Currency Wars and Currency Order1

In a recent Comment article in the Financial Times (“The world wisely edges away from talk of a currency war”, April 29), Barry Eichengreen argued that the world should welcome the fact that the Japanese monetary expansion is no longer being equated with a desire to depreciate the yen. This begs the question: how does one expect the monetary expansion to boost growth? If the answer is exclusively through currency depreciation, then the world’s re-evaluation amounts to dishonesty. The monetary expansion would simply reallocate a given level of demand so that more was satisfied by Japanese production and less by production in the rest of the world.

Now in practice no one assumes that monetary expansion only affects demand by depreciating the yen. Equally, no one doubts that it has this effect. The question is what proportion of the total effect operates through the exchange rate. Judging by the limited effect of QE on demand in the United States, or Europe or the UK, one has to believe that it will have very different effects in Japan to avoid the conclusion that the vast bulk of the effect will operate through the exchange rate. It follows that the Japanese surplus is likely to re-emerge as a policy problem.

This conclusion is consistent with a model of my former colleague, Bill Cline. He concludes that Japan’s sharp depreciation in recent months will lead to an increase in its current account surplus from 1 percent of GDP in 2012 to more than 4 percent in 2018, and that the yen nw needs to appreciate by about 9 percent to keep its medium-term surplus from exceeding 3 percent of GDP (the benchmark of the Fundamental Equilibrium Exchange Rate, or FEER). Of course, there are many models, and doubtless one could find a model that would give a different answer. I happen to hold this model in high esteem because it was the basis for the series of papers we did on the estimation of FEERs (e.g., Cline and Williamson 2012). Let us see models that give a different answer, and let us judge their relative plausibility.

I recently attended a seminar in which Liaquat Ahamed, the author of Lords of Finance, drew a parallel between the 1934 increase in the gold price by the United States and the program of large-scale monetary expansion (“QE”) by the central banks of the main developed countries. He also argued that the increase in the gold price was the critical event in reversing the Great Depression. I would not contest either proposition. The way I reconcile them with the skepticism previously expressed for the effect of QE on demand is by arguing that QE will in due course re-liquify the Western economies and in that way permit renewed monetary expansion. The effect was quicker with the increased gold price because the world was at that time suffering from a liquidity shortage, but in the long run it is entirely possible that the domestic effect of QE will prove much greater than its short-run impact. At that stage one may well reach a different answer on the channels through which Japanese monetary expansion is likely to work. But for the moment, it is virtually certain that the primary effect will work through the exchange rate.

Is there no way of avoiding the Japanese monetary expansion igniting the fear of a currency war other than by giving Japan carte blanche to depreciate and pretend that this will have no adverse effect on demand elsewhere in the world? Of course there is, though it will require abandoning the G7’s, and now the G20’s, boilerplate about not targeting exchange rates. (This is no great loss anyway: intervention to weaken the dollar, or to strengthen the euro, in late 2001, when the euro stood at about 80 U.S. cents due to a failure of the private market to think beyond its nose, would have been thoroughly appropriate.)

Suppose instead that the monetary authorities got together, presumably via the IMF, in order to agree a target set of exchange rates, and then agreed not to undertake any external act which would have the effect of pushing rates away from those agreed. This would still allow Japan to pursue an expansive monetary policy (provided, as Mr Kuroda has affirmed, that it does this exclusively by buying JGBs rather than foreign currencies), but it would leave in place an agreed (more appreciated) target for the yen that would discourage excessive depreciation. It would do this by serving notice on the private market that, if and when the authorities believed that Japan had recovered, the BoJ might intervene, but it could do this only to strengthen the yen. Contrast this with the present situation, in which the knowledge that the BoJ is seeking monetary expansion encourages the market to push the yen down with no restraint.

The big question is clearly that of determining the set of exchange rates to be targeted in this way. I doubt if there is scope for deviating very far from the approach that Bill Cline and I have developed in the series of publications already cited (e.g. Cline and Williamson 2012). This requires agreement (a) that target exchange rates should be set so as to limit the size of current account imbalances; (b) on the size of the allowable imbalances; (c) on the appropriate internal objective of economic policy (even if “internal balance” is agreed to be desirable, there are differences of view on how much slack countries have); (d) on a model that translates demand and exchange rates into current account imbalances. It is important that countries’ leaders be asked to do this in the abstract, rather than viewing its implications for actual exchange rates directly. Given that the only undertaking they are subscribing to is not to actively try to push exchange rates away from these targets, one can hope that they would see the wisdom of agreeing.


Cline, William R., and John Williamson. 2012. “Updated Estimates of Fundamental Equilibrium Exchange Rates”, PB 12-23, Peterson Institute for International Economics, Washington.

Eichengreen, Barry. 2013. “The world wisely edges away from talk of a currency war”, Financial Times, 29 April, p.9.

1 The author is indebted to William Cline for information on the results of his modeling.

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