Tuesday, February 19, 2013

Currency wars

I don’t subscribe to the theory that the world’s major economies are engaging in currency wars.  But it is correct to say that in the absence of a broader policy response to the woes of weak growth in output and lacklustre gains in employment, monetary policy is doing all the heavy lifting.  In that environment, central banks are using the only tools available to them, including quantitative easing.

The various central banks around the world have mandates that vary in scope.    In some cases, those mandates are quite broad. The US Federal Reserve, for example is mandated to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”.  Some are more narrowly focussed: the Reserve Bank of New Zealand has a goal of “maintaining a stable general level of prices”, defined as being average inflation near the 2% target mid-point of a 1%-3% range.  While its mandate is more directly tied to inflation outcomes than the Fed, the RBNZ is required to “have regard to the efficiency and soundness of the financial system, and seek to avoid unnecessary instability in output, interest rates and the exchange rate”.

Central banks are currently using the tools at their disposal to achieve their mandates.  In countries facing weak or negative output growth, weak labour markets and the risk of deflation some central banks have resorted to unconventional methods to ease conditions further as interest rates reached the lower bound.  That has involved quantitative easing (i.e. printing money) which has led to depreciating exchange rates in countries undertaking QE and appreciating exchange rates elsewhere, and accusations of competitive devaluations.  In the early days of QE most of the criticism came from emerging countries such as Brazil as the Real appreciated significantly.

The direct and foremost objective of quantitative easing is in expanding the money supply, thereby working against deflationary forces.  It is therefore more than a tad odd that it is Japan, a country that has been and still is mired in deflation that has come in for the most recent criticism for aiding and abetting currency wars.  It is even more peculiar that it was Germany, the primary winner in the “Euro project”, who started the criticism of Japan.

Regular readers will know that I have been somewhat dubious about the benefits of quantitative easing on real economic variables such as growth in output and jobs.  The transmission mechanisms exist, but they’re indirect and we really don’t know how strong they are.  The first is via higher asset prices like the US stock market.  Periods of QE by the Fed have coincided with strong gains in the S&P 500 which has fed through to higher wealth and stronger consumer confidence.  The second is via the debasing of the exchange rate resulting in a weaker currency which obviously supports export growth and makes domestic import competing domestic firms more competitive.

To me the critical issue isn’t so much whether central banks are engaging in competitive devaluations so much as it is whether some central bank mandates are too broad and that those banks are not getting enough support from policy makers.  There is simply too much expected of monetary policy to fix the woes of low growth and lacklustre jobs growth.  In short, building an environment of robust growth in output and jobs requires a broader policy response and policy-makers, particularly in the large developed economies, have been generally lacking in that response.

That has left central banks to do the heavy lifting, and I’m pleased they have.  In the absence of their action it’s possible that no-one would have been doing anything!  That would have most likely led to economic depression and deflation.  That’s a “new normal” that wouldn’t have been a good outcome for anyone.

The answer is (still!) structural reform, a phrase that is often confused with obfuscation and doing nothing.  But this time it matters.  Productivity, innovation, trade access and regulatory reform are all important ingredients for stronger growth.  To that end the most important part of President Obama’s recent “State of the Union” address was plans for the negotiation of a trade agreement with the European Union.  Now that’s the sort of action that matters.