With his ultra-orthodox monetary views, Jens Weidmann, president of the German Bundesbank, may not be everyone’s cup of tea. But when it comes to exchange rates, he talks a lot of sense.
There’s been much belly aching in euroland of late, particularly among French policymakers, about the supposed strength of the euro and the damage this may be doing to the competitiveness of the region’s exports.
Only a few months back it was the reverse complaint, with many of them worrying about whether the euro would survive at all. Better a strong euro than a dead one, you might think, but apparently not. Today’s concern is that the euro is too strong, and that rival economies are engaged in unfair currency competition, or “currency wars” as the phenomenon has become known.
It took Mr Weidmann to point out that actually the euro isn’t seriously overvalued on any reasonable assessment of where it should be, and that attempts to weaken it would almost certainly backfire. There was only one problem with his analysis: as far as Germany is concerned, the euro is, of course, not nearly strong enough, while for the beleaguered eurozone periphery, it is far too strong.
Perhaps unconsciously, Mr Weidmann was in essence articulating the case for free-floating exchange rates. In a fixed exchange rate regime or common currency, what’s good for one country can often be very bad for another. There is no such thing as what Eddie George, former Governor of the Bank of England, memorably called a “one size fits all” monetary policy. It follows that countries and regions ought to be allowed to do what they deem necessary to stimulate their economies, regardless of the consequences for the currency.
I’m pretty sure that this was what the G7 was trying to say in its currency wars statement this week, though by the time individual members had finished briefing on its meaning, it was actually quite hard to tell. As often occurs with collective statements of this sort, it ended up producing more confusion than clarity. Was the G7 praising currency competition or condemning it? It was impossible to know. The message was, I think, supposed to be that it was basically OK, but this somehow got lost in translation.
What’s sparked this latest outbreak of angst about competitive currency devaluation is “Abenomics”, or the suspicion that the new Japanese government is trying to stimulate its economy at the expense of its trading partners.
To some, this looks uncomfortably like a repeat of the 1930s, though in fact it is the very reverse. What occurred in the 1930s was that the fixed exchange rate regime operated through the gold standard prevented governments from applying measures that might have stimulated domestic demand, in much the same way as the euro does today.
Winston Churchill was later to describe allowing the Bank of England to persuade him of the merits of the gold standard as the biggest mistake of his political career. It wasn’t until Britain came off the gold standard in 1931 that her economy began to recover. Others that attempted to stick with the regime paid the price.
What Mr Abe is trying to do in Japan by targeting a slightly higher rate of inflation, flooding the system with stimulus, and thereby prompting weakness in the currency, is entirely legitimate and long overdue.
In any case, in today’s world, with its interconnected supply chains, devaluation is pretty much a zero sum game, as we are discovering to our cost here in Britain. Notionally, it helps exporters, but by raising the cost of imports, it adds to input inflation, which, in turn, damages living standards, crimping domestic demand and ultimately hitting the cost competitiveness of exporters.
All the complaint about currency wars is therefore basically just a lot of political hot air. If countries are to be allowed to stimulate growth and after more than two decades of going nowhere, it seems entirely reasonable that Japan should at least be allowed to try they are bound to take monetary action that will have consequences for the currency.
Politicians who complain about it are doing the equivalent of what business losers do when they are out-traded by rivals they go running off to the regulator screaming unfair competition. Why look to the mote in your own eye when there is always Johnny Foreigner to blame?
If we accept that countries are indeed trying to gain competitive advantage through devaluation, then of course Britain is one of the worst offenders. At Wednesday’s Inflation Report press conference, Sir Mervyn King, Governor of the Bank of England, aired some apparently shocking numbers. Since the financial crisis began, not only had interest rates been reduced to close to zero, but the Bank of England’s balance sheet had been expanded by a factor of five.
Expressed as a share of GDP, the increase has been greater than that of the US, greater than that of the European Central Bank, and greater than that of Japan. This is way beyond being an unprecedented degree of stimulus. These are completely uncharted waters we are in, and even Sir Mervyn seems to be getting worried by them.
Trouble is, he said, that applying ever more monetary stimulus is like “running up a hill”. In terms of growth, it seems to be increasingly less effective, but it’s turbo-charging asset prices, raising serious questions about how the country is going to cope with the eventual normalisation of interest rates.
We seem to have become addicted to quantitative easing; to withdraw it would only prompt the cold turkey of a bond and stock market crash.
It is perhaps with this in mind that Sir Mervyn seemed to be warning the Government on Wednesday that there is little more that monetary policy can do to support growth. Sir Mervyn promised that the Bank would continue “looking through” elevated rates of inflation, which in any case are now largely the result of deliberate government policies, but if George Osborne wants more, then he’s going to have to await the arrival of Mark Carney. But he may be disappointed on that front, too.
Thankfully, Carney has already ruled out the “helicopter drop”, an idea raised in a wide-ranging speech last week by one of his rivals for the job, Lord Turner. Monetising the deficit in the way Lord Turner suggested, or simply distributing the spoils of QE to the population at large by way of hand-outs, needn’t necessarily lead to hyper-inflation, and it is certainly quite hard to imagine that the Government could be any worse than the banks in applying the freshly minted money. But if you think QE is addictive, then this would be the same drug to the power of 10.
No government given the freedom to spend what it likes would know when to stop. You don’t have to cite the calamity of Weimar to see the damage this can do. Large parts of Europe in the 1970s serve as warning enough. There are limits to what monetary stimulus can achieve, Sir Mervyn said yesterday. Quite so.