Currency Wars Are Trade Wars

Paul Krugman is all for currency wars, but not trade wars:

First of all, what people think they know about past currency wars isn’t actually true. Everyone uses some combination phrase like “protectionism and competitive devaluation” to describe the supposed vicious circle of the 1930s, but as Barry Eichengreen has pointed out many times, these really don’t go together. If country A and country B engage in a tit-for-tat of tariffs, the end result is restricted trade; if they each try to push their currency down, the end result is at worst to leave everyone back where they started.

And in reality the stuff that’s now being called “currency wars” is almost surely a net plus for the world economy. In the 1930s this was because countries threw off their golden fetters — they left the gold standard and this freed them to pursue expansionary monetary policies. Today that’s not the issue; but what Japan, the US, and the UK are doing is in fact trying to pursue expansionary monetary policy, with currency depreciation as a byproduct.

There is a serious intellectual error here, typical of much of the recent discussion of this issue. A currency war is by definition a low-level form of a trade war because currencies are internationally traded commodities. The intent (and there is much circumstantial evidence to suggest that Japan at least is acting with mercantilist intent, but that is another story for another day) is not relevant — currency depreciation is currency depreciation and still has the same effects on creditors and trade partners, whatever the claimed intent.

Krugman cites Barry Eichengreen as evidence that competitive devaluation does not necessarily mean a trade war, but Eichengreen does not address the issue of a trade war directly, much less denying the possibility of one.  Indeed, while broadly supportive of competitive devaluation Eichengreen notes that the process was “disorderly and disruptive”.

And the risks of disorder and disruption are still very real today.

As Mark Thoma noted in 2010:

While the positive effects a currency war produced in the 1930s are unlikely to reappear, there is a chance of large negative effects such as a simultaneous trade war or the breakdown of the international monetary system, so let’s hope a currency war can be avoided.

The mechanism here is very simple. Some countries — those with a lower domestic rate of inflation, like Japan — have a natural advantage in a currency war against countries with a higher domestic rate of inflation like Brazil and China. If one side runs out of leverage to debase their currency because of heightened domestic inflation, their next recourse is to resort to direction trade measures like quotas and tariffs.

And actually, the United States and China in particular have been engaging in a low-level trade and currency war for a long time.

As I noted last year:

China and Russia and Brazil have all recently expressed deep unease at America’s can-kicking and money-printing mentality. This is partly because American money printing has exported inflation to the world, as a result of the dollar’s role as the global reserve currency, and partly because these states already own a lot of American debt, and do not want to be paid off in hugely-debased money.

Since I made that statement, there has been a great lot of debasement without any great spiral of damaging trade measures. But with the world locked into ever greater monetary and trade interdependency, and with fiery trade rhetoric continuing to spew forth from the BRIC nations, who by-and-large seem to continue to believe that American money-printing is damaging their interests, and who in the past two years have put together a new global reserve currency framework, it would be deeply complacent to believe that the risks of a severe trade war have gone away.

(Unfortunately, Krugman and Eichengreen both seem to discount the reality that Okun’s law has broken down, and that monetary expansion today is supporting crony industries, and exacerbating income inequality, but those are another story for another day)

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Is the Gold Price Dependent on China?

China now buys more gold than the Western world:

Gold_Demand_China_WGC

Does that mean, as some commentators are suggesting, that future price growth for the gold price depends on China? That if the Chinese economy weakens and has a hard landing or a recession that gold will fall steeply?

There’s no doubt that the run-up that gold has experienced in recent years is associated with the rise in demand for gold from emerging markets and their central banks. And indeed, the BRIC central banks have been quite transparent about their gold acquisition and the reasons for it.

Zhang Jianhua of the People’s Bank of China said:

No asset is safe now. The only choice to hedge risks is to hold hard currency — gold.

Indeed, this trend recently led the Telegraph’s Ambrose Evans-Pritchard to declare that the world was on the road to “a new gold standard” — a tripartite reserve currency system of gold, dollars and euros:

The world is moving step by step towards a de facto Gold Standard, without any meetings of G20 leaders to announce the idea or bless the project.

Some readers will already have seen the GFMS Gold Survey for 2012 which reported that central banks around the world bought more bullion last year in terms of tonnage than at any time in almost half a century.

