Ahead of the G20 meeting in Seoul on 11 and 12 November 2010, there has been much debate about exchange rates and the dangers of currency and trade wars. This debate has heated up since the Federal Reserve Bank announced that it was embarking on a second round of quantitative easing: a policy likely to drive down the exchange rate of the US dollar.
Writing in the Financial Times, Robert Zoellick, president of the World Bank, argues that co-ordinated global action needs to be taken to promote economic growth and stability. Amongst other things, this should include using gold as an ‘international reference point’.
“… the G20 should complement this growth recovery programme with a plan to build a co-operative monetary system that reflects emerging economic conditions. This new system is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalisation and then an open capital account.
The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.”
Would this be a return to the adjustable peg system designed at Bretton Woods in 1944 – a system that collapsed in the early 1970s? Zoellick thinks that the world should begin moving back to some sort of Bretton Woods system, with gold as the anchor against which currencies are pegged. Critics argue that this could be dangerously deflationary as the supply of gold is not something that can easily be increased. Read the articles below and consider whether such a move would be a good idea.
Zoellick seeks gold standard debate Financial Times, Alan Beattie (7/11/10)
The G20 must look beyond Bretton Woods Financial Times, Robert Zoellick (7/11/10)
World Bank chief calls for gold to anchor forex AFP on Google hosted news (8/11/10)
In Which Bob Zoellick Makes His Play for the Stupidest Man Alive Crown Grasping Reality with Both Hands blog, J Bradford DeLong (8/11/10)
Return to the Gold Standard would be madness Telegraph, Edmund Conway, (8/11/10)
There is room for debate on a gold standard Financial Times, James Mackintosh (8/11/10)
Private sector should lead gold standard adoption Reuters blogs, Martin Hutchinson (8/11/10)
Questions
- How did the Bretton Woods system work to correct balance of payments disequilibria?
- What was the role of (a) gold and (b) the dollar under the Bretton Woods system?
- If countries adopted a pegged exchange rate, what implications would this have for their monetary policy?
- Would using gold as a world currency, to which other currencies were pegged, inevitably have a deflationary effect on the world economy?
- To what extent is gold currently used as a world currency?
- What other measures could the G20 countries adopt to create greater exchange rate stability between the major currencies?
- What is the case for the private sector to start using gold in ordinary transactions?
In the wake of the credit crunch, the Federal Reserve Bank (the Fed) reduced interest rates to virtually zero in December 2008 and embarked on a huge round of quantitative easing over the following 15 months, ending in March 2010. This involved the purchase of some $1.7 trillion of assets, mainly government bonds and mortgage-backed securities. There was also a large planned fiscal stimulus, with President Obama announcing a package of government expenditure increases and tax cuts worth $787 billion in January 2009.
By late 2009, the US economy was recovering and real GDP growth in the final quarter of 2009 was 5.0% (at an annual rate). However, the fiscal stimulus turned out not to be as much as was planned (see and also) and the increased money supply from quantitative easing was not having sufficient effect on aggregate demand. By the second quarter of 2010 annual growth had slowed to 1.7% and there were growing fears of a double-dip recession. What was to be done?
The solution adopted by the Fed was to embark on a second round of quantitative easing – or “QE2”, as it has been dubbed. This will involve purchasing an additional $600 billion of US government bonds by the end of quarter 2 2011, at a rate of around $75 billion per month.
But will it work to stimulate the US economy? What will be the knock-on effects on exchange rates and on other countries? And what will be the effects on prices: commodity prices, stock market prices and prices generally? The following articles look at the issues. They also look at reactions around the world. So far it looks as if other countries will not follow with their own quantitative easing. For example, the Bank of England announced on 4 November that it would not engage in any further quantitative easing. It seems, then, that the USA is the only one on board the QE2.
