In 2010, Brazil's finance minister complained that his country was the victim of a 'currency war'. Following the 2008 crisis, the advanced countries set their interest rates close to zero and implemented quantitative easing. These policies caused their exchange rates to depreciate and encouraged capital flows, especially to emerging countries, forcing up exchange rates in these countries.
The advanced countries were accused of solving their domestic demand deficiency by beggar-thy-neighbour policies, distorting international comparative advantage to promote their own exports. Prime Minister Shinzo Abe's recent stimulus efforts in Japan have had the same effect on the yen. Has the currency war just escalated?
As might be expected, the countries responsible for these policies argue that they are just implementing conventional best-practice policy-making. A lower exchange rate is one of the routine transmission channels of accommodative monetary policy.
It's not analogous to putting on tariffs, where tit-for-tat responses could quickly lead to the sort of cumulative contraction of international trade that occurred in the 1930s. If competitive easing of monetary policy did occur, it might threaten price stability but would, if anything, expand world trade, as easy monetary policy boosts demand as well as affecting exchange rates. Just how much damage is done to other countries depends on the balance of these two efforts. This is US Fed Chairman Ben Bernanke's defence: everyone benefits from policies that enhance America's lacklustre demand, even if at the same time US exports are promoted.
The counter-argument is that the US stimulus is unbalanced. At the same time that monetary policy is exceptionally expansionary, fiscal policy is contractionary (the Japanese stimulus is less vulnerable to the beggar-thy-neighbour criticism, as it involves fiscal stimulus as well as monetary easing).
Whether this 'currency war' heats up may depend less on the theoretical niceties and more on how exchange rates and capital flows actually behave.
The Brazilians fired off the first salvos in this skirmish more than two years ago when they were subject to huge capital inflows and strong upward pressure on their currency. Since then, their exchange rate has fallen sharply, slower domestic demand has allowed their own high interest rates to be eased, and capital inflows have diminished.
As for the Japanese, the yen certainly appreciated painfully (by more than 20 per cent) in the wake of the 2008 crisis, and the sharp fall since it became clear that Abe would be elected just restores normality (in as far as normality can be judged with Japan's volatile exchange rate).
The US dollar has certainly weakened during the post-2008 period, but the change has not been dramatic. The main beneficiary of a weaker exchange rate has been the UK. Within the euro area, there are different views: the French are complaining, but the Germans, whose competitiveness has improved since 2008 and who continue to run a big external surplus, will muffle the French complaints.
What about the other countries on the receiving end of the 'war'? China tacitly accepted, long ago, that its exchange rate had to appreciate and has concentrated on ensuring that this is a controlled process. The yuan has appreciated by about 5 per cent over the last year or so, and perhaps twice that in inflation-adjusted terms. The current account surplus is below 3 per cent of GDP (ie. not abnormal) and foreign exchange reserves have leveled out. Most of the competitiveness adjustment is taking place in the form of rapid increases in domestic wages, which will at the same time address the consumption/investment imbalance.
Other Asian emerging countries have not so far been seriously affected, with exchange rates not under strong appreciation pressures. South Korea will feel the effect of the yen's weakness, but this offsets their own substantial depreciation in 2008, so they can't complain too much.
Among the advanced countries, the Swiss have had to resort to a fixed exchange rate to stem the loss of competitiveness, leaving them busy explaining this unusual action. Australia is accepting the abnormally high exchange rate, with the resources boom softening the pain, at least for the moment and for most of us.
This fortuitous conjuncture allowed recent meetings of G7 and G20 to issue bland communiques designed to down-play this issue. Avoiding acrimony is, of course, important. But this discussion was a distraction from the higher task of exploring the possibility of 'win-win' coordinated policy.
There is a growing recognition that the commitments made at the 2010 Toronto G20 to wind back budget deficits and official debt have been inappropriate for the feeble recoveries that have occurred: budget consolidation should be on a slower schedule. Easing the austerity would, at the same time, soften the 'currency war' fall-out of tighter monetary policy. Those emerging countries which have capacity to widen their external balances and welcome capital inflow could benefit from historically low borrowing rates to expand their infrastructure investment. China, freed from the chore of defending its exchange rate policies, might be ready to join in by allowing more consumer imports.
This exploration of international policy coordination might be the basis of a better discussion than the phoney 'currency war' debate, with its narrow focus on justifying domestic policy settings.
Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.