They added a net 536 tonnes in 2012 as they diversified fresh reserves away from the four fiat suspects: dollar, euro, sterling, and yen.

The countries driving the movement toward gold as a reserve currency by building their gold reserves is that they are broadly creditor nations whose dollar-denominated assets have been relatively hurt by over a decade of low and negative real interest rates. The idea that gold does well during periods of  falling or negative real rates held even before the globalisation of U.S. Treasury debt.

The blue line is real interest rates on the 10-year Treasury, the red line change in the gold price from a year ago:

fredgraph (15)

The historical relationship between real interest rates and the gold price shows that it is likely not “China” per se that has been driving the gold price so much as creditors and creditor states in general who are disappointed or frustrated with the negative real interest rate environment in dollar-denominated assets. What a slowdown in the Chinese economy (or indeed the BRICs in general) would mean for the gold price remains to be seen. While it is widely assumed that a Chinese slowdown might reduce demand for gold, it is quite plausible that the opposite could be true. For instance, an inflationary crisis in China could drive the Chinese public and financial sector into buying more gold to insulate themselves against falling or negative real rates.

Of course, this is only one factor. That are no hard and fast rules about what drives markets, especially markets like the gold market where many different market participants have many different motivations for participating — some see gold as an inflation hedge, some (like the PBOC) as a hedge against counterparty risk and global contagion, some as a buffer against negative real interest rates, some as a tangible form of wealth, etc.

And with the global monetary system in a state of flux — with many nations creating bilateral and multilateral trade agreements to trade in non-dollar currencies, including gold — emerging market central banks see gold — the oldest existing form of money — as an insurance policy against unpredictable changes, and as a way to win global monetary influence.

So while emerging markets and particularly China have certainly been driving gold, while U.S. real interest rates remain negative or very low, and while the global monetary system remains in a state of flux, these nations will likely continue to gradually drive the gold price upward.

When Currency Wars Become Trade Wars…

Beggaring thy neighbour has consequences. Neighbours might turn around and bite back.

China and the United States are already locked in an intractable and multilayered currency war. That has not escalated much yet beyond a little barbed rhetoric (although if China want to get a meaningful return on the trillions of dollars of American paper they are holding, one can only suspect that there will be some serious escalation as the United States continues to print, print, print, a behaviour that China and China’s allies are deeply uncomfortable with).

But Brazil are already escalating.

Brazil flag face

The Washington Post notes:

When the Brazilian economy began to stall last year, officials in Latin America’s largest country started pulling pages from the playbook of another major developing nation: China.

They hiked tariffs on dozens of industrial products, limited imports of auto parts, and capped how many automobiles could come into the country from Mexico — an indirect slap at the U.S. companies that assemble many vehicles there.

The country’s slowdown and the government’s response to it is a growing concern among U.S. officials worried that Brazil may be charting an aggressive new course — away from the globalized, open path that the United States has advocated successfully in Mexico, Colombia and some other Latin American nations, and toward the state-guided capitalism that the United States has been battling to change in China. As the world economy struggles for common policies that could bolster a still tentative recovery, the push toward protectionism by an influential developing country is seen in Washington as a step backward.

“These are unhelpful and concerning developments which are contrary to our mutual attempts” to strengthen the world economy, outgoing U.S. Trade Representative Ron Kirk wrote in a strongly worded letter to Brazilian officials that criticized recent tariff hikes as “clearly protectionist.”

And Brazilian officials are very, very clear about exactly why they are doing what they are doing:

Brazilian officials insist the measures are a temporary buffer to help their developing country stay on course in a world where they feel under double-barreled assault from cheap labor in China and cheap money from the U.S. Federal Reserve’s policy of quantitative easing.

“We are only defending ourselves to prevent the disorganization, the deterioration of our industry, and prevent our market, which is strong, from being taken by imported products,” Brazil’s outspoken finance minister, Guido Mantega, said in an interview. Mantega popularized use of the term “currency war” to describe the Federal Reserve’s successive rounds of easing, which he likened to a form of protectionism that forced up the relative value of Brazil’s currency and made its products more expensive relative to imports from the United States and also China.

