Casualties of Currency Wars
Oh, yeah: about those currency wars.
So, suppose the United States does what Switzerland just did, and announces that we’re simply going to print dollars until the dollar drops to, say, half a Euro in value.
What we’d be doing is seizing a larger share of world demand in exchange for making all our assets worth less. As such, you’d expect our action to be stimulative at home – but to result in contraction in the Euro zone.
In case you hadn’t noticed, the Euro zone isn’t doing terrible well itself these days. But the pain is not spread evenly. Germany is performing relatively well; it has higher unemployment than it used to (and still going up) but significantly lower than the situation in southern Europe. Italy and Spain, on the other hand, are going through a brutal contraction compounded by the requirements of governmental austerity. (And while Italy isn’t exactly a model citizen when it comes to government spending, it has done much better on that front in recent years than in much of its modern history – and Spain was in fact a model citizen.)
All of this is leading to substantial pressure on European institutions. A default in the periphery will inevitably lead to a massive recession across the continent and, indeed, worldwide. But a default is unavoidable without either substantially higher inflation, massive fiscal transfers from the center (mostly Germany) to the periphery, or some kind of debt forgiveness.
A substantial American devaluation would make all these pressures much worse. It is possible that, as the pressures reach intolerable levels, the various European polities will suddenly work out a viable solution that saves the Euro zone. In the same way, it is possible that a credible external threat will bring a group of squabbling countries together to unite against the common enemy.
But it’s also possible that it won’t. And if it doesn’t, then Europe goes over the cliff.
Normally, the risk with a currency war is competitive devaluations that lead to generally higher inflation, but with the added element of higher uncertainty about future exchange rates imposing a kind of transaction tax on international trade. If that were the only result, then we’d be back to our discussion about whether higher inflation as such is something we want.
But in the current environment, I think the risks are far more significant than that. A massive devaluation by the United States would basically be betting the world economy that the ECB will follow suit.
Even if they did, if I were a European policymaker, I would appreciate having an economic gun that size put to my head by their American allies.
I think your reasoning and conclusions on monetary policy are flawed in several ways but here I just want to point out how they are at odds with scholarship over the last couple of decades on the impact of so-called competitive devaluations during the Great Depression. See for example the 2009 NBER paper by Eichengreen and Irwin” “The slide to protectionism during the Great Depression: who succumbed and why”, Eichengreen’s 1992 “Golden Fetters” book or Bernanke’s 1993 AER paper “The world on a cross of gold”.
The newer research emphasizes the role of the gold standard in initiating and propagating the global slump. Faced with the enormous shortfall in aggregate demand and persistent deflation, countries on the gold standard had no independent monetary policy instrument with which to reflate economies. Countries that abandoned the gold standard earliest—that is, devalued—also experienced earlier recovery from recession, not only because of stronger exports,but also because they had more room to expand money supply and cut interest rates. Meanwhile countries that stuck with the gold standard were also the ones that — in desperation — resorted most to protectionism as a way to try and boost demand. The optimal policy response to the Great Depression, in this view, should have been a coordinated, unsterilized devaluation against gold by all countries suffering deflation. In effect, this would have been a coordinated global monetary easing, but without beggar-thy-neighbor effects on trade.It’s also what we need now, rather desperately.
— nb · Sep 8, 08:00 AM · #
nb:
I don’t think I disagree. I am not – emphatically not – an advocate of deflation. Deflation is far more dangerous even than inflation, and must be avoided. America experienced double-digit deflation in 1931, 1932 and 1933, a truly catastrophic situation that we refer to as the Great Depression.
Nor am I an advocate of the gold standard, precisely for the reasons you articulate. Under a gold standard, there is no way to fight a deflationary contraction – which is why we had several such in the 19th century, to very destructive effect. (Moreover, you can’t fight inflation when gold supplies increase – the Spanish economy was basically hollowed out over the course of the 17th century due to the inflation caused by the massive silver discoveries in the New World.)
