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.