There has been a lot of debate lately about competitive devaluations, “currency wars” and QE2. Some of the commentary seems to jump from the accounting fact that world current account balances should add up to zero (although in the real world, and for different statistical reasons, this accounting identity shows a non trivial discrepancy from zero) to the wrong inference that a devaluation in a specific country, while expanding output there, always does that at the expense of output and employment opportunities from the rest of the world (thus becoming a policy of “begging-your-neighbor”).
When these debates started several weeks ago the first thing that came to my mind was the 1984 analysis of whether the devaluations in the 1930s were “beggar-thy-neighbor” policies by Eichengreen and Sachs (Exchange Rates and Economic Recovery in the 1930s. NBER Working Paper No. 1498. November 1984). At least Brad de Long and Eichengreen himself have recently referred to that paper too. It is useful to re-read it.
Eichengreen and Sachs show that whether devaluation in a country expands or contracts demand and output in the rest of the world (i.e. whether policies are “begging-your-neighbor” or “helping-your-neighbor”) depends on a) the rest of the policies accompanying the devaluation in the country that has devalued its currency; and b) the policy reaction in the rest of the world. They analyze different scenarios, some expansionary and some contractionary for the rest of the world, depending on different combinations of domestic and external policies (Barry Eichengreen and Peter Temin also speculate on different scenarios of devaluations and policy responses in “Counterfactual Histories of the Great Depression” October 2001. http://www.econ.berkeley.edu/~eichengr/research/counter_histories.pdf).
Their model implies the existence of unemployment in labor markets. Therefore, the outcome also depends, as usual, on whether there is significant slack in labor markets, and, I would add, in other key markets as well (more on this below).
Moving from the gold standard model of Eichengreen and Sachs to the current situation, and in very simple economic terms, there are three different issues to be considered: a price effect, an income effect (related to current demand and output), and an interest rate effect (which determines the division of demand and output between current and future periods). The income effect relates mainly to the fact that demand and supply for exports and imports, also depends on GDP of exporters and importers (as calculated, for instance, in William Cline 2005. “The United States as a Debtor Nation.” Washington: Institute for International Economics; in particular, he considers an income elasticity of import demand of about 1.5 for the US; see also his post in http://www.roubini.com/piie-monitor/259961/estimating_the_impact_of_the_exchange_rate_on_the_trade_balance_and_jobs)
While the “currency wars” debate seems to focus on the relative price effect, the other two effects may be more important for overall world economic performance. President Obama seems to be focusing on the income effect when he argues that QE2, by stimulating the U.S. economy, is good for the world (which the high U.S. income elasticity in Cline’s work seem to support), even though, one may add, the relative price effect of the devaluation may be negative for other countries. He could have also argued that there is a positive interest rate effect of QE2 (the other effect mentioned by Eichengreen and Sachs) on at least part of the rest of the world (e.g. over-indebted countries).
It is interesting to note that the Chinese authorities are also arguing that a revaluation of their currency would generate a harmful income effect on China that would affect negatively the rest of the world (i.e. the potentially positive price effect of the revaluation for the rest of the world, would be more than compensated by the impact, also on the rest of the world, of the negative income effect on China). They could have also added that they have been contributing to lower interest rates for the whole world, as well.
Of course the effect of QE2, which will be felt globally, may generate different scenarios depending on a) the rest of the US policies (particularly fiscal and trade policies), and b) the policy reaction in the rest of the world, and not only China.
An additional complicating factor is that although there seems to be slack in labor markets in the industrialized world, and that China (and many developing countries) would argue that they still have a lot of Lewisian unemployment (or, a Marxian “army reserve of unemployed,” depending on your analytical tastes), there are several key commodity markets that seem to be experiencing supply side problems.
For instance, the next Table shows the ratio of food and grain nominal prices to the nominal cost of fertilizers (monthly data starting in January 1960 and ending on October 2010; data comes from the “Pink Sheet” of the World Bank; we appreciate the help from the people working with this database at the World Bank).
Even with the recent high nominal prices for food commodities and grains, if those series are compared to the cost of fertilizers, the ratio is the worst in many decades for food and grain production. There appear to be cost-push factors on top of all the usual demand-side considerations for high nominal prices in food and grains.
Is the world going to experience a repeat of what happened in the second half of the 1970s? Then, expansionary macroeconomic policies in industrialized countries after the 1974/1975 recession combined with still strong growth in developing countries (which in the aggregate were barely touched by the recession; see Table) to produce the second commodity price shock of the late 1970s and early 1980s.
The current configuration of global trends seems to be somewhat different from the second half of the 1970s (see Table below; data on the 1970s is from the World Bank and for the 2000s and projections are from IMF, so the two events are not completely comparable). In the next four years after 1974/1975 the world jumped back to a growth rate well above 4%, with all industrialized countries following expansionary policies, until the inflationary shocks of the late 1970s and early 1980s forced a complete change in global policies and developing countries suffered the 1980s debt crisis. In contrast, the 2008/2009 recession has been deeper, also slowing down developing countries. Furthermore, now not all developed countries are following expansionary policies and the projections are for lower world growth rates, mostly because industrialized would experience subpar growth rates.
Determining now who is begging or helping what neighbor, and whether the world will get or not an inflationary explosion from current policies, may get extremely complex. Answering that question would require an extension and updating of the model presented in Eichengreen and Sachs, 1984 (including for instance the consideration of commodity markets with little or no slack) and a significant expansion of the scenarios presented there. Still the paper is worth re-reading, particularly in these times when one is bombarded with simplistic analysis.
(The opinions here expressed are personal and do not reflect those of the IDB or the governments involved)