Satyajit Das: Why relying on devaluation to attain prosperity is a flawed policy

Midweek View: Currency conflicts are merely skirmishes in the broader economic wars between nations and a shift to isolationism
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The Independent Online

Financial markets are now dancing to a new version of The Weather Girls' hit single: "It's raining yen!" Japan under Prime Minister Shinzo Abe has opened a new front in the "currency wars", a term coined by the Brazilian Finance Minister Guido Mantega in 2010. The US, UK and Switzerland are all already enjoined, with Europe likely to take up arms shortly. Nations which constitute around 70 per cent of world output are "at war", pursuing policies which entail devaluation and currency debasement.

But currency conflicts are merely skirmishes in the broader economic wars between nations. In a shift to economic isolationism, all nations want to maximise their share of limited economic growth and shift the burden of financial adjustment on to others. Manipulation of currencies as well as overt and covert trade restrictions, procurement policies favouring national suppliers, preferential financing and industry assistance policies are part of this process.

Most developed nations now have adopted a similar set of policies to deal with their own low economic growth, unemployment and overhangs of high levels of government and consumer debt. Central banks are increasingly deploying innovative monetary policies such as zero interest rates, quantitative easing and outright debt monetisation to try to engineer economic recovery.

Artificially low interest rates reduce the cost of servicing debt, allowing higher levels of borrowings to be sustained in the short run. Low rates and quantitative easing measures help devalue the currency, facilitating a transfer of wealth from foreign savers as the value of a country's securities denominated in the local currency falls in foreign currency terms.

A weaker currency boosts exports, driven by cheaper prices. Stronger export-led growth and lower unemployment assists in reducing trade and budget deficits.

The policies have significant costs, including increasing import prices, increasing the cost of servicing foreign currency debt, inflation and increasing government debt levels.

Eventually, when QE programs are discontinued, interest rates may increase, compounding the problems. In extreme cases, the policies can destroy the acceptability of a currency.

The policies also force the cost of economic adjustment on to other often smaller nations, especially emerging countries, via appreciation of their currency, destabilising capital inflows and inflationary pressures. Given that emerging markets have underpinned tepid global economic growth, this risks truncating any recovery in developed nations.

Actions to weaken currencies risk economic retaliation. Affected nations could intervene in currency markets, try to fix its exchange rate (as Switzerland has done against the euro), lower interest rates, undertake competitive QE programs, implement capital controls or shift objectives to targeting nominal growth or unemployment (as the US has done).

Ultimately, a policy of devaluation to attain prosperity is flawed, especially when all major nations adopt similar policies. Everybody cannot have the cheapest currency.

Currency wars are not conflicts between equals. In the worst case, the US and Europe have the economic size and scale to retreat into near closed economies, surviving and retooling its economy behind explicit or implicit trade barriers. This option is unavailable to smaller nations requiring access to external markets for its products and foreign capital.

Smaller countries are unable to bear such costs of defending themselves in the currency wars. For example, the Swiss National Bank's direct intervention in 2010 to attempt to maintain the euro at 1.50 Swiss francs resulted in losses totalling Sfr27bn (£19bn).

New Zealand's Finance Minister Bill English admitted: "To influence the exchange rate you need a couple of hundred billion US in the bank so they take you seriously. We'd be out in the war zone with a peashooter."

Asked about a potential alliance with the Vatican, Stalin allegedly asked "how many divisions does the Pope have"? Major economies possess superior weapons of financial destruction. British statesman Lord Palmerston noted: "Nations have no permanent friends or allies, they only have permanent interests".

To expect nations not to use fiscal and monetary policy to manipulate currencies is disingenuous. Desperate policy makers are now using every available policy tool to serve individual national interests.

Satyajit Das is a former banker and author of 'Extreme Money' and 'Traders, Guns & Money'