The current Fed agrees with me. They moved heaven and earth, taking a variety of extraordinary measures – some not obviously authorized by law – to counteract deflation.
But that’s consistent with a mandate to achieve price stability. Price stability means no inflation or deflation. In practice, that means modest inflation, because for conventional monetary policy to work you need to stay north of the zero bound (and everyone would prefer for monetary policy to be conducted usually using conventional tools; nobody likes quantitative easing or the other unconventional tools the Fed is now forced to use).
The question on the table isn’t whether the Fed ever has to loosen, nor whether deflation should be fought with every tool available. The question is whether, once deflation has been avoided, the Fed should target higher inflation, and maintain a higher inflation target until unemployment drops below a certain level.
I think it shouldn’t. Perhaps slightly higher inflation to “catch up” with a price level consistent with a 2% long-term inflation rate is a better idea than simply targeting a 2% inflation rate every year; that strikes me as a minor debate. (Would people who advocate such a catch-up period also favor catching up on the other side, when inflation overshoots? Thought not.)
After the USA left the gold standard, we had a rapid recovery – because we’d finally stopped the deflation. But we didn’t then enter a period of accelerating inflation. The CPI rose by less than 3% in each of 1934, 1935, 1936 and 1937. We had fairly stable – rather than falling – prices.
Then we had an austerity budget in 1938, and tripped back into recession.
We need a sound monetary policy that targets price stability, and an expansionary fiscal policy that focuses on labor-intensive investments that will have a long-term positive effect on national productivity.
— Noah Millman · Sep 8, 03:27 PM · #
You may want to address the recent and – it seems to me – powerful arguments by economists like Scott Sumner and David Beckworth for a Fed nominal GDP growth rate target (e.g. 5%). Under the present near recessionary conditions, this would entail a temporary push for nominal growth well above 5%, so as to get us back to the level implied by the pre-recession trend. Ramesh Ponnuru has been expounding this view at an admirably elevated intellectual level at National Review, much to the fury of the “movement conservative” and “austrian” types who frequent the online commenter pages there. (Apologies if you have already discussed the nominal GDP target perspective – I haven’t had the time to check out your earlier posts).
— nb · Sep 8, 10:53 PM · #
Scott Sumner makes a very interesting argument. I put a few questions to him here most of which he answered in the comments.
It still seems to me that, because real growth is quite volatile, NGDP targeting would make short rates much more volatile as well. Sumner thinks long rates would become more stable because NGDP would become more stable, and NGDP expectations are what long rates reflect (which is true) but this assumes NGDP targeting would work, and because of the high volatility of real GDP I worry it wouldn’t. Of course, maybe if we adopted NGDP targeting, real GDP would stabilize; maybe it’s only volatile because we’re targeting the price level. Who knows. This is really wildly speculative since I don’t believe any central bank currently does NGDP targeting, nor has one done so in the past.
The most counter-intuitive part of Sumner’s argument is that, in his view, when we have a surge in productivity we should tighten (because higher productivity drives real growth up, which drives NGDP up all else being equal, so we need lower inflation to offset and keep NGDP stable) while in response to supply-driven inflationary shock (a spike in oil or food prices, say) the Fed should ease (because the supply shock does more harm to real growth than it does to boost inflation, so NGDP will drop, and we need even more inflation to make up for it). In other words: if we’re actually getting wealthier faster than we thought we would – that’s what a rise in real growth means – then we need to make money more expensive, reducing the volume of economic activity; and if we’re getting wealthy slower than we thought we would – that’s what a hit to real growth would mean – but prices are rising nonetheless, then we need to make prices rise even more.
That’s really, really counter-intuitive. Like, sufficiently counter-intuitive that it scares me.
I think Sumner’s ideas are well worth further exploration. I’d be really interested to see a minor central bank – Sweden, Australia, someone like that – try it out and see how it performs. But it’s a pretty radical departure from established practice.
— Noah Millman · Sep 9, 03:36 AM · #
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