Currency wars are
nothing new, the earliest
forms date back to the
classical ages, when
such wars were being
waged for the purpose of
improving the economic
plight of competing
nations.
In the pre 19th century era, currency wars played a far less significant role, as “free” trade was rather scarce in a world dominated by mercantilist colonial powers. Monopolies reigned; colonies were frequently banned from trading with rivals and wars were waged through military means as conquest meant control over scarce resources. Controlling resources provided greater self-sufficiency, which in turn resulted in
less of an incentive to trade.
Currency debasements did occur occasionally but the main purpose was directed towards boosting the domestic money supply and increasing the wealth of the authorities1. Rarely was it used as a tool to compete economically. The mercantile-based economies of the time ensured competitive gains mainly through the subsidizing of exports and the imposition of tariffs on imports.
So the world has come a long way from the “gunboat diplomacy” days of the earlier centuries. The change happened gradually as free trade superseded mercantilism. Currencies have become a potent monetary policy tool that can help steer an economy out of trouble but also cause trouble in certain circumstances. For it to work effectively requires agreement and cooperation between trading partners2.
Things can become complicated when several countries are facing similar economic challenges around the same time. Actively weakening a currency can only work if the currency against which it is losing value appreciates in return. When the central banks of several countries actively pursue the depreciation of their respective currencies simultaneously, it is bound to do more harm than good by causing a general decline in trade.
Depreciating a national currency is a potent stimulus weapon mainly because of the speed at which it is able to affect the economy. Think about it, you get almost instant gratification on the current account, as exports of the country suddenly become more competitive3. Large depreciations also have drawbacks in the form of imported inflation.
For countries that have borrowed heavily from abroad, however, a depreciation of the currency will make it more expensive for them to service their debt. This is also why a strengthening currency is an attractive outcome for heavily indebted nations that have a large proportion of their debts denominated in foreign currencies.
Currency depreciation is also a quick and relatively painless way of rendering the labor market of an economy more competitive, something that Eurozone members sorely lack. Their painful alternative has been to cut down nominal wages, which has caused significant negative repercussions on the economy. One of the Eurozone’s major “Achilles heels” stems from sharing a single currency amongst countries with highly divergent economies.
Unlike the U.S. where federal aid and a highly mobile labor market ensure greater regional harmonization, Eurozone members are confined to mainly fiscal means of impacting their economies. The Federal Reserve also has a dual mandate of ensuring price stability and full employment, in contrast to the ECB’s sole official mandate, which is to keep inflation in check.
We are living in precarious times; oil is at record lows, inflation is conspicuously absent and growth keeps sputtering. Many of the high powered stimulus tools have been spent and there is limited visibility on the global economic outlook front. The ECB is about to deploy massive amount of quantitative easing and the Euro has already weakened substantially. A currency war might be brewing, the consequences of which would be nasty.
1 One form of debasement involved reducing the amount of precious metal content in a coin. Through this method, known as Seigniorage, the authorities could collect a tax in return for producing and distributing the currency.
2 In early 2013, for example, G7 members made a joint announcement in which they declared that they would support policy in Japan that would effectively weaken the Yen. The aim was to provide the Japanese economy with enough stimulus to pull it out of a decades long deflationary slump.
3 The effect on exports is not exactly instant and may actually take months. In economics, this is known as the “J-curve” effect in which exporters need time to adjust to the sudden surge in export demand. The short term adjustment is usually through price.
In the pre 19th century era, currency wars played a far less significant role, as “free” trade was rather scarce in a world dominated by mercantilist colonial powers. Monopolies reigned; colonies were frequently banned from trading with rivals and wars were waged through military means as conquest meant control over scarce resources. Controlling resources provided greater self-sufficiency, which in turn resulted in
less of an incentive to trade.
Currency debasements did occur occasionally but the main purpose was directed towards boosting the domestic money supply and increasing the wealth of the authorities1. Rarely was it used as a tool to compete economically. The mercantile-based economies of the time ensured competitive gains mainly through the subsidizing of exports and the imposition of tariffs on imports.
So the world has come a long way from the “gunboat diplomacy” days of the earlier centuries. The change happened gradually as free trade superseded mercantilism. Currencies have become a potent monetary policy tool that can help steer an economy out of trouble but also cause trouble in certain circumstances. For it to work effectively requires agreement and cooperation between trading partners2.
Things can become complicated when several countries are facing similar economic challenges around the same time. Actively weakening a currency can only work if the currency against which it is losing value appreciates in return. When the central banks of several countries actively pursue the depreciation of their respective currencies simultaneously, it is bound to do more harm than good by causing a general decline in trade.
Depreciating a national currency is a potent stimulus weapon mainly because of the speed at which it is able to affect the economy. Think about it, you get almost instant gratification on the current account, as exports of the country suddenly become more competitive3. Large depreciations also have drawbacks in the form of imported inflation.
For countries that have borrowed heavily from abroad, however, a depreciation of the currency will make it more expensive for them to service their debt. This is also why a strengthening currency is an attractive outcome for heavily indebted nations that have a large proportion of their debts denominated in foreign currencies.
Currency depreciation is also a quick and relatively painless way of rendering the labor market of an economy more competitive, something that Eurozone members sorely lack. Their painful alternative has been to cut down nominal wages, which has caused significant negative repercussions on the economy. One of the Eurozone’s major “Achilles heels” stems from sharing a single currency amongst countries with highly divergent economies.
Unlike the U.S. where federal aid and a highly mobile labor market ensure greater regional harmonization, Eurozone members are confined to mainly fiscal means of impacting their economies. The Federal Reserve also has a dual mandate of ensuring price stability and full employment, in contrast to the ECB’s sole official mandate, which is to keep inflation in check.
We are living in precarious times; oil is at record lows, inflation is conspicuously absent and growth keeps sputtering. Many of the high powered stimulus tools have been spent and there is limited visibility on the global economic outlook front. The ECB is about to deploy massive amount of quantitative easing and the Euro has already weakened substantially. A currency war might be brewing, the consequences of which would be nasty.
1 One form of debasement involved reducing the amount of precious metal content in a coin. Through this method, known as Seigniorage, the authorities could collect a tax in return for producing and distributing the currency.
2 In early 2013, for example, G7 members made a joint announcement in which they declared that they would support policy in Japan that would effectively weaken the Yen. The aim was to provide the Japanese economy with enough stimulus to pull it out of a decades long deflationary slump.
3 The effect on exports is not exactly instant and may actually take months. In economics, this is known as the “J-curve” effect in which exporters need time to adjust to the sudden surge in export demand. The short term adjustment is usually through price.
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