And if all this wasn’t enough, now we have the dreaded spectre of competitive devaluation. In the 1930s, one country after another pushed down its exchange rate in a desperate effort to export its way out of depression. But each country’s depreciation only aggravated the problems of its trading partners, who saw their own depressions deepen. Eventually even countries that valued currency stability were forced to respond in kind.
In the end competitive devaluation benefited no one, it is said, since all countries can’t devalue their exchange rates against each another. The only effects were to fan political tensions, heighten exchange rate uncertainty, and upend the global trading system. Financial protectionism if you will.
Now, we are warned, there are signs of the same. The Bank of England is not exactly discreetly encouraging the pound to fall. And just last week the Swiss National Bank intervened in the foreign exchange market to push down the franc. Will Japan, the United States and China be long to follow? Will we all yet again end up shooting ourselves in the foot?
In fact, this popular account is a misreading of both the 1930s and the current situation. In the 1930s, it is true, with one country after another depreciating its currency, no one ended up gaining competitiveness relative to anyone else. And no country succeeded in exporting its way out of the depression, since there was no one to sell additional exports to. But this was not what mattered. What mattered was that one country after another moved to loosen monetary policy because it no longer had to worry about defending the exchange rate. And this monetary stimulus, felt worldwide, was probably the single most important factor initiating and sustaining economic recovery.
It is true that the process was disorderly and disruptive. Better would have been for the countries concerned to co-ordinate their moves to a more stimulative monetary policy without sending exchange rates on a roller-coaster ride. But, not for the first time, they failed to agree. Those in the most precarious positions had no choice but to pursue the new policy unilaterally.
In any case, monetary easing achieved through a process of “competitive devaluation” was better than no monetary easing. Those countries that shifted in this direction first were also first to recover. But in the end – the end coming after an excruciating five years – they had all moved in the requisite direction, and they all began to recover.
This, in a nutshell, is our situation again today. Sterling’s weakness reflects, in part, the exceptional severity of the British slump. But it also reflects the fact that the Bank of England has moved further and faster in the direction of quantitative easing than any other central bank. With the Old Lady buying up British Treasury bonds hand over fist as a way of bringing interest rates down, it is no surprise that sterling should fall. It is no surprise, that is, given the failure of the ECB and the Fed to move as quickly to quantitative easing. And, in the event, this aggressive quantitative easing is precisely the medicine needed by a British economy on life support.
Now the Swiss National Bank has followed suit, announcing a shift to quantitative easing in response to mounting fears of deflation. It implemented that policy last week by buying foreign exchange and corporate bonds, rather than government debt as in Britain, but the net result was the same. It was a sharp fall in the exchange rate, by 3%, on the first day of the new regime.
So sterling and the franc are falling because their central banks are administering precisely the treatment that their economies require. Will other central banks, seeing their own currencies strengthen, conclude that the threat of deflation has grown more immediate and also now move quickly to quantitative easing? If so, exchange rates against sterling and the franc will revert to more normal levels. And, with quantitative easing all around, the world will receive the additional dose of monetary stimulus that it desperately needs.
Better of course would be for the major countries to agree to co-ordinate their monetary policy actions. Then exchange rates will not move by large amounts in one direction today and the opposite direction tomorrow. There will not be further disruptions to the global trading system. There will not be international recriminations over beggar-thy-neighbour policy. The G20 countries could even make such co-ordination part of their agreement at the 2 April summit in London. Or not.
Originally published at The Guardian and reproduced here with the author’s permission.