How long until other nations join with Brazil in declaring trade measures against the United States is uncertain, but there may be few other options on the table for creditors wanting to get their pound of flesh, or nations wishing to protect domestic industries. After all, the currency wars won’t just go away; competitive devaluation is like trying to get the last word in an argument. The real question is whether the present argument will lead to a fistfight.

QE ∞

The Keynesians and Monetarists who have so berated the Federal Reserve and demanded more asset purchases and a nominal GDP target to get GDP level up to the long-term growth trend have essentially got their wish.

This is a radical departure:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.  These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months.  If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.  In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

I tweeted this earlier in favour of the idea that the Fed would adopt open-ended asset purchases:

Those who didn’t anticipate the possibility of open-ended asset purchases should have looked much more closely at Bernanke’s words at Jackson Hole:

If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy. Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board’s FRB/US model of the economy found that, as of 2012, the first two rounds of large scale asset purchases may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.

Essentially, this is nominal GDP level targeting. The reason why Bernanke has framed it in terms of lowering unemployment is that his mandate relates to price stability and unemployment, not nominal GDP level. But as Bernanke himself noted in his academic days:

Estimates based on data from more recent years give about a 2% decrease in output for every 1% increase in unemployment.

To those who accept Okun’s Law, raising nominal GDP level and lowering unemployment are effectively the same thing. Bernanke seems to believe unemployment will fall in a (roughly) linear fashion as asset purchases increase. By itself, this is a problematic assumption as the past is not an ideal guide to the future.

Yet more importantly the data shows no real job recovery in the post-2008 quantitatively-eased world. This is the prime-age employment-population ratio:

And even if unemployment falls without triggering large-scale inflation as per the Fed’s design, this is no cure for the significant long-term challenges that America faces.

As I wrote back in November 2011, when nominal GDP targeting was just appearing on the horizon America faces far greater challenges than can be solved with a monetary injection. Financial fragility, moral hazard, energy dependency, resource dependency, deindustrialisation, excessive private debt, crumbling infrastructure, fiscal uncertainty, and a world-policeman complex. The underlying problems are not ones that Bernanke really has power to address.

And how long before rising food prices cause more riots and revolutions? After, all handing over more firepower to speculators tends to result in increased speculation.

Meanwhile, US creditors and dollar-holders (particularly China) would seem from past comments to be deeply unhappy with this decision.

President Hu Jintao:

The monetary policy of the United States has a major impact on global liquidity and capital flows and therefore, the liquidity of the US dollar should be kept at a reasonable and stable level.

The dollars they accrued will lose purchasing power to every new dollar printed and handed over to the American banks in exchange for mortgage backed securities. The Chinese perspective on this will be that Bernanke is essentially engaging in theft. On the other hand, they should have considered this likelihood before they went about accruing a humungous pile of fiat dollars that can be duplicated at a press of a button. No, matter; China won’t get burnt like this again.

As PBOC official Zhang Jianhua noted:

No asset is safe now. The only choice to hedge risks is to hold hard currency — gold.

Chances of future trade and currency wars between the United States and China seem to be rising as fast as Chinese gold accruals.

No! Currency Wars Are Not Good!

Matthew O’Brien claims that competitive debasement is good for the global economy:

Currency wars get a bad rap. The trouble starts with that second word. Wars, as we all know, are very bad. And a currency war — where countries compete to lower their exchange rate to boost their exports — reminds people of the kind of trade protectionism that killed some economies in the 1930s. But currency wars are the best kind of war. Nobody dies. Everybody can profit. In fact, currency wars didn’t contribute to the Great Depression. They ended it.

The downside of devaluation is that no country gains a real trade advantage, and weaker currencies means the prices of commodities like oil shoot. But — and here’s the really important part — devaluing means printing money. There isn’t enough money in the world. That’s the simple and true reason why the global economy fell into crisis and has been so slow to recover. It’s also the simple and true reason why the Great Depression was so devastating. We know from the 1930s that such competitive devaluation can turn things around.

The world needs more money. Currency wars create money. It’s time for policymakers to forget the wrong lessons from history, get competitive, and start pushing down their currencies.

Since the last recession every major central bank in the world has fluffed up its balance sheet with purchases, pushing out new money into the system, and driving down exchange rates. So we already have a currency war.

