundamentals that the yen "deserves" to fall more than the dollar. Over the long sweep of economic history, current-account adjustments – from deficit to balance – are invariably accommodated by currency depreciation. On that basis, it’s only a matter of when – not if – the dollar falls.
Nor does the unbalanced state of the global economy suggest that yen depreciation would be appropriate. Since 1995, the United States has accounted for fully 64% of the cumulative increase in world GDP, double its share in the global economy (as measured at current exchange rates). This reflects an extraordinary dichotomy in domestic demand conditions around the world. For example, in the five years ending in mid-2000, domestic demand growth averaged 5% in the US and only about 2% in the rest of the world. As America’s gaping and ever-widening current account deficit suggests, such imbalances are not sustainable. Global rebalancing requires a realignment in relative prices. As the world’s most important relative price, I believe that a weaker dollar makes a good deal of sense under such circumstances.
The case for a weaker yen rests mainly on the state of desperation now gripping the Japanese economy. Having effectively exhausted its conventional monetary and fiscal ammunition, the currency becomes something of a last-gasp lever for the Japanese authorities. To the extent that the United States has more ammunition left in its traditional stabilization arsenal and that its macro condition is healthier, Japanese officials are arguing that Japan should be given the benefit of the doubt. But this would not be a panacea for all that ails the world’s second largest economy. It would merely buy some time, goes the argument, while Japan finally gets on with heavy lifting of structural reform.
Yet there’s always the risk that such a strategy will backfire. That’s especially the case in Japan. To the extent that the Japanese economy enjoys the temporary reflationary benefits of a weaker yen – stronger external demand and imported inflation – the incentives for structural reform might diminish. That’s, in fact, exactly what happened in the latter half the 1990s. The pressures for such reforms were extreme in early 1995 when the yen/dollar cross-rate briefly pierced the 80 threshold. The urgency to act, however, was tempered by three and a half years of sharp currency depreciation, which took the yen/dollar cross rate back to 147 by August 1998. Led partly by exports, Japanese GDP growth accelerated to a 2.4% average annual rate over the 1995-97 interval, and the imperatives of restructuring were quickly forgotten. Based on that experience, there is good reason to be suspicious of Japanese promises to deliver on structural reform while the yen is depreciating. A stronger yen, by contrast, would leave Japan with little choice other than to restructure.
The same argument could be used with respect to Europe: A stronger euro would leave Corporate Europe with no choice other than to restructure. It is in that context that the efficacy of currency policy should be considered. In my opinion, the currency can either be a "a carrot or a stick" in shaping structural change. The experience of the last 25 years – especially the restructuring of Smokestack America during the strong-dollar era of the early 1980s – tells me that the "stick approach" is far more effective. And so I reluctantly conclude that just as the world now needs a weaker dollar to temper global imbalances, the world also needs a stronger yen and a stronger euro to force long overdue restructuring in both regions.
Nor do I believe that a world in distress will sit back and tolerate a unilateral initiative by Japan to reflate via currency depreciation. If it becomes evident that traditional counter-cyclical stabilization measures are not gaining traction in the US or Europe, then the authorities in both countries might well consider shifts in their own currency policies. The result could be an increasingly vicious cycle of competitive currency devaluations that would achieve nothing but ill will. That would then up the ante for national policy makers to turn to trade protectionism as a true last-gasp option to shield their economies from imported deflation and the seemingly unrelenting pressure of import penetration into domestic markets. Sadly, that’s right out of the script of the early 1930s.
It doesn’t have to end that way. If US policy makers establish traction with their recent and prospective monetary and fiscal actions, then deflation can be avoided without an explicit shift in dollar policy. At the same time, if the rest of the world embraces pro-growth policies of its own, the currency lever need not be utilized to accomplish this objective. If, however, the authorities fail to achieve these results, then all bets would be off for the US and the broader global economy. Competitive currency devaluations almost always end in tears.
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