Financial Shock and Awe
The world's central banks are at war. What does that mean for the rest of us?
In popular histories of World War I, the outbreak of hostilities is portrayed as essentially inadvertent. Rather than resulting from the struggle for dominance between a rising power and its established rivals, the war was a byproduct of a series of misunderstandings. Today, the flashpoint may be currencies rather than the Balkans, but the danger — of misunderstanding leading to escalation and retaliation — is fundamentally the same.
The misunderstanding is the belief that the phenomenon we are now witnessing — vaulted into the front pages last week when Brazil’s finance minister decried the onset of an “international currency war” — is a zero-sum game. The story goes like this: The The Bank of Japan (BOJ), it is said, by intervening in the foreign exchange market to weaken the yen is making life harder for other countries. The Bank of England, likewise, is happy to see sterling decline, given how domestic demand is depressed by the government’s aggressive austerity program, but this only creates problems for its neighbors. The Fed has no objection if the market produces a weaker dollar, even if this frustrates the BOJ’s best efforts. The People’s Bank of China continues to intervene big time to keep the renminbi down. Other emerging markets, from Brazil to India to South Korea, find themselves either having to fight fire with fire or watch as their manufacturing sectors wither. Meanwhile, the economy most desperately in need of a competitive exchange rate, Europe, ends up saddled with the opposite.
This diagnosis, which is now conventional wisdom, reflects a series of dangerous misunderstandings. First, it is a misunderstanding to believe that the policies pursued by the BOJ, the Fed, and the Bank of England come at one another’s expense. What we are seeing, in all three cases, is not exchange rate manipulation but what is known as quantitative easing, actual or incipient. The evolution of BOJ policy makes this clear. What two weeks ago started as a modest foreign exchange market intervention has now turned into an explicit program of purchasing 5 trillion yen of Japanese treasury bonds and bills, commercial paper, exchange traded funds, and real estate securities. The Bank of England has made no bones about its continued commitment to quantitative easing. The Fed is moving slowly, slowly in the same direction.
This, of course, is precisely what is needed in a world where deflation has again become a problem and fiscal policy, for better or worse, is off the table. It is not a "beggar thy neighbor race to the bottom." If anything it is a race to the top.
Second, the current situation reflects misunderstandings over strategies on the part of other central banks, many of which are still fighting the last war. (Here, of course, the analogy is with the Maginot Line and World War II.) The European Central Bank (ECB) insists on fighting yesterday’s enemy, inflation, when deflation is Europe’s clear and present danger. The ECB evidently thinks that now, when growth everywhere else in the world is decelerating, is the time to scale back its special credit facilities and prepare to raise interest rates. This beggars belief. Back in 2007, some economists thought emerging markets could "decouple" from the advanced economies. We now know better. If the ECB believes that Europe can decouple it is about to learn the same lesson the hard way. If the euro strengthens as a result of quantitative easing elsewhere and the European economy gets smashed then the ECB has only itself to blame.
The People’s Bank of China and, more importantly, its political masters similarly insist on fighting the last war, which in their case means keeping the exchange rate at levels that maximize the growth of exports. China cannot continue to grow indefinitely on the basis of exports alone. It should start rebalancing its economy toward demand. And the easiest way to do so is by letting its currency rise.
Not only will this be good for China, but it will ease the strain on other emerging markets, such as Brazil and India, that are seeing their manufacturing sectors atrophy as a result of overly strong currencies. Their producers compete with China, partly on the basis of low labor costs, to a much greater extent than do, say, those in the United States. A strong renminbi won’t solve all their problems, but it will make it at least somewhat easier for them to compete.
Tensions and recrimination are not inevitable. What is needed to avoid them is leadership from the three big central banks. The Fed needs to stop dithering and make precise the extent of the quantitative easing it intends. Uncertainty about whether it will move in increments or adopt a policy of shock and awe is contributing to the erratic behavior of the dollar exchange rate.
Not only would more clarity help that exchange rate settle down, but in addition it would make it easier for other central banks to calibrate their own policies. In particular, a Fed policy of shock and awe which, recent data increasingly suggest, is what is called for will make it easier for China to calibrate an appropriate response. With China experiencing inflation rather than deflation, looser credit conditions are the opposite of what it needs. Its challenge is to continue to modestly cool off its economy. Delinking from Fed policy by delinking from the dollar is the obvious way of achieving this result.
The only thing now standing in the way is the belligerence of politicians and commentators in other countries, since the last thing the Chinese government is willing to do is lose face. Even U.S. Treasury Secretary Timothy Geithner, an experienced China hand, feels compelled for domestic political reasons to pile on. This is not helpful.
The ECB, for its part, needs to start planning for the next battle instead of incessantly fighting the last. If it ends up with an exchange rate of $1.50 to the euro, the European economy tanks, and in the absence of growth the Greek, Irish, and other fiscal austerity programs will collapse. It will only have itself to blame. Here’s a prediction: Contrary to what the markets currently assume, the ECB will eventually join the quantitative easing bandwagon. The only question is whether by the time it does it will already be too late.