Good and bad currency wars

Canadian Finance Minister Jim Flaherty is concerned that Switzerland's actions to depreciate the Swiss Franc against the Euro could lead to a currency war. But currency wars don't have to be bad; they could be good. It depends on how they are fought. If fought the right way, an invisible hand may lead to a good outcome that was unintended by any of those fighting the war.

Just to illustrate what I mean, let's first start with a simple example of the Gold Standard. This would help us understand currency wars of the 1930's.

Under the Gold Standard, every country pegs the value of its currency against gold. And suppose we start out in equilibrium, where every country believes it has sufficient gold reserves to enable it to cover foreseeable circumstances where it might need to sell gold in exchange for its currency at that price of gold.

Then something bad happens that causes every country to want to double its gold reserves. What happens next?

1. There might be a bad currency war. Each country raises interest rates and cuts its spending to increase capital account inflows and net exports to attract gold from abroad. In terms of gold, it's a zero sum game. One country's gain of gold is another country's loss of gold. From a wider context, it's a negative sum game, because the world will suffer recession and deflation.

2. Or, there might be a good currency war. Each country raises the price of gold to devalue its currency to increase net exports to attract gold from abroad.

Why is that second war a good currency war? It's still a zero sum game, isn't it? One country's net exports are another country's net imports? One country's gain of gold is another country's loss of gold?

In terms of gold, it truly is a zero sum game. But from a wider context, it's a positive sum game. Step back and think how the problem could be cured, at a global level. If each country wants to hold double the amount of gold reserves, it can't be done. There's only so much gold in the world. You can't double the tonnes of gold in existence. But you can double the value of those tonnes of gold in terms of money. If every country doubled the price of gold (halved the value of its currency against gold), that would get the world back to equilibrium. One tonne of gold reserves would now be able to do the same job that two tonnes of gold reserves would have been able to do at the old exchange rates.

And the good currency war, where each country tries to gain gold reserves by raising its own price of gold (devaluing its own currency), leads us exactly to that global cure. All it needs is for every country to wage war enthusiastically and keep on retaliating until each has its own desired doubled value of gold reserves.

A simple story of the 1930's is that it started out as a bad currency war. Each country tightened its monetary policy, and that lead to the Depression. And then it eventually turned into a good currency war. The Depression slowly ended as countries devalued against gold and thereby loosened their monetary policies.

That was the gold standard. It's different today. The problem isn't an international shortage of gold reserves; its an international shortage of monetary demand for goods. And we can't print gold, but we can print paper money. And each country wants to expand the monetary demand for its own goods, in part by devaluing its exchange rate to increase net exports. And net exports are a zero sum game. But just as under the gold standard example, there are two different ways to fight the war: a bad way and a good way.

1. The bad way to fight a currency war is to devalue your own currency by making other countries' currency more scarce. Your country might gain, since your net exports might increase; but the world as a whole loses monetary demand for goods.

2. The good way to fight a currency war is to devalue your own currency by making your own currency more plentiful. Your country will gain, since your net exports will increase; but the world as a whole gains monetary demand for goods.

If countries fight a currency war by loosening their own monetary policy, rather than by tightening other countries' monetary policy, it doesn't really matter if each individual country sees most of its gains as coming from increased net exports. That just gives them the extra incentive to be doing something they all ought to be doing anyway.

Here are a couple of hypothetical examples, for a world of two identical countries:

1. Country A devalues by buying B's currency in exchange for A's bonds. Country B retaliates by buying A's currency for B's bonds. The net result is exactly as if each country did an open market sale of bonds. There is less currency in circulation and more bonds. That's a bad currency war. It's a tightening of global monetary policy. It's a negative sum game.

2. Country A devalues by buying B' bonds in exchange for A's currency. Country B retaliates by buying A's bonds in exchange for B's currency. The net result is as if each country did an open market purchase of bonds. There is more currency in circulation and less bonds. That's a good currency war. It's a loosening of global monetary policy. It's a positive sum game. It's global quantitive easing.

Those two examples, being hypothetical, are much simpler than real world cases. But the underlying point remains: if countries are devaluing by loosening their own monetary policy, rather than by tightening others' monetary policy, it's a war we want to break out.

(For more on the Swiss devaluation, see Scott Sumner, David Beckworth, Josh Hendrickson, David Glasner, and Marcus Nunes. What the Swiss experience reinforces, as those bloggers note, is that there is a lot more to monetary policy than just setting an interest rate.)

Comments

[Too Much Fed]

rsj said: "My personal opinion in the U.S. was that the stock market was saved by the combination of credit easing -- e.g. the alphabet soup lender of last resort agencies -- together with TARP.

Without these two facilities, most of the banks, which accounted for 1/4 of SP 500 market cap pre-crisis -- would have zeroed their equity holders out. To me, that is a clear example of strategic fiscal and monetary policies, working together, that significantly boosted asset prices at relatively low cost.

My second order assessment is that without our safety net spending -- unemployment insurance, welfare spending, and foodstamps, the market would have fallen much more."

How about the market would have gone backwards in time further?

TARP = gov't debt
safety net = gov't debt

So when debt repayments and debt defaults caused the amount of medium of exchange to go down, did the gov't go into debt to maintain the amount of medium of exchange and/or its velocity?

[Too Much Fed]

"Were there "early" bank-like failures in both cases?"

"Too Much Fed,

Yep, though the timing doesn't suggest a connection. The financial crisis didn't pick up big steam until October 2008."