Articles
QE2 – What is the Fed Doing? Will it Work? Kansas City Star, William B. Greiner (5/11/10)
The ‘Wall Of Money’: A guide to QE2 BBC News blogs: Idle Scrawl, Paul Mason (2/11/10)
Federal Reserve to pump $600bn into US economy BBC News (4/11/10)
Beggar my neighbour – or merely browbeat him? BBC News blogs: Stephanomics, Stephanie Flanders (4/11/10)
Too much cash, bubbles and hot potatoes Financial Times (5/11/10)
Bernanke Invokes Friedman’s Inflation-Fighting Legacy to Defend Stimulus Bloomberg, Scott Lanman and Steve Matthews (7/11/10)
The QE backlash The Economist (5/11/10)
Former Fed Chairman Volcker says bond buying plan won’t do much to boost US economy Chicago Tribune, Kelly Olsen (5/11/10)
Ben Bernanke’s QE2 is misguided Guardian, Chris Payne (6/11/10)
Effects on commodity prices and stock markets
Gold hits record high, oil rallies on Fed stimulus Taipei Times (7/11/10)
Analysis: Fed’s QE2 raises alarm of commodity bubble Reuters, Barbara Lewis and Nick Trevethan (5/11/10)
Fed’s Bernanke defends new economic recovery plan BBC News (7/11/10)
Sit back and enjoy the ride that QE2 has set in motion Financial Times, Neil Hume (5/11/10)
US accused of forcing up world food prices Guardian, Phillip Inman (5/11/10)
Effects on other countries
The rest of the world goes West when America prints more money Telegraph, Liam Halligan (6/11/10)
Backlash against Fed’s $600bn easing Financial Times, Alan Beattie, Kevin Brown and Jennifer Hughes (4/11/10)
China, Germany and South Africa criticise US stimulus BBC News (5/11/10)
G20 beset with fresh crisis over currency International Business Times, Nagesh Narayana (5/11/10)
European Central Bank Keeps Rates at Record Lows New York Times, Julia Werdigier and Jack Ewing (4/11/10)
Official statements by central banks
FOMC press release Board of Governors of the Federal Reserve System (3/11/10)
News release: Bank of England Maintains Bank Rate at 0.5% and the Size of the Asset Purchase Programme at £200 Billion Bank of England (4/11/10)
ECB Press Conference ECB, Jean-Claude Trichet, President of the ECB, Vítor Constâncio, Vice-President of the ECB (4/11/10)
Questions
- How has the Fed justified the additional $600 billion of quantitative easing?
- What will determine the size of the effect of this quantitative easing on US aggregate demand?
- How will QE2 influence the exchange rate of the dollar?
- Why have other countries been critical of the effects of the US policy?
- What will be the effect of the policy on commodity prices?
In the run-up to the Comprehensive Spending Review a battle is raging. On one side are those who argue that cuts are necessary to secure long-term growth and to maintain confidence on the UK economy. These people include leaders of 35 major companies in the UK who wrote a letter to the Telegraph (see below) suppporting George Osborne’s policy of cuts.
On the other side are those who maintain that the cuts will drive the economy back into recession or, at least, will hamper economic recovery. The Federation of Small Businesses warns that “Some small firms rely on public-sector contracts for 50 or 60 per cent of their turnover. If the cuts are swingeing and overnight, these companies will be lost to the UK economy forever.”
Read the following articles to get a clear understanding of the arguments on both sides. Hopefully this will then put you in a better position to assess the cuts and their impact.
Articles
Osborne’s cuts will strengthen Britain’s economy by allowing the private sector to generate more jobs Telegraph, letter from 35 business leaders (18/10/10)
Spending Review 2010: cut now or pay later, say business leaders Telegraph, Andrew Porter, and Robert Winnett (17/10/10)
35 business leaders back Osborne’s cuts BBC News blogs: Peston’s Picks, Robert Peston (17/10/10)
Prominent Tory donors among business leaders who backed Osborne’s cuts Independent, Andrew Grice (19/10/10)
On the tight side The Economist (30/9/10)
History will see these cuts as one of the great acts of political folly Observer, Will Hutton (17/10/10)
Osborne has taken the coward’s route Guardian, David Blanchflower (18/10/10)
Osborne reading Christian Andersen, claims economist The Herald, Ian McConnell (19/10/10)
Time to broaden the debate on spending cuts Guardian, Ha-Joon Chang (19/10/10)
Slugging it out over spending cuts Independent, Sean O’Grady (19/10/10)
Spending Review 2010: We should all fear the darkness, David Cameron included Telegraph, Mary Riddell (18/10/10)
Spending cuts: Molehill and mountain BBC News blogs: Stephanomics, Stephanie Flanders (19/10/10)
Does fiscal austerity boost short-term growth? A new IMF paper thinks not The Economist (30/9/10)
Spending Review: Forecasts rely on ‘heroic assumptions’ BBC News (20/10/10)
Spending cuts: City divided on whether cuts are good for recovery Yorkshire Evening Post (20/10/10)
Spending Review 2010: Spending cuts will hit small businesses hardest Telegraph, James Hurley (20/10/10)
Speech
Rebalancing the Economy Speech by Mervyn King, Bank of England Governor (30/9/10)
Mervyn King warns of 1930s-style collapse (Extract from above speech) BBC News, Mervyn King (19/10/10)
Questions
- What are the main arguments for making large-scale cuts to government spending at the present time?