The most obvious point is that the last thing the global geopolitical system — already knotted and twisted — needs is more strain, or more abrasions, and to some degree a currency war could strain relations. The biggest players in the developing world — China, Brazil, Argentina, India — are already experiencing elevated inflation. China and Russia and Brazil have all recently expressed deep unease at America’s policy.

Under such conditions, is it not reasonable to foresee that greater competitive debasement might lead to a full-blown trade war? An easy means for developing nations to stanch the decline in dollar-denominated holdings (FOREX, Treasuries, etc) would be to constrain the flow of dollars coming into their nations. How might that be done? Export quotas, and capital controls. I have long been of the view that the hyper-productive Eurasian nations do not “need” American consumption when they already have a big enough dollar hoard to recycle in domestic and regional consumption. America’s real economy is not being sustained by The Fed (that is sustaining the financial system), but rather by the ongoing free flow of goods and resources and energy from the developing nations to America. That’s the main reason why America spends so much money policing the world, to keep global trade flowing, and goods flowing into America. America consumes far more than she produces in terms of energy, in terms of finished goods, and in terms of components.

Simply, America has enjoyed a humungous free lunch on the back of the dollar’s reserve currency status. Nations throughout the world were willing to trade out their productivity, their resources and their energy for dollars, the international medium of exchange. America could sit back and diversify out of domestic productivity and into unproductive but nominally-higher-yielding financial services, consultancy, communications and entertainment. But dollars are no longer in such short supply; America has traded trillions and billions of them away. So some nations appear to be asking: Why do we need dollars? Why should we subsidise the Americans, when our own people go without? And of course, the Eurasian ASEAN bloc — and all the various new bilateral currency agreements, where Eurasian nations have agreed to ditch the dollar, and instead trade in their respective national currencies — is growing precisely to further this end, to diminish the American economic hegemony, and end the American free lunch. A series of currency wars could very easily be the thing that pushes the system into chaos.

A History of Reserve Currencies in One Graph

From J.P. Morgan:

 Or, as I wrote last year:

Safer assets like the US dollar? Sure, that’s what the textbooks tell you has been the safest asset in the post-war era. But are they really safe assets? On dollars, interest rates are next to zero. This means that any inflation results in negative real rates, killing purchasing power. Let’s have a look at the yields on those “super-safe” 30-year bonds:

At 2.87%, and with inflation sitting above 3.5% these are experiencing a net loss in purchasing power, too. Yes, it’s better than losing (at least) half your purchasing power on Greek sovereign debt, or watching as equities dip. But with the virtual guarantee that stagnant stock markets will usher in a new tsunami of QE cash, expect even more inflation, and even lower interest rates.

The Emperor is wearing no clothes.

Like with most things in life, the end of a global reserve currency is a matter of when, not if.

Japan and China Ditch the Dollar for Bilateral Trade

While American hawks will have been unsurprised that long-time antagonists Russia and China have ditched the dollar for bilateral trade, this year’s post-Christmas bombshell will shock many who believe that America’s ongoing reign as petrodollar superpower is assured.

From Bloomberg:

Japan and China will promote direct trading of the yen and yuan without using dollars and will encourage the development of a market for companies involved in the exchanges, the Japanese government said.

Japan will also apply to buy Chinese bonds next year, allowing the investment of renminbi that leaves China during the transactions, the Japanese government said in a statement after a meeting between Prime Minister Yoshihiko Noda and Chinese Premier Wen Jiabao in Beijing yesterday. Encouraging direct yen- yuan settlement should reduce currency risks and trading costs, the Japanese and Chinese governments said.

This is a Japan that remains under the yoke of American imperial occupation. That simple logistical fact means that this cannot have been an easy decision.

Of course — having run the gauntlet of twenty years of Keynesian (or, more accurately, Bernankean) failure — it is probable that Japan is growing sick of Anglo-American demand-side economics. Having unsuccessfully taken Bernanke’s Rooseveltian Resolve treatment for so long — and now watching America doing the exact same thing to herself — the temptation of closer relations with young, vigorous China will be strong for the Japanese.

And so China moves one step closer to her monetary endgame — dethroning the debased petrodollar as the global reserve currency, and replacing it with the yuan.

What will America — grossly indebted to her enemies, dependent on foreign oil and goods, and bogged down in her role as world policeman — do about it?

The Sun sets over the Petrodollar Empire