Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

Currency Wars

Wednesday, July 22, 2015


One of the most memorable phrases in the literature on international finance is “beggar-thy-neighbor”–a term used by a distinguished British economist in the mid-1930s to describe the declines in the prices of the British pound, the U.S. dollar and several other currencies in terms of gold from 1930 to 1937. Supposedly each country reduced the price of its currency in the effort to increase exports, and hence employment in its manufacturing sector at the expense of its trading partners. The declines in the prices of individual currencies occurred over a six year period, much like a slow motion version of falling dominoes. The first currencies to fall were the Argentinean peso and the Chilean peso in 1930. Then in May 1931 the price of the Austrian schilling declined sharply when Credit Anstalt, the largest bank in the country, failed; this bank was indebted to German and other foreign banks. Speculative pressure was deflected to the German mark because some of the German banks had borrowed money from British banks. Germany adopted exchange controls to thwart the speculative pressure and protect the price of the mark. Speculative pressure then was transferred to the British pound; its parity in terms of gold was severed in September 1931. Then the speculators began to short the U.S. dollar; the United States nationalized all privately-owned gold in March 1933, a day or so after Franklin Roosevelt became President, to forestall the speculative pressure against the U.S, banks.

The U.S. dollar was floating for the next ten months, and the U.S. dollar price of gold was nudged upward; at the end of January 1934, the U.S. Government adopted a new parity for gold at $35 an ounce. The speculative pressure then was directed at France and the other countries that still retained their 1930 parities for gold, including the Netherlands, Belgium, and Switzerland; these countries devalued in 1936.

The staggered declines in the prices of currencies have been viewed as skirmishes in a currency war as countries attempted to stabilize their economies after the political and economic dislocations that followed the First World War. When the war started, most countries stopped pegging their currencies to gold and adopted exchange controls to limit foreign payments. Government spending during the war was financed with extensive borrowing from the banks, and while every country experienced a significant increase in its price level, the increases were much larger in most foreign countries than in the United States. Three empires–the Austrian-Hungarian, the Russian, and the Ottoman–disappeared; a clutch of new countries, including Austria, Hungary, Czechoslovakia, Poland, Latvia, Yugoslavia, and Greece appeared. Each of these newly independent countries needed its own currency and established a central bank. Germany was saddled with a large reparations bill; its borders had shrunk and its colonial empire shattered. France hoped that reparations receipts would enable it to repay its indebtedness to the United States and Britain.

The price of the German mark declined sharply after 1921 as the government borrowed from the banks to obtain the cash to buy the foreign currencies that it needed for reparation payments; a hyperinflation resulted. Germany adopted a new currency early in 1924, and at a price that was low so that thereafter Germany developed trade surpluses. In contrast Britain returned to its pre-1914 gold parity in April 1925 at a price that was fifteen to twenty percent too high. (Winston Churchill then was the Chancellor of the Exchequer. Keynes wrote a pungent critique of Churchill’s initiative to re-establish the 1914 parity titled “The Economic Consequences of Mr. Churchill”) A speculative attack on the French franc in the 1926 led to a dramatic decline in its price; after the government authorities adopted a sharply contractive monetary policy to stem the attack, the price of the franc increased, and the government anchored the franc to gold at a price that was significantly undervalued.

The staggered increases in the price of gold in the1930s in terms of various currencies were belated adjustments to the increases in national price levels during and immediately after World War I.

The rationale for establishing the International Monetary Fund (IMF) in the first half of the 1940s was that the turmoil in the currency market in the 1930s and the inward looking nationalist economic policies were major factors that led to the Second World War. The thrust of the IMF’s Articles of Agreement was that a member country could reduce the price of its currency only after it had satisfied its trading partners that it was in “fundamental disequilibrium”–which meant that its current account deficit was too large to be sustainable when it was at or near full employment.

France engaged in currency warfare in the mid-1960s when General de Gaulle instructed the Bank of France buy gold from the U.S. Treasury to induce the U.S. Government to reduce the country’s payments deficit and to increase the U.S. dollar price of gold. In 1971 the Nixon Administration applied a tariff of ten percent on dutiable imports from Japan to induce the Government of Japan to allow the price of the yen to increase.