- What are the main arguments against making large-scale cuts to government spending at the present time?
- To what extent should the government’s poplicy on the size and timing of the cuts be influenced by international economic relations?
- What role might the ‘inventory cycle’ play in the economic recovery?
- Why may the government “pay heavily unless it learns to temper its bloody cuts with humanity”?
- How will large-scale spending cuts impact on (a) consumer confidence; (b) business confidence; (c) the confidence of international financiers?
- Will monetary policy allow fiscal policy to be tightened without causing a recession? Explain the effectiveness of monetary policy in these circumstances.
With countries around the globe struggling to recover from recession, many seem to believe that the answer lies in a growth in exports. But how can this be achieved? A simple solution is to lower the exchange rate.
Under a pegged exchange rate, the currency could be devalued. Alternatively, if the country’s inflation is lower than that of other countries, merely leaving the exchange rate pegged at its current level will bring about a real devaluation (in purchasing-power parity terms).
Under a floating exchange rate, one answer would be to lower interest rates. This would involve open market operations to support the lower rate and that would increase the money supply. But with central banks’ interest rates at virtually zero, it is not possible to lower them further. In such circumstances a solution would be a deliberate policy of increasing the money supply through “quantitative easing”. For example, the USA is considering a second round of quantitative easing (known as “QE2”). This would tend to push down the exchange rate of the dollar.
But stimulating exports through devaluation or depreciation is a zero-sum game globally. If currency A depreciates against currency B, currency B necessarily appreciates against currency A. Country A’s gain in exports to Country B are an increase in imports for Country B. It is logically impossible for every currency in the world to depreciate! Yet depreciation is exactly the policy being pursued by countries such as Japan, South Korea and Taiwan, all of which have directly intervened in the currency markets to lower their exchange rates. And, in each case of course, other countries’ currencies have an equivalent appreciation against them.
Economists and politicians in the USA argue that the dollar is fundamentally over valued against the Chinese yuan (or ‘renminbi’ as it is sometimes called). They are calling on China to revalue by far more than the 2% increase since June 2010. But what if China refuses to do so? On 29 September the House of Representatives passed a bill giving the executive branch the authority to impose a wide range of tariffs on imports from China. The bill was passed with a huge majority of 348 to 79.
So is this the start of a trade war? Many in the USA argue that China is already waging such a war by giving subsidies to a wide range of exports. And that war is hotting up. China has just announced that it is imposing traiffs ranging from 50% to 104% on various poultry imports from the USA. And if it is a trade war, will there be any winners? The following articles investigate.
Global recovery’s weakness raises possibility of trade war Guardian, Larry Elliott (4/10/10)
Tension mounts as China and US trade insults over currency Independent, Stephen Foley (1/10/10)
Is the world in a trade war? Time Magazine blogs: The Curious Capitalist, Michael Schuman (29/9/10)
Trade War Is Here – and We’ve Disarmed The Huffington Post, Robert Kuttner (3/10/10)
US House Passes Anti-China Trade War Bill GlobalResearch.ca, Barry Grey (1/10/10)
Currencies the key to market’s next move BBC News, Jamie Robertson (3/10/10)
A Message for China New York Times (30/9/10)
Taking On China New York Times, Paul Krugman (30/9/10)
Krugman Makes Two Powerful Arguments Against “Taking on China” Wall Street Pit, Scott Sumner (2/10/10)
Why the U.S. can’t win a trade war with China The Globe and Mail (Canada), Carl Mortished (4/10/10)
China-Japan trade war looms CTV News (Canada), Mark MacKinnon (23/9/10)
IMF chief’s warning of currency war ‘real threat’ BBC News, interview with Dominique Strauss-Khan, head of the IMF (7/10/10)
Could disputes over currency levels lead to a depression? BBC World Service, interview with Robert Zoellick (8/10/10)
China stands firm over yuan move BBC News, Andrew Walker (9/10/10)
What to do about China’s currency? Washington Post (10/10/10)
How to stop a currency war The Economist (14/10/10)
What’s the currency war about? BBC News, Laurence Knight (23/10/10)
Nominally cheap or really dear? The Economist (4/11/10)
Questions
- Why are competitive devaluations globally a zero sum game while global trade wars are a negative sum game?
- What are the arguments for and against using tariffs as a means of stimulating recovery?
- Why has quantitative easing so far had a more discernible effect on asset prices than on the real economy?
- Do a search on “Smoot-Hawley Tariff Act” of 1930 and describe its impact on the global economy in the 1930s. Are there any parallels today?
