Currency Wars: Hot or Cold?

July 2013

Dave Altig: Hi, this is Dave Altig. I'm the director of research at the Federal Reserve Bank of Atlanta, and I'm speaking this morning with Dr. Barry Eichengreen, the George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California–Berkeley. Professor Eichengreen, welcome.

Barry Eichengreen: Thank you.

Altig: So the topic is currency wars. When people say currency wars, what do they generally mean?

photo of Barry Eichengreen

Photo courtesy of
Wilford Harewood/
The Halle Institute

Eichengreen: They mean what happened in the 1930s, where the image of the 1930s everyone has is competitive devaluation where countries push their currencies down against those of their trading partners to try to boost their exports and begin to recover from the Great Depression. They have in mind policies that beggar their neighbors that were good for the initiating country but bad for their trading partners. The worry has been that the same consequences have flowed from the Fed's quantitative easing [QE], from the policies of the Bank of England, and now from the policies of the Bank of Japan.

Altig: So let's start back at the Great Depression. Were the currency wars effective? Were they problematic? What's your take on the situation?

Eichengreen: I think the question is, were they really currency wars? Were they efforts to recover at the neighbor's expense? Or were they really policies designed to boost the home economy without necessarily negative repercussions for the neighbors? I think the latter, by and large, is the correct answer. That the essence of the policies of the 1930s when countries left the gold standard and cut the level of interest rates was to try to stabilize unstable financial systems. Central banks were freed to act as lenders of last resort and to encourage interest rate sensitive forms of spending—spending on housing, consumer durables, and so forth. Sometimes when currencies fell as a result there could be negative effects for the neighbors, as spending was switched away from foreign goods and toward domestic goods. But at the same time, recovery was good for everyone. It had positive effects at home and as spending began to rise, positive effects abroad. I think the negative perception of currency policies of the 1930s, therefore, is something of an exaggeration and misconception.

Altig: So if a currency war is not the right description for policies in the 1930s, is it the correct description for policies today?

Eichengreen: Similarly, I think it's not the correct description for what has been happening in recent years. Policymakers in emerging markets have complained about the Fed's three rounds of quantitative easing. They have complained about the large capital flows into their markets that they've experienced because interest rates in Brazil and Turkey and China have been higher than interest rates here, given the Fed's policies. But they really have to ask the what if question. They have to ask, would they really have been better off had the Fed and other advanced countries' central banks been following tighter policies through the Great Recession? Emerging markets would not have experienced those large capital inflows, but the global economy would have been weaker, and those same emerging markets would not have been better off as a result.

Altig: So as we speak today, we're roughly a week or so after the Federal Reserve has made some adjustments to its policies. I guess that might hearten someone who is a believer in the currency war aspect, but you're not. So do you have a particular point of view on recent Fed communications?

Eichengreen: When markets began to worry about the Fed tightening, we had kind of a natural experiment in what the world would have been like without the so-called currency wars. What we've seen is capital flows to emerging markets come to a sudden stop, emerging market currencies have declined, stock markets and bond markets in emerging economies have slumped. And there are big worries there about finances, about economic growth. So policymakers in emerging markets have seen suddenly in the most graphic possible form that QE was actually good for their economies and that the possibility that it will now end is causing them a considerable amount of grief.

Altig: So let's go back to the Great Depression again, which you've spent a lot of time thinking about. If the currency war was not at the heart of the problems in the Great Depression, what was at the heart of the problems and how do we avoid those mistakes today? Or are we avoiding those mistakes today?

Eichengreen: The heart of the problem lay in financial instability. [Milton] Friedman and [Anna Jacobson] Schwartz and their classic on the United States—their Monetary History of the United States—emphasize the three banking crises in this country between 1930 and 1933. And we learned from Mr. Bernanke in his academic incarnation that those banking crises had financial as well as monetary effects on the economy.

My own work emphasizes the gold standard as a constraint on the ability of central banks and governments to step in and do anything about those problems. So I think that history was to our good fortune well understood by modern policymakers so they did step in, especially notably in this country, to stabilize financial markets and recapitalize the banks with the benefit of hindsight.

Altig: Do you think that even now we suffer in any way from perhaps too much concern about the inflationary consequences down the road of these policies that you say and indicate have been very helpful?

Eichengreen: I think it is right to be concerned about the longer-term implications of the policies that have been pursued. And there's a real question about whether the enlarged balance sheet that the Fed has acquired since the crisis will be compatible with price stability. Put the point in a less academic way, will the Fed be able to exit from current policies smoothly? It is a question and I think it's one that Bernanke and company have begun to try to answer in the last week. Sure, inflation should be a concern. But when I look at the longer-term history, I think what we see is an evolution away from very simple rigid rules like the gold standard, like Friedmanesque monetary targeting rules, in the direction of relying on central banking independence, the credibility of policy, communication on the part of central bankers as a way of reassuring the public and investors that the central bank is committed to low inflation, and that it has a strategy for exiting from current policies that will work.

Altig: To turn for a second to the interaction of monetary policy with the other large player in the game, fiscal policy. I believe you've said that the combination of the gold standard with fiscal austerity was a source of considerable issue in the Great Depression. Can you explain that?