Since the move to the floating currency arrangement in the early 1970s, the IMF’s interest in the stability in the prices of currencies has waned, perhaps because of the belief that market forces would ensure that a country would no longer experience a fundamental disequilibrium in its international payments; instead the price of its currency would more or less automatically decline if it had a trade deficit. Currency speculators would remain benign because changes in the prices of currencies would be continuous and gradual and track the differences in national inflation rates.

One of the major surprises in the last forty years is that the deviations between the market prices of currencies and their long run average or equilibrium prices have been much greater than when currencies were anchored to parities. In the 1950s and the 1960s, the deviations between the market prices of currencies and the long run average prices resulted from differences in national inflation rates; a country developed a trade deficit when its price level increased more rapidly than those in its trading partners. Since the move to the floating currency arrangement these deviations have resulted from sharp changes in the market prices of currencies, much as in the 1920s and 1930s.

About 2005 Senators Schumer and Graham noted that the price of the Chinese yuan was too low and being manipulated by the Peoples Bank of China. In 2010 Guido Montengo, then the finance minister of Brazil, used the term “currency war” to refer to the tension between the United States and China over the large Chinese trade surplus and the low price of the yuan. In 2011 James Rickards published Currency War; he was concerned about the challenges to the United States from the European Union and China, and the initiatives that they might adopt to weaken the United States both economically and politically.

About three years ago, officials in the BRICS countries (Brazil, Russia, India, China, and South Africa) complained that the Federal Reserve’s Quantitative Easing program was a form of currency warfare. The low interest rates on U.S. dollar securities led carry-trade investors to borrow U.S. dollars and buy securities denominated in the Brazilian real, the Indian rupee, etc; moreover firms in these countries borrowed the U.S. dollar and used the money to pay down indebtedness in their own currency. The central banks in these emerging market countries then faced the choice between a market-driven increase in the price or their currencies or an increase in their monetary base–the mirror of the deflate and devalue challenge of the 1930s.

Every change in a country’s monetary policy has both domestic and external impacts. The test of whether a change in monetary policy qualifies as an act of currency warfare is whether its primary intent is to increase domestic employment. QE1 and QE2 were motivated by the desire to hype the U.S. economy by increasing the prices of securities and real estate, increases in the prices of foreign currencies were an unintended by-product. The motive for the Volcker shock of October 1979 was the desire to reduce the U.S. inflation rate; the unintended consequence was that the U.S. manufacturing industry was “hollowed out” as the price of the U.S. dollar increased sharply.

In December 2012 Prime Minister Abe “talked down” the price of the Japanese yen by twenty percent even though the economy has been growing by one and one half percent a year, the unemployment rate was four percent, and the country’s current account surplus was two percent of its GDP. Japan had developed a fiscal deficit of eight percent of GDP to absorb excess saving because business investment was faltering. Abe believed that as the price of the yen declined, exports would increase, and the current account surplus might increase to five or six percent of its GDP.

Within the last six months the U.S. dollar price of the Euro has declined by more than twenty percent. Matteo Renzi the prime minister of Italy suggested that the Euro might go to “parity”–US$1.00 would equal 1 Euro; which was a prescriptive statement to talk down the price of the currency. Growth in the Eurozone countries has increased modestly, although the unemployment rate is north of ten percent. As a group the Eurozone countries have a current account surplus of two percent of their combined GDP. However, Germany and the Netherlands have current account surpluses that are too large to be sustainable, while France, Italy, and several others have large counterpart fiscal deficits. A decline in the price of the Euro not likely to have a significant impact in reducing the imbalances among the Eurozone countries, but it is likely to postpone the date when the members must think about how to deal with their massive imbalances.

The prices of the currencies of Canada, Brazil, Australia, and other countries that produce primary products have declined as the prices of petroleum and copper and iron ore have fallen.

The price of the Chinese yuan has not changed significantly in the last five years. In May the Wall Street Journal reported that the International Monetary Fund would soon say that the Chinese yuan was no longer undervalued, even though China continues to have a large trade surplus and to have an exceptionally high levels of tariffs and other barriers to imports. China’s trade surplus is likely to increase, both because of the sharp decline in the price of petroleum and other raw materials and because the decline in the rate of economic growth in China–now almost certainly below five percent–will lead smaller spending on imports.

