I like this post by Menzie Chinn at Econbrowser – primarily because I agree with it It is well worth a read on its own.
I will however take some bits out for those who don’t want to leave right now:
In a game theoretic context, we usually think of competitive devaluation as a form of the prisoner’s dilemma, where the devalue option dominates the no-devalue option, and both parties end up with a devalued currency, but no net improvement because countries cannot all devalue against each other.
Indeed, we normally assume it is a net loss because of the costs of implementing policy in the future place. However, things are different. We have:
- Some countries stuck at the zero lower bound for interest rates
- Other countries with inflation problems brewing, who use capital controls to keep their dollar “devalued”.
The Chinese can raise interest rates in order to stabilize inflation by cooling off the economy. However, that interest rate increase would exacerbate the capital inflow that would tend to appreciate the CNY. That in turn implies even greater forex intervention by PBoC, which in turn requires even greater sterilization measures, either by issuing more PBoC bonds, or by raising reserve requirements. The US measures to push down long term rates via QE2 have made that option more difficult.
Hazzah! Further easing by the Fed actually makes matters more difficult for China in terms of keeping its currency devalued. I would also note that there is a trade off for China given that it is building up reserves of US currency with these controls – if it extends controls, it increases the potential loss on currency reserves … implying that they will want to balance the competing goals of devaluation, and not being “too exposed” to the US dollar. This implies some appreciation in the Yuan.
And finally …
One last speculation. The other countries facing a negative output gap (primarily other advanced countries) will face the same incentives as the US, and so will more likely try to depreciate their currencies. It’s true that this will tend to negate the US depreciation — but to the extent that this induces greater monetary easing in those countries, this is a positive outcome.
Yes, yes and yes. This is why I find Europe’s view of what is going on perplexing (and to a lesser degree our Bank’s view of exchange rate movements) – I thought that an appreciating dollar would lead to central banks in advanced economies with depressed activity cutting interest rates (relative to what they would have done – so holding still instead of raising counts).
Why are so many developing countries acting like they can’t loosen monetary policy in the face of this. If they don’t think its appropriate, it is because they MUST believe that current policy is consistent with their mandate (to keep inflation near target) and in that case why do they have a problem?
The US isn’t intervening in currency markets to try and change relative prices per see, it is simply easing monetary conditions because inflation is expected to come in below target.
Overall, it appears to me that a “currency war” that doesn’t turn into a trade war, and is based on independent central banks moving in the interest of their inflation targets is a GOOD thing. It both ensures that:
- Monetary stimulus is sufficient
- There is additional pressure on countries that devalue their currency to allow appreciation.
Concerns about exchange rate volatility in this environment are important, and concerns about the potential for trade wars are also important. But are we really going to blame the US for this?
I would blame Europe (as they seem unwilling to work with the US to ensure appropriate international monetary conditions) and countries that are determined to fiddle their currency – such as China. And I’ll tell you want, if the Western World prints a bunch of money and they make an asset loss on their reserves, that’s China’s own fault – that was the cost they took on the build up their manufacturing industries.
Discuss [I say this as I've taken a specific, extreme, position in the overall section of this post in the hope of getting push back]