roach on competitive currency devaluation

  1. 470 Posts.
    Stephen Roach (New York)

    Guns are blazing on the anti-deflation front. Policy makers in Japan and the
    United States have elevated deflation to their number one concern. Even
    European authorities have finally joined the game, as evidenced by an
    aggressive 50 basis point ECB easing, with the euro-zone inflation rate still above
    the so-called price-stability threshold. The full force of the global policy
    arsenal now seems aimed at arresting deflation. And that's very good news.
    The bad news is that there's no guarantee the medicine will work. Policy
    traction is most difficult to achieve at low levels of inflation and nominal
    interest rates. Just ask Japan. In the case of the US economy, stabilization
    policies typically work their charm on three sectors - consumer durables,
    homebuilding, and business capital spending. With all three sectors having
    gone to excess in recent years, any response to policy stimulus could be
    surprisingly muted. In Europe, monetary stimulus is being offset by the
    combined headwinds of fiscal consolidation and lingering structural
    rigidities, especially in the labor market. History tells us that
    deflationary remedies must be administered early and aggressively. Only time
    will tell if it already isn't too late.

    But there's another piece of bad news on the deflation watch - the risk that
    a policy clash gets played out in foreign exchange markets. That's
    especially the case with respect to Japan and the United States, where
    senior officials in both countries have lately hinted at playing the
    currency-devaluation trump card in the battle against deflation. Haruhiko
    Kuroda, the Japanese MOF vice minister for international affairs, has become
    quite vocal in recent days attempting to manage the yen lower - first with
    an opinion piece in the Financial Times (see "Time for a Switch to Global
    Reflation" published on 1 December 2002) and now with a rhetorical salvo
    implying that the Japanese currency has only just begun to fall from a
    position of "excessive strength." At the same time, Fed Governor Ben
    Bernanke has introduced the possibility of dollar devaluation as an
    anti-deflation remedy as one option in a broad array of "non-traditional"
    actions that the US central bank could take against deflation (see his 21
    November 2002 speech before the National Economists Club, "Deflation: Making
    Sure 'It' Doesn't Happen Here"). While the coexistence of a weaker yen and a
    weaker dollar seems highly unlikely, just the mere suggestion by authorities
    in both countries to reflate through currency depreciation conjures up the
    perils of competitive currency devaluation - a highly disruptive outcome for
    the global economy and world financial markets.

    It's times like this that bring out the worst in xenophobic policies. When
    faced with the perils of deflation, it's "every man for himself!" Yet since
    foreign exchange rates are relative prices, it is mathematically impossible
    for all of the major economies in the world to embrace currency devaluation
    as a tactic to stave off deflation. The case for a weaker dollar is
    especially compelling, in my view. As seen through the lens of the real
    effective exchange rate, the dollar is more than 30% above its 1995 level,
    whereas the yen is off about 15% over the same period. In that regard, and
    in the context of America's massive current-account deficit (an estimated
    -4.6% of GDP in 2002) and Japan's outsize external surplus (an estimated
    +3.3% of GDP in 2002), it's hard to argue on the basis of economic
    fundamentals that the yen "deserves" to fall more than the dollar. Over the
    long sweep of economic history, current-account adjustments - from deficit
    to balance - are invariably accommodated by currency depreciation. On that
    basis, it's only a matter of when - not if - the dollar falls.

    Nor does the unbalanced state of the global economy suggest that yen
    depreciation would be appropriate. Since 1995, the United States has
    accounted for fully 64% of the cumulative increase in world GDP, double its
    share in the global economy (as measured at current exchange rates). This
    reflects an extraordinary dichotomy in domestic demand conditions around the
    world. For example, in the five years ending in mid-2000, domestic demand
    growth averaged 5% in the US and only about 2% in the rest of the world. As
    America's gaping and ever-widening current account deficit suggests, such
    imbalances are not sustainable. Global rebalancing requires a realignment in
    relative prices. As the world's most important relative price, I believe
    that a weaker dollar makes a good deal of sense under such circumstances.
    The case for a weaker yen rests mainly on the state of desperation now
    gripping the Japanese economy. Having effectively exhausted its conventional
    monetary and fiscal ammunition, the currency becomes something of a
    last-gasp lever for the Japanese authorities. To the extent that the United
    States has more ammunition left in its traditional stabilization arsenal and
    that its macro condition is healthier, Japanese officials are arguing that
    Japan should be given the benefit of the doubt. But this would not be a
    panacea for all that ails the world's second largest economy. It would
    merely buy some time, goes the argument, while Japan finally gets on with
    heavy lifting of structural reform.

    Yet there's always the risk that such a strategy will backfire. That's
    especially the case in Japan. To the extent that the Japanese economy enjoys
    the temporary reflationary benefits of a weaker yen - stronger external
    demand and imported inflation - the incentives for structural reform might
    diminish. That's, in fact, exactly what happened in the latter half the
    1990s. The pressures for such reforms were extreme in early 1995 when the
    yen/dollar cross-rate briefly pierced the 80 threshold. The urgency to act,
    however, was tempered by three and a half years of sharp currency
    depreciation, which took the yen/dollar cross rate back to 147 by August
    1998. Led partly by exports, Japanese GDP growth accelerated to a 2.4%
    average annual rate over the 1995-97 interval, and the imperatives of
    restructuring were quickly forgotten. Based on that experience, there is
    good reason to be suspicious of Japanese promises to deliver on structural
    reform while the yen is depreciating. A stronger yen, by contrast, would
    leave Japan with little choice other than to restructure.

    The same argument could be used with respect to Europe: A stronger euro
    would leave Corporate Europe with no choice other than to restructure. It is
    in that context that the efficacy of currency policy should be considered.
    In my opinion, the currency can either be a "a carrot or a stick" in shaping
    structural change. The experience of the last 25 years - especially the
    restructuring of Smokestack America during the strong-dollar era of the
    early 1980s - tells me that the "stick approach" is far more effective. And
    so I reluctantly conclude that just as the world now needs a weaker dollar
    to temper global imbalances, the world also needs a stronger yen and a
    stronger euro to force long overdue restructuring in both regions.

    Nor do I believe that a world in distress will sit back and tolerate a
    unilateral initiative by Japan to reflate via currency depreciation. If it
    becomes evident that traditional counter-cyclical stabilization measures are
    not gaining traction in the US or Europe, then the authorities in both
    countries might well consider shifts in their own currency policies. The
    result could be an increasingly vicious cycle of competitive currency
    devaluations that would achieve nothing but ill will. That would then up the
    ante for national policy makers to turn to trade protectionism as a true
    last-gasp option to shield their economies from imported deflation and the
    seemingly unrelenting pressure of import penetration into domestic markets.
    Sadly, that's right out of the script of the early 1930s.

    It doesn't have to end that way. If US policy makers establish traction with
    their recent and prospective monetary and fiscal actions, then deflation can
    be avoided without an explicit shift in dollar policy. At the same time, if
    the rest of the world embraces pro-growth policies of its own, the currency
    lever need not be utilized to accomplish this objective. If, however, the
    authorities fail to achieve these results, then all bets would be off for
    the US and the broader global economy. Competitive currency devaluations
    almost always end in tears.
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