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Friday, October 15, 2010

Currency and Trade Wars Feed on Stagnation, a take from Nouriel Roubini

Only the Weak Survive
Nouriel Roubini
Project Syndicate
October 14, 2010

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.


  1. China can over night reduce its need for savings by having a decent social safety net. The risks of unemployment without unemployment benefits and lack of a state pensions system mean that individuals have to over provide to prevent such problems in future. Also with China's one child policy they will have a demographic time bomb to deal with as well. So Chinese savings are not the problem. The export of those savings is another matter. The movement of funds out of China lowers the currency enabling China to maintain its competitiveness.

    What would be better is for countries to solve their external deficits through import substitution. The US could impose much higher energy efficiency standards. That will cut oil imports.

    Countries with surpluses will need to need to find ways of increasing domestic demand as those countries with deficits do everything to reduce their deficits. the alternatives would either be capital restrictions or trade wars.

    Though I doubt that anyone will do anything than push the problem further down the path for the next administration to deal with. I fully expect double dips in many countries though not necessarily globally.

  2. Ben Bernanke has abandoned his helicopter for an Earth observational satellite. From his new digs he will be electronically “kicking out” hundreds of billions of dollars into the global economy.

    This iteration of expansionary monetary policy may also be thought of as any of the following:

    Debt Deflation Demand Depositing;
    Forced-Flight-from-Quality Investment;
    Conspicuous Alleviation;
    Aggravate Demand;
    Bully Reserving; or
    If your country has a Main Street we are coming to take the money from it.

    Make no mistake, this policy of increasing the money supply will further increase already rising commodity prices worldwide and result in unrest, violence, price instability, and food riots.

    The United States desires to increase its exports; the exports here however are only what we have been working on domestically over the last roughly two years, namely: our capacity for under-utilization and our willingness to maintain a massive sacrifice ratio, stagnating and holding back the lives and dreams of millions of Americans.

    When and how will we learn that we need to make real investments instead of propping up a vacuous economy whose principle aim is creating money gags?

  3. I agree. A return to strict lending criteria might be painful in the short term but would kill off any speculative bubbles. Asset deflation is over blown. It was over priced to start with. So worrying about deflation is pointless. What is needed is a full employment policy and until that happens the US will suffer permanent and high unemployment.