Currency Wars: Monetary Policy as a Zero-Sum Game

For every action there is an equal and opposite reaction -Sir Isaac Newton

I have always thought that Isaac Newton would have been a great investor and/or economist. Not because of his rigorous dedication to his craft. Not because of his mathematical ingenuity. But because of his ability to step outside of conventional thinking and to see the bigger picture. Isaac Newton advanced the field of physics, but he could have equally advanced the field of economic theory. He understood that forces don’t exist in a vacuum and came to realize that every action has its consequences. In fact, forces between people and governments are strikingly similar to forces in nature.

John Makin, a resident scholar at the American Enterprise Institute (AEI), recently published an informative piece on Japan’s two-decade period of stagnation and provided a few takeaways for current U.S. policy. You can read it here.

After the Japanese real estate bubble burst in 1990, the Japanese economy has more than just struggled to regain its footing. Makin points to deflation as the primary cause in the prolonged stagnant economy. Because the Yen hasn’t appreciated in twenty years, debt levels have soared. Governments must pay down their debts in nominal terms, and unlike a country that experiences a reasonable inflation rate of 2% per year, the tax base has also remained stagnant. His proposed solution is to print money, ramp up inflation, increase the tax base, force investors into riskier assets, devalue the Yen, and boost export competitiveness.

So far, so good. This is very sound economic advice and advice that the Japanese government is starting to reflect in their own policy changes. Yesterday, Japanese prime minister, Shinzo Abe, chose Haruhiko Kuroda to stabilize Japan’s money supply. However, Abe has made a very, clear mandate for the new central bank governor: print money. Following up on that dovish promise, Abe has chosen someone who is willing to devalue the currency, avoid deflation at all costs, and set an inflation target to help out Japanese industrial competitiveness. So much for central bank independence.

I agree that in an insular world, this policy makes the most economic sense. It may be a Keynesian way of thinking, but it is a policy that should stimulate an economy that has been stagnant for way too long.

Unfortunately for Japan (and for the rest of the world), monetary policy doesn’t exist in a vacuum. As one country devalues, every other country revalues. Like physics, it is an inherent law that any currency devaluation is followed by a currency revaluation on the other end.

The Federal Reserve, the ECB, and the BOE have all pursued aggressive monetary policies as of late. In September when Bernanke proposed yet another round of quantitative easing, Brazilian finance chief, Guido Mantega, expressed his disapproval. While Bernanke may have been focused on easing credit markets, this action weakened the US dollar and strengthened other currencies around the world, including the Brazilian Real.

In Europe, the ECB has long been expanding its balance sheet (more out of political necessity than economic self-interest). The BOE continues to pursue aggressive monetary policy and has even spoken of negative nominal interest rates, which would entail charging banks a fee for keeping money with the central bank.

So is Japan just playing catch up. Yes, they are. But what happens when the end goal is currency competitiveness and everyone is acting towards the same goal. Like any prisoners’ dilemma game, no one wins. But even worse, everyone loses.

Why does everyone lose? Because the transmission mechanism for expansionary monetary policy (aka printing money) is lowering interest rates. And when short-term rates are at 0%, you lower long-term rates. And suddenly, no one is better off and the economy looks a lot more fragile, with interest rates that are not in line with economic fundamentals.

Many of the fundamental economic problems in the US are large and quickly expanding entitlement programs, like Social Security and Medicare. If the American taxpayer believes he will need to pay more taxes in the future, he will demand a higher return for lending his money to the Federal government. The way to push long-term rates down and incentivize risk-taking is to reform these medium-run obstacles in Congress, not by printing more money at the Fed. Again, structural problems need to be solved structurally. Any monetary remedies are just band-aids.

It is worth noting that many central bankers do believe that lower interest rates (rather than a competitive currency) is key to economic growth. Others, however, tend to disagree. Jeremy Stein, a  member of the Federal Reserve Board of Governors, has alluded to the problem of pushing interest rates far beyond their fundamental range. In this speech, he discusses some of the problems with low interest rates, most notably excessive risk-taking. While the Fed is actively encouraging investors to take risks, too much easing can incentivize excessive risk-taking, much like we saw in the run up to the 2008 financial crisis. A summary of his talking points can be found here.

The global economy is stagnating, not because monetary policy is too tight, but because of political uncertainty. The Yen fell after Kuroda’s appointment, but jumped right back up earlier today when the Italian election results added more uncertainty to the Eurozone mess. Meanwhile in Washington, Bernanke testified before the Senate Banking Committee, reaffirming his bond-purchasing mandate.

How do we get rid of political uncertainty? A currency war will certainly not help. There needs to be more coordinated action at the national level with regards to both fiscal and monetary policy. While monetary policy is supposed to be independent of politics, that independence has unfortunately been compromised. Open communication between central bank governors would help move the global economy in the right direction. Much like meetings between G20 finance ministers, central bank governors should meet more often and make their monetary goals more transparent. The Fed, ECB, BOE, and BOJ need to lead the way; presumably, other countries would follow. However, if the banks continue to fight for a competitive currency, no one wins, and we all lose.