In memory of Dr. Andreas Höfert

Currency wars are useless

| Tags: Andreas Höfert

Having served seven years as the first president of the Euro Group (i.e. the finance ministers of the Eurozone), Jean-Claude Juncker, also prime minister of Luxembourg, has now left his post to Jeroen Dijsselbloem, the Dutch finance minister.

Mr. Juncker will be remembered for his disarmingly honest assessments on the euro crisis like, “We all know what to do, we just don’t know how to get re-elected after we’ve done it,” or the Jesuitical statement, “When it becomes serious, you have to lie.”

Among his closing remarks before leaving last week, Mr. Juncker said, “The Eurozone has become more stable after lots of efforts, some from me. The euro foreign-exchange rate is dangerously high.” The last two words triggered an intraday decline of the euro against the US dollar. Together with the Bank of Japan's recent announcements of an open-ended asset purchase program, Juncker's can be seen as the latest shots fired in the so-called “currency war.”

This term, used by the Brazilian finance minister in 2010, describes the goal of many countries to devalue their own currencies at the expense of their trading partners, and thus to re-boost their economies through export-led growth. Four of the five major currencies of developed economies are presently in battle: the US dollar and the British pound, through successive rounds of quantitative easing measures by their central banks, the Swiss franc, through its floor at 1.20 against the euro and now, as a latecomer, the Japanese yen, through the aforementioned open-ended asset purchase program.

The euro, so far, has taken part only passively. In fact, when it weakened over the past two years it was not at the behest of the European Central Bank, but occurred whenever the euro crisis was heating up. Juncker’s recent comments on the euro were by far not as dramatic as past utterances of former ECB president Jean-Claude Trichet when he spoke of “brutal” currency moves. However, the fact that Juncker managed nonetheless to trigger a mini sell-off of the euro shows how deeply mistrust about the common currency is still entrenched with investors. So it is safe to assume that the euro is at least a “stealth fighter” in the currency war.

Who will ultimately win? This is not an easy question to answer. What does “winning a currency war” actually mean? Is the currency which is the weakest once the war is over the winner? Or is it the country with the highest trade surplus by the end of the war? Or is it the country with the highest growth rate? Who even declares the end? One might think that warriors' objectives are the same or at least related, but this is not necessarily the case.

Indeed, a weak currency does not necessarily ensure a trade surplus, nor does a trade surplus ensure a high growth rate. Just remember the experience of the mid-1980s to mid-1990s between the US and Japan after the Plaza Accord. The exchange rate between the Japanese yen and the US dollar went from its peak at over USDJPY 250 in 1985 to below 85 in 1995, meaning a depreciation of 66% of the US currency against that of Japan. So the winner is the US.

But the Japanese trade balance was always in surplus during this period, on average at 3% of GDP, while the US trade balance was always in deficit, averaging 2% of GDP. Even more telling: The bilateral trade balance between Japan and the US was constantly in surplus for Japan (over 2% of its GDP) and in deficit for the US (slightly lower than 1% of its GDP) during this period. So according to this criterion, the winner should be Japan.

Then again, average real GDP growth between 1985 and 1995 was 2.9% per year for the US and 3.1% per year for Japan. So it is a draw, although the growth dynamics at the end of the period would clearly favor the US over Japan, but for other reasons than an overvalued Japanese yen.

This experience leads one to conclude that despite all the ongoing noise, currency wars - once the fog of war is lifted completely - cannot achieve the goals they were supposed to achieve. Moreover, they usually bear costs in the form of lower trade (since the trading partners tend to retaliate) and higher import prices, which weigh on domestic consumers. The outcomes of currency wars are at best inconclusive and hence such wars are useless.