Bring on the “Currency war”

I have been giving the issue of devaluation a bit of attention recently. In my view most people fail to understand the monetary aspects of currency moves – both within a floating exchange rate regime and with managed or pegged exchange regimes.

I have already in my post “Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons” argued that what we should focus on when we are talking about the effects of devaluation is the impact on the money supply and on money-velocity rather than on “competitiveness”. In my post “Mises was clueless about the effects of devaluation” I argued that Ludwig von Mises basically did not fully comprehend the monetary nature of devaluations.

The failure to understand the monetary nature of devaluation often lead to a wrongful analysis of the impact of giving up pegged exchange rates or leaving a currency union – or for that matter giving up the gold standard. It also leads to a very wrong analysis of what has been called “competitive devaluations” – a situation where different countries basically are moving to weaken their own currencies at the same time. This discussion flared up in the second half of 2010 when (the expectations of) QE2 from the Federal Reserve triggered a strengthening of especially a number of Emerging Market currencies. Many EM central banks moved to counteract the strengthening of their currencies by cutting interest rates and intervening in the FX markets – basically undertaking QE on their own. Brazilian Finance Minister Guido Mantega even talked about currency war (and he has apparently just redeclared currency war…)

However, the term “currency war” is highly misleading. In a world of depressed global NGDP and deflationary tendencies there is no problem in competitive devaluations. The critiques would argue that not all countries can devalue and that the net impact on global economic activity therefore would be zero. This, however, is far from right. As I have earlier argued devaluation is not primarily about competitiveness, but rather about the impact on monetary conditions. Hence, if countries compete to devalue they basically compete to increase the money supply and velocity. This obviously is very positive if there is a general global problem of depressed nominal spending. Hence by all means bring on the currency war! Furthermore, it should be noted that in a situation where there is financial sector problems it is likely that the transmission mechanism would work much stronger through the FX channel than through the credit channel. See my related post on this here.

Imagine this highly unrealistic scenario. The ECB tomorrow announces a target for EUR/USD of 1.00 and announce it will buy US assets to achieve this target. The purpose would be to increase the euro zone’s nominal GDP by 15% and the ECB would only end its policy once this target is achieved. As counter-policy the Federal Reserve announces that it will do the opposite and buy European assets until EUR/USD hits 1.80 and that it will not stop this policy before US NGDP has been increased by 15%. Leave aside the political implications of this (the US congress would freak out…) what would happen? Well basically the Fed would be doing QE in Europe and ECB would be doing QE in the US. EUR/USD would probably not move much, but I am pretty sure inflation expectations would spike and global stock markets would increase strongly. But most important NGDP would increase sharply and fast hit the 15% target in both the euro zone and the US. Obviously this policy could lead to all kind of unwarranted side-effects and I would certainly not recommend it, but it is a illustration that we should not be too unhappy if we have “friendly” currency war. By “friendly” I mean that the currency war does not trigger capital restrictions and other kind of interventionist policy and that is clearly a risk. However, it is preferable to the present situation of depressed global NGDP.

Matthew O’Brien the associate editor at The Atlantic reaches the same conclusion in a recent comment. In “Currency Wars Are Good!” Matthew aruges along the same lines as I do:

A currency war begins, simply enough, when a country decides to push down the value of its currency. This means either printing money or just threatening to print money. A cheaper currency makes exports cheaper, and more competitive exports means more growth and happier people. Well, everybody except people in other countries who were just undersold and lost exports. That’s why economists call this kind of devaluation a “beggar-thy-neighbor” policy: Countries boost exports at the expense of others.

This sounds bad. Rather than cooperating, countries are fighting over trade. But in this case, some fighting is good, and more fighting is better. Countries that lose exports want to get them back. And the best way to do that is to devalue their own currencies too. This, of course, causes more countries to lose exports. They also want to get their exports back, so they also push down their currencies. It’s devaluation all the way down. All thanks to economic peer pressure.


War is good if it creates more of something you want. A “charity war” between friends is good because it leads to more donations. A currency war is good because it leads to more money. If war is politics by other means, a currency war is stimulus by other means.