But were some firms already insolvent before that (October 2008), and it took a "bank-like run" on them to prove it?

Were there "bank-like failures" back in around 1929 because of the 10% stock market margin requirement?

[W. Peden]

(A direct connection, that is. The sub-prime crisis et al were certainly relevant.)

[W. Peden]

Too Much Fed,

I don't really know. I was a bit young to be following these sort of things closely in 2008, and certainly in 1929 in the US. My familiarity with the Great Depression is with the UK, where there weren't any bank failures at any point during the crisis.

[K]

W Peden: " I think we all agree that (with whatever minor provisios) the purchase of the security by the central bank doesn't (in itself) change the volume of deposits."

Can we say "t-bill" instead of "security?" Are we talking about money creation, or are we talking about an asset swap? There is no reason to conflate these issues. David Person addressed the asset swap (t-bill for bond/stock whatever) above: in principle, like full Ricardian equivalence, it has no effect because the returns from the risk asset still come back to the citizens through future taxes and government expenditures. In reality, the redistributive effects may not be zero sum and may even be positive, especially in a liquidity trap or if some agents are borrowing constrained, or markets aren't remotely complete, or a million other possible market shortcomings. This channel is, of course, effectively fiscal. Note that there is no money creation here and no effect on banking! Just a change in the availability of investable assets.

The other part of QE, the purchase of t-bills, creates reserves and may also create deposits. If the t-bill was sitting on the balance sheet of an unleveraged investor a bank will purchase it using a new checking deposit and then sell it on to the cb in exchange for new reserves. So a deposit is created. But the commercial bank couldn't care less. It's situation is utterly unimpacted economically as reserves add literally nothing to it's risk weighted assets/reg cap. No one at the bank will even notice. And the investor now has a bank deposit instead of a t-bill. He doesn't care either cause the t-bill earned zero anyways. The money is exactly equivalent from an investment perspective. So there is no hot potato. The potato is stone cold. The only time the potato could ever get hot again is if the cb ever raised rates again. But before they do that they have to take back all the excess reserves cause it's impossible to get banks to borrow fed funds at a non-zero rate if there are excess non-interest bearing reserves in the system. So there is not even any expectation of ever being stuck with a hot potato because the fed would take it back while it's still stone cold.

Does that make sense or do we still have a disagreement? What is it about credit/money creation that you think we havent fully addressed or understood. Are you saying there are theoretical reasons why QE should work, or are you just claiming empirical evidence?

[W. Peden]

K,

I think that, until you stop trying to fit me into the "he believes that reserves create deposits" dialectic, we won't be able to proceed. I'm trying to follow your argument, but it's impossible to tell when a sentence is supposed to be arguing against what I'm saying or whether it's just part of a standard formula.

[Too Much Fed]

Maybe rsj (or anyone else) can help me with this one?

Here is a graph of CurrCir and Currency:

http://research.stlouisfed.org/fred2/graph/?g=26H

What is the difference between those two? Thanks!

[Nick Rowe]

Sorry I'm not keeping up with all these comments, and responding to them. But my new post is in part my response.

[W. Peden]

Too Much Fed,

I'm not sure about the exact definition of "currency in circulation" here, but the currency component of M1 includes banks' holdings of physical currency (till money etc.) whereas it would make sense to use "currency in circulation" to describe the non-bank public's holdings of cash. That might also explain why they seem to move in step, because banks don't radically vary their holdings of till money.

(Notice the spike around December 1999. I know that Greenspan expanded the monetary base dramatically around that time in order to prevent a run on banks resulting from people taking money out of ATMs before the Millenium Bug was supposed to hit. I read a paper- written after the most recent crisis- a while back that argued that that was the closest the US financial system has been to total meltdown since the Great Depression, since- if the monetary base had not been expanded dramatically- the huge increase in the demand for base money would have killed off every last bank.)

[David Pearson]

W. Peden

I think you misunderstood my question.

Private sector portfolios are aggregations of desired risk, for which they receive a risk premium. This risk can be decomposed into liquidity, duration and earnings volatility risks.

The Fed's purchases of "interest bearing" securities merely transfers duration risk from the private sector to the Fed's balance sheet, to the Treasury, and back to the private sector. In other words, some insurance company winds up with less duration risk (it reacts by increasing it), some taxpayer ends up with more (and reacts by reducing it). The Fed cannot eliminate a risk that it passes on to Treasury; it merely shuffles it around between private sector actors.

The Fed "adds value" by creating bank reserves, an activity over which it has a monopoly. If demand for marginal bank reserves is zero, it cannot add value in that way. The existence of ER's reflect that.

The Fed can also "add value" by reducing private sector liquidity risk, as its balance sheet can never have that risk.

[Anon]

Nick:

I think rsj's arguments and graphs are showing it pretty convincingly that QE does not have much effect on demand, due (severe) elasticity asymmetry between the financial sector and households.

This also matches the data from Japan.

So while the CB does not have to do much to communicate its wishes of where the short-term interest rate should be: it has very direct ammunition worth trillions to back up that wish. The market knows that and any late movers are punished financially. So new rates propagate into short term bond prices instantly.

OTOH the CB does not have much effect on household spending - so it cannot credibly promise higher spending - thus the market has no '100% confidence' that it will occur, pretty much regardless of what the CB does.

So if the CB promises with the same amount of conviction that it wants higher demand, and backs that with lots of bond purchases - the Pavlovian reflex that triggers for short-term rates is missing in action for consumer spending.