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James Rickards’ recent book, Currency Wars: The making of the next global crisis, is worth reading if you are interested in a history lesson of international monetary politics. As you can probably tell from the title, the book’s central thesis is that currency values are primarily the result of domestic and internationally coordinated policy decisions, and in times of stress, the lack of coordination results in a race to the bottom, and a disastrous economic outcome for all nations involved.
Given the current global agenda is competitive devaluation, the insights from this book, and more importantly, the idea that looking at history for lessons in the current global economic malaise, is extremely important. I want to use this review to pick up on some of the theoretical and political points.
In the book, Rickards questions the theoretical proposition that devaluing the currency is a useful tool to stimulated demand in a recession, particularly if government and private spending are constrained. In practice, he argues, this theoretical outcome is rare, and provides a number of examples to make his point.
I was disappointed that Rickards didn’t expand his theoretical position about the impact of currency devaluation on domestic demand. While cross-border trade can be a large component of economic activity, it is the country’s net trade position that determines the impact on domestic demand of a currency devaluation.
Countries with large external deficits (in particular trade deficits) will actually see a short-term decline in demand from devaluation. Imports are a larger share of GDP compared to exports, so the increase in prices from devaluation won’t be offset by an increase in demand from the external sector. However, for a country with large trade surpluses, steady devaluation can sustain a high level of aggregate demand.
On the flip side, countries with large trade deficits will appear more wealthy if their currency appreciates. Therefore, we see that trade balances ‘naturally’ become entrenched over time as surplus nations benefits from low currency, and deficit countries benefit from a high currency, and any adjustment away from this path becomes more and more painful.
History shows that the ultimate end-game of international power plays, of which trade balances, currency manipulation, and domestic capital accumulation become both the cause, and the preparation for, is conflict (or international bargaining under the threat of war).
All of this is one reason that for much of the 20th century currencies were tightly regulated by international agreements – from gold standards, to Bretton Woods, to the Plaza Accord and many other treaties and agreements.
Given these important observations – lock in effects, and the history of agreements – I found it odd that Rickards failed to mention Keynes’ proposition for dealing with accumulations of foreign debt and the lock-in effects of long term trade surpluses or deficits.
Keynes’ Bretton Woods proposals sought to engineer a way around this impasse by requiring creditor nations to make room for debtor expansion by reducing their trade surpluses, funding foreign investment or rescheduling debt. But in 1944, America wouldn’t agree to such cramping of its style.
In our current global environment what does this all mean?
In Europe I expect the Euro to be defended even at a very high cost. After political battles over fiscal policy are played out, I expect much tighter integration of European nations. With tighter integration, some long-term rebalancing may be possible, or may even not be required if intra-EU fiscal transfers become enshrined as a kind of EU national welfare policy. Of course I note that we live in a complex system, and that in times of crisis, the crowd is not so wise, and other paths are possible, even is less ‘logical’.
In the US, we can expect the trade deficit to continue growing, regardless of their efforts to devalue to the US dollar. For every attempt to do so, other major economies will fight back.
China’s massive accumulation of capital and ongoing trade surpluses will be seen as a threat to the established dominant Western powers, especially the US. Whether they bring the international community together to further nudge China to revalue the Yuan, or whether this situation unwinds into playground bullying tactics, I don’t know.
The big lesson though is that rebalancing is a multi-decade project that requires commitment and cooperation from both sides. Surplus nations will take a short term hit from reduced export demand and a higher currency, and deficit nations will take a short term hit from a lower currency and the decreased demand that results.