Currency Devaluation and Domestic Demand

In the latest issue of ‘Foreign Affairs’ (March/April 2011), Liaquat Ahamed (author of ‘Lords of Finance’ – winner of FT/Goldman Sachs Book of the Year Award in 2009) and Raghuram Rajan (winner of FT/Goldman Sachs Book of the Year award in 2010 for his book, ‘Faultline’) have articles on the risks of competitive currency devaluation in the world. Both of them appear to struggle to decide whether they should be optimists or pessimists. Liaquat Ahmad writes with an optimistic bent but concludes on a note of caution. Raghuram Rajan maintains a stance of caution and scepticism throughout, by and large. These articles could be available only to print subscribers of ‘Foreign Affairs’. Hence, I am not providing the links here. 

Liaquat Ahamed thinks that the damage caused by currency devaluation in the 1930s could be exaggerated. Further, he points that the risk of its repetition now are lower. One, the world accepts, by and large, that the US needs a lower dollar. Developing countries are adopting a good blend of currency appreciation, capital controls and reserve accumulation and are not engaging in beggar-thy-neighbour depreciation. Protectionism has remained muted since the World Trade Organisation has a fair mechanism for dispute hearing and resolution. What is missing, according to him, is the absence of a world leader sovereign. Kindleberger has, apparently, written in the 1970s that in a crisis, the global economy can remain open only if one country is willing to provide leadership – to be the supplier of capital when others are in a panic, to keep its markets open in the face of protectionist pressure, and to act countercyclically as an economic locomotive for the world.

The US is not in a position to do so now. In fact, Walter Russell Mead’s lead article in the same issue of ‘Foreign Affairs’ on the ‘Tea Party and American Foreign Policy’ talks of the dominance of Jacksonian thinking that heightens the risk of a confrontation with China.

Raghuram Rajan focuses on rebalancing of global demand. He sees the bright side in China beginning to shift its focus towards domestic demand. He notes that India and Brazil had not been actively pursuing mercantilist policies, in any case. In fact, he comes across as more worried about the aims and strategies of US policymakers. He makes the point that has been the pet peeve of TGS that the United States, thanks to the reserve currency status of the US dollar, is effectively setting monetary policy for the world. That is how it engendered globally loose monetary conditions in 2001-07 and is doing so again.

To that extent, TGS maintains that the US monetary policy is significantly and partially responsible for the global commodities boom. That the boom in the prices of food items benefits US farmers would not be lost on the Federal Reserve, surely. Incidentally, see John Taylor’s blog post where he disagrees with Bernanke’s interpretation of the Taylor rule.

Raghuram Rajan sees the United States pursuing more spending whereas it should be pursuing less spending. He is concerned about the short-run focus on unemployment and its policy implication resulting in continued fiscal stimulus. He is pessimistic that the Congress would legislate on the US Federal Reserve accepting its global monetary policy leadership as a factor in its policy formulation. At the minimum, he wants financial stability as one of Fed’s monetary policy goals along with price stability and full employment.

In the developing world, he wants regulators to focus on macro-prudential and counter-cyclical regulatory framework. In the developed world, he wants regulators to focus on ‘too big to fail’ issues and fairness in the pricing of risk and in the sharing of the consequences of risk-taking. In other words, debt and equity holders and not taxpayers should bear the consequences of their lending and investment decisions.

He concludes that governments know what they should be doing. He is not sure if they have the stomach for short-term pain that would come with the right decisions that they could make.

TGS is more sympathetic to the arguments that Raghuram Rajan makes. TGS is not sure if the optimism on the absence of the competitive currency devaluations exuded by Liaquat Ahamed automatically spills over into the future. Stresses that would force countries to resort to competitive devaluations might yet develop. The much-hyped rate hike by the European Central Bank could be the trigger. Jean Claude Trichet has called for ‘strong vigilance’ on inflation and that is usually a code for rate hike in the subsequent monetary policy meeting. That might well be the trigger for the Euro to drop precipitously. After all, the PIGS nations have still a problem with their debt, deficit and overall competitiveness.

The second trigger is China’s policy turnaround. In the Party Congress that is currently underway, the Chinese government appears to be laying more stress on inflation rather than on economic growth. Check out this blog post by Patrick Chovanec on why inflation has become more important for China than economic growth. The XII Plan growth rate target was brought down to 7.0% from 7.5%. So, instead of boosting economic growth, if China concentrated on inflation fighting, then one is not sure if China is helping the world economy to rebalance. It might be similar to what the United States and France did in the 1930s when they did not loosen credit even as they accumulated gold.

So, it is too early to celebrate the absence of competitive currency devaluation.

Originally published at The Gold Standard and reproduced here with permission.