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)

23 thoughts on “Currency Wars Are Trade Wars

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  3. Isn’t the whole advantage of having flexible exchange rates that different countries can have different monetary policies? Now, you have those same countries that are stuck in deleveragings where debt/income ratios are extremely high. What’s the easiest way to correct debt/income ratios? Increase incomes by printing money. I don’t see why countries wouldn’t do this.

    I will add in one caveat. I do not agree with the way the countries are printing money(stashing money in bank reserves). However, I do think that all countries have basically no choice but to print money; especially when you look at things from a political perspective.

    • I hear ya, Suvy! I’ve written several letters to President Obama imploring him to send everybody in the world a check for USD10M.

      • I’m not saying that printing money is a good thing. However, inflation is a way to pay off the debts and when you have a situation where a society is highly indebted, printing money(in the right amounts, doses, and ways may be necessary. Otherwise a debt deflation may take place; that would have happened without any money printing. However, inflation is a tax; as Keynes said, it is the cruelest tax. However, there are situations that small amounts of inflation may be necessary.

    • Yeah, I think that ultimately all countries have little choice but to print or watch mass defaults accumulate. Unfortunately the transmission mechanism is totally screwed up right now, leading to the enrichment of the financial sector, financialisation, the Cantillon Effect.

      • There’s no reason that the financial sector would even need to have been saved; you just need to keep spending stable. If you had massive amounts of spending coming either from money printing and/or fiscal stimulus that offsets the destruction in debt, there would be no reason required to save the banks. The key point is in keeping spending stable and encouraging productive activities. Things like infrastructure projects and other public works would be extremely beneficial.

        One possible solution is to set up some sort of National Investment Bank that could be set up by the Federal Reserve where the Fed would print money and it could be then used for investment projects that are directed by state and local governments alone. Money from the institution could be apportioned to the state according to the population, the size, and other things like that. There would be no restrictions to how states and local governments could spend this money. I definitely think that some kind of genuine investment would go a long way; I also think decentralization is critical as well. I think the benefits of decentralization cannot be overstated.

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  7. All thats changed is that the net importers have started to play the same game as the net exporters.
    It is impossible for a nation to have generational net exports without engageing in currency manipulation.
    Chinas dollar reserves are the result of currency manipulation.

    “if they each try to push their currency down, the end result is at worst to leave everyone back where they started.”
    True, under certain circumstances, but we dont meet those circumstances
    The importers have far more inflation tolerance than the exporters.
    The Dollar, the Pound and the Euro could all halve in value, with some inflationary damage.
    Double the cost of food in china and their will be civil war within the week

  8. The primary purpose of government is in enforcing the prevailing economic system. Since human beings are involved [in group form], this means massive manipulation, cheating, stealing, etc., etc., in all markets, especially currency markets where the institution placed in charge freely counterfeits the currency.

    It would seem that if this was taking place, people [especially educated people] would say something about it, but now you understand how all of the atrocities throughout history took place.

    Institutions use human frailty [fear] as a weapon against individuals, thus allowing something as destructive as counterfeiting the currency to take place as if nothing strange was happening what-so-ever.

    • I mean, even under the gold standard there was no gold pulled out of the ground. I’m not necessarily against fiat currencies and expansionary monetary policy (especially if the new money is distributed uniformly to avoid the Cantillon Effect), because I don’t believe in dictating my views to others. I just think that there should be the ability to opt out, i.e. currency competition. Luckily even under the current system there is the ability to opt out, to some degree.

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  10. I don’t know, I am just enjoying the strong Australian Dollar, and buying high quality US products while I can.

    Since we manufacture sweet stuff all now (We used to have bullet proof machines tools etc) we can just use automated mining to send more volume of minerals overseas, even if we lose on the dollar with the appreciated currency (People still earn interest on their savings that just, just beats inflation) we still live a good life. But when the minerals run out, we can rely on our crappy Universities and flimsy apartments to earn dollars from Asians and Indians hoping to study to earn a work visa and right to become an Aussies citizen.

    Our Registered Mortgage Backed Securities Market is spring back to life now, Benny Bucks are reaching cowboys who are buying these bonds, so who know maybe we’ll have a housing boom, and import more Chinese made building products (See Boral earnings announcement)

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