So true, so true. So next time somebody starts to worry about “currency war” please tell them that is exactly what we want and for those countries where monetary policy is not too tight tell them to let their currencies appreciate. It will not do them harm. Is monetary policy is already too loose currency appreciation will be a welcomed tightening of monetary conditions.

PS you obviously don’t want to see competitive devaluations in a world of high inflation. That is what happened during the 1970s, but we can hardly talk of high inflation today – at least not in the US and the euro zone.

Leave a comment


  1. jpirving

     /  March 5, 2012

    Great post Lars.

    What do you think of the appreciation of the Norwegian crown in the last two or so weeks? A sign of strength vis-a-vis EMU or of unoffset demand for their non-euro linked currency? Something else? My working hypothesis is that it is the early stages of what happened to Switzerland, though this might just be intellectual laziness.

  2. jp,

    In terms of what is happening in NOK it is similar to what happened in Swiss franc in the sense that the demand for the currency outpaces the supply of the currency. That is of course nearly tautological to claim of course, but nonetheless correct. But if you ask me if the demand fro NOK is increase for the same reason as we saw an increase in the demand for CHF I would disagree.

    During part of the sharp increase in euro zone worries in the Autumn the inflow into all of the Scandinavian currencies increased sharply. This was “save haven” demand. What we are seeing now is different in the sense that we are also seeing for example the Polish zloty and the Turkish lira strengthening. This in my view reflect that the central banks of Norway, Poland and Turkey really would not like to see easier monetary policy as inflationary pressures are growing in these countries. That, however, fits into the story that emerged in the second half of 2010 – where everybody was talking QE2 in the US and that lead to a strengthening of most EM currencies.

    I would rather like that we today are in a situation like the Autumn of 2010 than the Autumn of 2011. This time is driven by the Fed moving toward QE, but by the fact that the ECB finally are engaging in QE through the so-called LTRO.

  3. Max

     /  March 5, 2012

    Suppose the Fed and the ECB agree to swap money at the current exchange rate. The market impact is zero, so it’s hard to see how this could be a stimulus, regardless of how much money is “printed”.

  4. Great post Lars. In my own experience people tend to make the converse mistake when countries join a fixed regime such as the gold standard, arguing that this is aimed at fixing international currency prices when its main benefit (or curse) is to prevent the use of the money supply as a policy tool, such as in the US after the Civil War and the Redemption Act (which Friedman and Schwartz describe in A Monetary History).

  5. Rob

     /  March 5, 2012

    I understand your argument and agree with it but something about it still make me uneasy.

    – In your example the both zones will increase the money supply but both will miss the currency target they set for themselves. Taken literally there would be an inflationary spiral if both zones strive to meet the target. If the aim is really to increase NGDP then why set a currency target and not explicitly target NGDP ?

    – In the example each zone buys assets in the other zone. One option would be to buy the other currency directly. This would undermine the attempt by the other zone to increase its NGDP. A currency war could indeed start with different zones buying larger and larger amounts of each others currency and to no net benefit.

    I’m not sure I understand the benefits of achieving an NGDP target via a currency target rather than by simply adjusting the domestic money supply. If all economies were able to maintain its own NGDP at its optimal level then currencies would adjust via free trade to reflect underlying reality with no need for CB manipulation of exchange rates.

    • Max, monetary policy primarily works through expectations. In my view it is likely that if both the ECB and the Fed announced a policy of buying of foreign assets until the reach the +15% NGDP target then the market would do most of the lifting and neither the ECB nor the Fed would have to buy much in terms of foreign assets.

      Rob, I should stress that I used this example not as a policy recommendation but a way to illustrate how currency intervention impact monetary conditions. The important thing is of course to announce the NGDP target. I then also happen to believe that doing QE via the FX market probably is more effective than trying to inject money into for example the banking sector. But again the import thing is the NGDP.

  6. Lars: Yep. And if the problem were too high NGDP growth and inflation, we should hope that war breaks out in the opposite direction, with competitive rounds of currency appreciation.

  7. Nick, I certainly agree, but unfortunately that never happened during the 1970s and the early 1980s. What we really need is certain banks that follow clear rules – then there is no need for currency wars and other third or forth best solutions.

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