Who is afraid of currency wars?

Worries about global currency wars have resurfaced in recent weeks, mainly because of Japanese action on the yen. This is only the latest of several such flare-ups since the 2008 financial crash. It is hard to avoid the suspicion that the unconventional monetary policies of the US, UK and others are designed to drive down their exchange rates in order to indulge in “beggar thy neighbour” policies of the type which Samuel Brittan has condemned.

Currency wars strike dread into the hearts of most economists because they contributed greatly to the severity of the Great Depression in the 1930s, especially in the worst phase from 1931-33. The damage done to global trade in that period took several decades to repair, and a repeat of this nightmare cannot be entirely ruled out. However, there are very large differences between the policies pursued in the 1930s and what is happening now, and the results may also be very different.

It is important to think carefully about exactly what mean by the term “currency wars”. In his recent best selling book, James Rickard seems to define a currency war as any policy which is deliberately designed to drive down the internal or external value of a currency, whether by domestic inflation or a decline in the exchange rate. Viewed from any economy in isolation, these two alternatives amount to much the same thing in the long run, since a rise in inflation relative to other countries will eventually be fully reflected in a lower exchange rate.

But that is clearly not what is meant by currency wars in the present context. In order to be accused of a “beggar thy neighbour” policy intervention, a country would need to try to improve its competitiveness by reducing its nominal exchange rate, while keeping inflation unchanged. That approach would switch expenditure, perhaps only temporarily, towards the devaluing economy and away from the rest of the world. Japan is being accused of doing this today.

The worst phase of the currency wars in the 1930s was triggered by the departure of sterling from the Gold Standard in 1931, which in effect involved a devaluation by the UK against all of its major trading partners. Many of them responded not by leaving the Gold Standard themselves, but by introducing direct controls over free trade, including tariffs, quotas and (worst of all) exchange controls, all designed to switch expenditure back to their own economies. This had the effect of reducing world trade very sharply relative to global industrial production. The immediate consequence was chaos in the production and distribution mechanism which deepened the recession. In the longer term, there was damage to the supply side by reducing the gains from free trade.

In their definitive study of this episode, Barry Eichengreen and Douglas Irwin trace the slide into competitive devaluations and trade protection on a country-by-country basis, and reach a conclusion which is highly relevant to today’s currency wars. They argue that those countries which left the Gold Standard relatively early in the episode (eg the Sterling Bloc nations, which mostly left in 1931) resorted relatively less to direct trade protection through tariffs, quotas and exchange controls. Meanwhile, those countries which remained on the Gold Standard for longest (eg France and the rest of the Gold Bloc, which remained members until 1936) resorted to direct trade protection relatively more.

This is important because competitive devaluations have entirely different consequences from direct trade protection. Consider the case of a country like the UK leaving the Gold Standard and engaging in a competitive devaluation. This allowed the UK simultaneously to adopt much easier domestic monetary policies, which helped the economy to recover quickly from the recession. Other countries, like France, were net losers because the sterling devaluation switched expenditure away from French producers and towards UK producers.

This induced France to try to switch expenditure back towards themselves by imposing a 15 per cent tariff on all imports. As other countries retaliated against both France and Britain by imposing direct trade controls of their own, world trade slumped by more than 20 per cent in six years, compared with a negligible loss in global industrial production. This gap, with all the lost “gains from trade” which it implied, remained in place until well after the second world war.

What if France had decided to retaliate against the sterling devaluation by also leaving the Gold Standard, and devaluing the franc? That would have switched expenditure back to French producers, but without causing the large drop in trade flows which were implied by the 15 per cent tariff it actually adopted. As a further benefit, France could also have eased its domestic monetary policy, which would have boosted domestic demand, following the British example.

The conclusion from this is that a currency war which results in tit-for-tat currency devaluations, along with monetary easing, would probably have been much less damaging than the direct trade and exchange control retaliations which actually occurred in the 1930s. That has been borne out by the pattern since 2008, when countries have engaged in tit-for-tat currency devaluations – the most recent coming from Japan and Switzerland – while direct trade controls have mercifully been much less pronounced.

As a result, the decline in world trade from 2008 onwards was not much larger than that in industrial production, and trade then rebounded much more quickly than in the 1930s. There seems to have been no permanent loss of trade relative to industrial output, though the long term rise in the openness of most economies to foreign trade does seem to have stopped since the crash. This is probably because there have been some limited direct trade controls introduced since 2008, including anti-dumping measures, domestic preferences in government procurement, protective regulatory standards and the like.

There are various reasons why countries have been less inclined to adopt the worst option, direct trade controls, since 2008 than they were in the 1930s. The existence of international trade agreements and organisations like the WTO and IMF has clearly helped. Companies are much more dependent on global supply chains, so the political pressure for import controls has been much less. And the lessons of the 1930s, taught in many economics classes around the world, have been remembered by our political leaders.

There is no room for complacency. Currency wars could still develop into direct trade wars. Even if they do not, they could lead to other problems, like commodity inflation and asset price bubbles in the emerging economies. But we are not seeing a repeat of the 1930s, so far at least.