Japanese imports from China will decline in response to the lower price of the yen. China is likely to respond to the surge in excess capacity in manufacturing with a decline in the price of the yuan.

The U.S. dollar price of the British pound is more or less unchanged in the last five years. Britain’s largest export market is the Eurozone countries; the decline in the price of the Euro means that export competitiveness of firms producing in Britain has declined sharply. Moreover even before these recent declines in the price of the Euro Britain had a current account deficit of five percent of its GDP and a fiscal deficit of five percent of its GDP, both of these ratios were too high to be sustainable. The implication is that the Cameron government might conclude that the solution for its fiscal deficit and its current account deficit is a lower price of the pound.

But Britain never misses an opportunity to make a mistake about its currency policy. Churchill talked up the price of the pound in 1924 and in April 1925 pegged the currency to gold at its 1914 parity even though costs and prices in Britain had increased by fifteen to twenty percent relative to those in the United States in the previous ten years. The U.S. dollar price of the pound was reduced from $2.80 to $2.40 in September 1967, more than three years after its price should have been reduced. Britain pegged the price of the pound at too high a level in the 1972 Smithsonian agreement, and then was the first country that folded and stopped pegging its currency. Since the increase in the price of oil in the early 1980s the British pound has been almost consistently overvalued; The Bank of England made a “gift” of many millions of dollars to George Soros in 1992 because of its reluctance to leave the European exchange rate mechanism. The implication is that the price of the pound is not likely to decline as long as funk money from the Gulf, Russia, and China continues to flow to London.

Whether the term “currency warfare” should be applied to the sequence of declines in the prices of currencies in the 1930s is debatable. Each country that reduced the price of its currency was responding to a speculative attack on its ability and willingness to accept the costs of adhering to the parity for its currency in terms of gold. Argentina and Chile stopped anchoring their currencies to gold when they could no longer finance their trade deficits, because the U.S. credit markets froze after the sharp decline in stock prices in October 1929. Austria went off gold in May 1931 in response to the speculative sales of the schilling. Britain gave up its traditional gold parity in September 1931 in response to a speculative attack. Similarly the United States went off the gold standard in March 1933 in response to a surge in the demand for gold, which threatened the ability of U.S. banks to remain open. Each country sought to protect its domestic economy from a speculative attack on its currency; each was “playing defense” and when faced with the “deflate or devalue” each first deflated and then devalued.

The recent managed declines in the prices of the yen and the Euro differ from those in the 1930s; now Japan and the Eurozone countries seek even larger current account surpluses as solutions for their domestic problems.

If the IMF were still the sheriff for determining whether a country could reduce the price its currency, it would have concluded that neither Japan nor the Eurozone countries were in fundamental disequilibrium, and that the proposed declines in the prices of the yen and the Euro were unacceptable. The beggar-thy-neighbor charge is more fully applicable to the events of the last several years than it was in the 1930s.

The United States has become the “punching bag” for the other countries as they reduce the prices of their currencies to increase their exports. The global demand for manufactured goods is more or less fixed in the short run; if Japan and the Eurozone countries increase their net exports, the U.S. trade and current account deficits will increase. U.S manufacturing output will decline and the U.S fiscal deficit will increase.

In the 1930s the United States eventually responded to the decline in the price of the British pound by the increase in the U.S. dollar price of gold by seventy percent. An increase in the U.S dollar price of gold is no longer an option for the U.S. government. About the only response to the currency protectionism is trade protectionism.

The U.S. economic expansion will be shortened by the currency manipulation in Asia and Europe. U.S. corporate profits will be adversely impacted by the declines in the prices of foreign currencies and the reduction in U.S. exports, as well as the decline in the U.S. dollar equivalent of the foreign profits of U.S. multinational firms.

All wars–even currency wars–end. This currency war is likely to become more intense before it abates. And at some stage the United States and its major trading partners will conclude that they need a new set of rules that will limit the ability of countries to manage the prices of their currencies to import manufacturing jobs from their trading partners.

Thanks for your patience.