Nouriel Roubini's Global EconoMonitor

Only the Weak Survive

Editor’s Note: This is a short excerpt of a much longer piece of research made available to RGE clients last week.

The risk of global currency and trade wars is rising, with most economies now engaged in competitive devaluations. All are playing a game that some must lose.

Today’s tensions are rooted in paralysis on global rebalancing. Over-spending countries – such as the United States and other “Anglo-Saxon” economies – that were over-leveraged and running current-account deficits now must save more and spend less on domestic demand. To maintain growth, they need a nominal and real depreciation of their currency to reduce their trade deficits. But over-saving countries – such as China, Japan, and Germany – that were running current-account surpluses are resisting their currencies’ nominal appreciation. A higher exchange rate would reduce their current-account surpluses, because they are unable or unwilling to reduce their savings and sustain growth through higher spending on domestic consumption.

Within the eurozone, this problem is exacerbated by the fact that Germany, with its large surpluses, can live with a stronger euro, whereas the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) cannot. On the contrary, with their large external deficits, the PIIGS need a sharp depreciation to restore growth as they implement painful fiscal and other structural reforms.

A world where over-spending countries need to reduce domestic demand and boost net exports, while over-saving countries are unwilling to reduce their reliance on export-led growth, is a world where currency tensions must inevitably come to a boil. Aside from the eurozone, the US, Japan, and the United Kingdom all need a weaker currency. Even Switzerland is intervening to weaken the franc.

Meanwhile, China is intervening massively to resist appreciation of the renminbi and thus maintain its export performance. As a result, most emerging-market economies are now similarly worried about currency appreciation, lest they lose competitiveness relative to China, and are intervening aggressively and/or imposing capital controls to stem upward exchange-rate pressure.

The trouble, of course, is that not all currencies can be weak at the same time: if one is weaker, another must, by definition, be stronger. Likewise, not all economies can improve net exports at the same time: the global total is, by definition, equal to zero. So the competitive devaluation war in which we find ourselves is a zero-sum game: one country’s gain is some other country’s loss.

The first salvos in this war came in the form foreign-exchange intervention. To diversify away from US dollar assets while maintaining its effective dollar peg, China started to buy Japanese yen and South Korean won, hurting their competitiveness. So the Japanese started to intervene to weaken the yen.

This intervention upset the EU, as it has put upward pressure on the euro at a time when the European Central Bank has placed interest rates on hold while the Bank of Japan (BoJ) and the US Federal Reserve are easing monetary policy further. The euro’s rise will soon cause massive pain to the PIIGS, whose recessions will deepen, causing their sovereign risk to rise. The Europeans have thus already started verbal currency intervention and may soon be forced to make it formal.

In the US, influential voices are proposing that the authorities respond to China’s massive accumulation of dollar reserves by selling an equivalent amount of dollars and buying an equivalent amount of renminbi. Meanwhile, China and most emerging markets are accelerating their currency interventions to prevent more appreciation.

The next stage of these wars is more quantitative easing, or QE2. The BoJ has already announced it, the Bank of England (BoE) is likely to do so soon, and the Fed will certainly announce it at its November meeting. In principle, there is little difference between monetary easing – lower policy rates or more QE – that leads to currency weakening and direct intervention in currency markets to achieve the same goal. In fact, quantitative easing is a more effective tool to weaken a currency, as foreign exchange intervention is usually sterilized.

Expectations of aggressive QE by the Fed have already weakened the dollar and raised serious concerns in Europe, emerging markets, and Japan. Indeed, though the US pretends not to intervene to weaken the dollar, it is actively doing precisely that via more QE.

The BoJ and the BoE are following suit, putting even more pressure on the eurozone, where a stubborn ECB would rather kill any chance of recovery for the PIIGS than do more QE, ostensibly owing to fears of a rise in inflation. But that is a phantom risk, because it is the risk of deflation, not inflation, that haunts the PIIGS.

Currency wars eventually lead to trade wars, as the recent US congressional threat against China shows. With US unemployment and Chinese growth both at almost 10%, the only mystery is that the drums of trade war are not louder than they are.

If China, emerging markets, and other surplus countries prevent nominal currency appreciation via intervention – and prevent real appreciation via sterilization of such intervention – the only way deficit countries can achieve real depreciation is via deflation. That will lead to double-dip recession, even larger fiscal deficits, and runaway debt.

If nominal and real depreciation (appreciation) of the deficit (surplus) countries fails to occur, the deficit countries’ falling domestic demand and the surplus countries’ failure to reduce savings and increase consumption will lead to a global shortfall in aggregate demand in the face of a capacity glut. This will fuel more global deflation and private and public debt defaults in debtor countries, which will ultimately undermine creditor countries’ growth and wealth.

Originally published at Project Syndicate.

All rights reserved, Roubini GlobalEconomics, LLC

10 Responses to “Only the Weak Survive”

economicminorOctober 18th, 2010 at 9:48 am

In the US the story is about housing debt fraud. were a lot of very sloppy business practices used in dealing with the actual notes which are the real IOU security that backs the collection of money as stipulated under a mortgage or trust deed. In some cases it appears that greed overwhelmed what was legal and proper. The proper transfer of many of the security notes was not followed. In others, the notes were just lost. Differing reasons given. At this point no one really knows how many. But this made the foreclosure on these notes legally impossible. So the institutions, caught between damned if you don’t and a free pass if and when they get away with it, did what I’m sure they believed they had to do. They put in the FIX.This mess could easily expand into a tsunami and dwarf all the worries over currency wars. All that can be determined right now is that the tide is definitely going out.

GloomyOctober 18th, 2010 at 3:23 pm

But the US will win this war. Who would have thought that it would be the US who would destroy the dollars value as a reserve currency rather than outsiders?PS-How ya been? Can this blog ever get restarted?

economicminorOctober 19th, 2010 at 8:49 am

Hi Gloomy,Where did all the others drift off to? It was such a lively group. I miss the old days.I’ve been as well as an older person who worked hard and played hard in my youth should expect. Aches and pains and now high blood pressure but way better off than many.Mostly spent my summer on gardening and projects around the place. Planted a few more fruit trees and battled with the birds and critters who wanted the fruits of my labor as much as I did. Went to a few concerts and rode my motorcycle some. All in all a pretty productive year. Didn’t travel as much as I like to. Maybe next year. We are going to Puerto Rico right after Christmas for 10 days. Don’t ask. Wasn’t even on my secondary list. But I always have a good time no matter where I go and it will be warmer than here in the NW.The unfolding of the economic scenarios around the states and the globe and the politics still fascinates and entertains me. Always something new yet it is the same old themes, greed, selfishness, hubris, power, hate, envy, and slovenliness. It will never change, just the players. Yet as the world gets more connected, the more easily obtained resources used and an ever growing population that there is a huge risk for a major calamity.Some days I feel totally a bystander and others I feel that I am standing in a tunnel looking at the headlight of a high speed train coming right at me.You take care and keep your eyes on the tide going out. It may be fascinating but it also means a big wave is coming.

blindmanOctober 20th, 2010 at 7:57 pm

e,do you cut your fruit trees to a height of aprox 8 feetand fertilize at the drip line? seriously. i heard a guy recommending this.

CarlSNovember 15th, 2010 at 4:36 pm

Hmmm. I came here to learn a bit about economics, and now I am treated to a garden blog and travelogue! Well, whatever works. I am certainly a newbie in the Economics one.By the way, I really like Puerto Rico. It’s just like US only Hispanic. You can drink the water, eat the food, have a good time – and not too expensive. I have a daughter in law from there, and 2 grandkids that are bi-lingual. You’ll enjoy it!

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