Eichengreen: In the Great Depression countries suffered simultaneously from restrictive monetary policies, as central banks clung to the gold standard and attempted to defend it, and from restrictive fiscal policies, as governments attempted to balance budgets and raise taxes in the face of a very deep recession. Sounds like Europe today. In other words, there has been a lot of talk about whether fiscal consolidation, eliminating large budget deficits, can in fact be expansionary. What the history shows, including the history of the 1930s when you look across countries, is that fiscal consolidation can be expansionary or at least avoid doing macroeconomic damage only if monetary policy is at the same time supportive. So we have seen that in the United States. Our economy is continuing to grow. To all appearances it is picking up steam now at least a little bit in the face of fiscal consolidation, considerable fiscal headwinds with the sequester, and some trimming of the Bush tax cuts. And I attribute that to the fact that the Fed has been supportive of growth, that monetary policy has been reasonably accommodating until now.

The situation in Europe has been different, fiscal consolidation and nonaccommodative monetary policy—not surprisingly, recession in the euro zone. So to come back to the U.S., that raises issues for us now. If fiscal policy remains austere with continuing declines in the budget deficit as a share of GDP [gross domestic product], that's what the CBO [Congressional Budget Office] now projects, and the Fed does indeed move to the exits, it's not clear to me that the reasonably strong growth that we have seen in recent quarters will continue.

Altig: You mentioned in response to some questions at the speech you gave that the European project is not only complicated by their mix of macroeconomic austerity along with relatively tighter monetary policy then say maybe in the U.S., but also more institutional features, the lack of a banking union, the lack of a political union. To what degree is it the macroeconomic policy mix and to what degree is it this more fundamental structural problem?

Eichengreen: Will you forgive me if I say 50/50? I think they have a macroeconomic policy mix problem with both monetary and fiscal policy not being supportive of economic growth, but they also have a dysfunctional banking system. Their banks are overleveraged still, undercapitalized still, and not lending. And you can't get an advanced economy to grow without a functioning banking system. The constraint on fixing the banking system is, who pays? Who moves first? And that's what the negotiation over banking union is all about.

Altig: Let me ask a similar question about Japan. So Japan, the people who sort of watched Japan closely are somewhat mixed in the opinion of whether or not the Abe, for example, program of much more macroeconomic stimulus will work versus those who would also claim that there's some deep structural issues that Japan has just never resolved. In which camp would you fall?

Eichengreen: Mr. [Shinzo] Abe's program has what they refer to as three arrows, the monetary arrow, the fiscal policy arrow, and the structural reform arrow. So the Japanese understand that they have to do something mainly in terms of monetary policy to end deflation, get prices to begin to rise at 2 percent a year, and thereby to encourage people to spend while at the same time doing structural reform. It's very much like the European situation that they need to get spending up through macro policy but they also need to do structural reform. The difference between Japan and Europe is that in Europe the ECB [European Central Bank] refuses to move first. And it says we will relax policy only if we see governments balancing their budget and doing reform. In Japan, the central bank has moved first and it's working together with the government rather than, if you will, at cross-purposes. And now we will see whether the government will follow through. So to come to your question, will they follow through? Only time will tell.

Altig: So let's turn our light back on the Federal Reserve and U.S. monetary policy.  There's really been two pillars, you might say, of U. S. policy. One, of course, the asset purchase quantitative easing monetary element that we've already discussed to some degree. The other part is about communications and guidance. Have these been equally successful components of the mix of policies in the United States, in your view?

Eichengreen: I think both of them have played a positive role. Both of them are contentious in the subject of criticism because both of them really are very much works in progress. The Fed had never done this kind of not only quantitative easing but credit easing, selective intervention in credit markets, at least to the same extent, and the communication policy that the Fed is developing or experimenting with is, again, a work in progress. I think we saw this last week where Mr. Bernanke's communique startled the markets for reasons that, to my mind, for reasons that are not obvious. So, yes, I think both have played a positive role.

Altig: Returning back to the issue that we started with, currency war issue, I think you've argued persuasively that the currency war is probably not the way to think about the spillover effects that might occur from current mix of policies, particularly in advanced economies, but you did note that there is a challenge for emerging market economies in particular. If you were to give your best advice of how to meet those challenges, what would it be?

Eichengreen: I think for emerging markets, the ideal formula is the same as for the United States: target monetary policy at price stability and full employment, and use regulatory instruments to deal with the consequences of those spillovers. In the era where the problem was a weak dollar and large capital flows to emerging markets, an era that now may be ending, I think the right response for emerging markets was to tighten up on bank and financial market regulation in response.

Altig: So maybe that sets up a final question, since we're two economists talking, ending on a dour note is probably appropriate. So if you were to articulate your largest concern about the global economy at the moment, what would it be?

Eichengreen: Well, at the moment, it is about those emerging markets. So for a long time my dominant concern, like everyone's, has been Europe and there are glimmerings that the European economy may be about to turn around. A lot of people are worried about China at the moment, where there has been a big spike in interest rates and a bit of a growth slowdown, but I think the Chinese economy will continue to motor along with 6 percent growth, low by their standards, but good by everyone else's. So my worries are about emerging markets like Turkey and Brazil. They are important players in the world economy as well. They're now the ones that are financially stressed.

Altig: Professor Eichengreen, thank you.

Eichengreen: Thank you.