Yesterday, Tim Geithner accused China of “manipulating its currency,” something we’ve heard periodically over the last several years but not in much in the last few months. (Of course, Geithner then said that “a strong dollar is in America’s national interest,” whatever that means.) Switzerland threatened to intervene on foreign exchange markets to suppress the value of the Swiss franc. And the French finance minister criticized the U.K. for letting the pound depreciate. (Hat tip Macro Man for the last two.)
Theoretically, devaluing your currency is not as bad as import tariffs. If every country tries to devalue its currency at the same time, exchange rates will remain the same; this is a zero-sum game in that sense. It’s a little more complicated, because there are at least two ways of devaluing your currency. One is for the central government to sell its own currency and buy everyone else’s currency on the foreign exchange market. The other, however, is to run an expansionary monetary policy (lower interest rates, more money creation, etc.), which is inflationary. So one possible outcome is that every country runs an expansionary monetary policy, exchange rates remain the same, but commodity prices go up because there is more money floating around. In today’s environment of low or negative inflation expectations, however, that might not be such a terrible thing.
But the other side of competitive currency devaluations is that not all countries are equally well armed. In particular, countries that use the euro cannot devalue their currencies, because they don’t control their monetary policy and they don’t have the scale to intervene significantly on the market for euros. In short, other countries can devalue their currencies at the expense of Eurozone members. This is one of the reasons why, as we (and Martin Feldstein) have warned, the economic crisis will increase tensions within the Eurozone. The New York Times just ran an article on this exact topic:
Germany, France and the Scandinavian countries are mounting billion-dollar stimulus plans and erecting fences to protect their banks. But the peripheral economies are being left to twist in the market winds.
This is a good indicator that fears about the Eurozone are going mainstream.
Originally published at the Baseline Scenario and reproduced here with the author’s permission.