- How is it possible for massive trade surpluses and deficits to persist and yet for individual countries’ exchange rates and overall balance of payments to be in equilibrium?
- Are global trade imbalances widening, and if so why?
- What would determine the size of the effect on the US balance of trade of an appreciation of the yuan?
For the past three years the Japanese yen has been appreciating against the US dollar and many other currencies. From the end of June 2007 to 14 September 2010, the yen appreciated from ¥100 = $0.81 to ¥100 = $1.20 (a 48% appreciation). Over the same period the yen exchange rate index rose from 113.3 to 172.4 (a 52% appreciation). The rising yen has been impeding Japan’s recovery as it has made its exports more expensive, while, at the same time, making imports cheaper and thus making it harder for domestic firms to compete.
Until 14 September 2010, the yen was freely floating. But on 15 September, the Japanese central bank decided to intervene by selling yen and buying dollars and other currencies.
But why had the yen risen so strongly? There are four main reasons.
The first is the persistent Japanese trade surpluses, partly stimulated by falling costs of production in Japan.
The second is the unwinding of the carry trade. Before the banking crisis of 2007/8, many banks and other financial institutions borrowed yen, given the low interest rates in Japan, and used the yen to purchase dollars and pounds, given the much higher interest rates in the USA and the UK. The effect of this ‘carry trade’, as it was known, was to drive up the exchange rates of the dollar and sterling and drive down the value of the yen. This encouraged further speculation as people sold yen in anticipation of further depreciation and purchased dollars and sterling in anticipation of further appreciation. With the banking crisis, however, short-term financial flows decreased and the current account became more important in determining exchange rates. The carry trade began to unwind and people began selling dollars and sterling and buying yen. What is more, towards the end of 2008, interest rates were reduced substantially in the USA and the UK in order to stimulate aggregate demand. The interest rate differential between Japan and the USA and UK virtually disappeared. This further encouraged the purchase of yen and the sale of dollars and sterling as carry trade investors began paying back their loans to Japan.The third reason for the appreciation of the yen is the actions of the Chinese who have used their surpluses to buy other currencies: originally mainly dollars, but increasingly yen.
The fourth reason is speculation. As the yen has risen, so increasingly people have bought yen in anticipation of further appreciation. But, of course, this speculation has brought about the very effect the speculators anticipated. Such speculation can be very powerful, given that some $4 trillion goes across the foreign exchange markets every day (see The inexorable growth of FOREX).
So will the intervention by the Bank of Japan be successful in causing the yen to depreciate? Or will the forces that drove up the yen prove impossible to resist? The following articles consider this question and also look at the factors that caused the yen to appreciate and its effects on the Japanese economy.
Articles
Japan’s $21b move to weaken yen may be futile Sydney Morning Herald (16/9/10)
Japan acts to weaken surging yen Guardian, Larry Elliott and Graeme Wearden (15/9/10)
Q+A: How is Japan judging success in yen intervention? Reuters, Hideyuki Sano and Charlotte Cooper (17/9/10)
Tokyo action puts brake on yen Financial Times, Peter Garnham (17/9/10)
It’s hard to keep a strong yen down CTV, Canada, Brian Milner (16/9/10)
Firm stance on yen stressed / Govt, BOJ strike decisive pose, but drastic action still required Daily Yomiuri, Japan, Tadashi Isozumi and Yomiuri Shimbun (16/9/10)
Bernanke Shadow of Easing Limits BOJ Success With Yen Weakness Bloomberg, Ron Harui and Joshua Zumbrun (17/9/10)
The Bank Of Japan Is Spitting In The Wind Wall Street Journal blogs: The Source, Nicholas Hastings (16/9/10)
Japan intervenes in markets to combat rising yen BBC News, Mariko Oi (15/9/10)
Q&A: What’s moving the Japanese yen? BBC News (15/9/10)
Currency intervention’s mixed record of success BBC News, Russell Hotten (16/9/10)
Yen intervention: Because I Kan The Economist (16/9/10)
Beggar, then sneakily enrich, thy neighbour The Economist (15/9/10)
The yen and gold The Economist, Buttonwood (15/9/10)
Data
Dollar/yen exchange rate X-rates.com
Statistical Interactive Database – interest and exchange rates data Bank of England
Currencies BBC News
Currency converter Yahoo Finance
Questions
- Why has the Japanese yen appreciated so much over the past three years?
- What will be the effect of the Bank of Japan’s exchange market intervention on Japanese money supply? What will determine the size of this effect?
- Why might the Bank of Japan’s actions have been influenced by the anticipation of further quantitative easing by the US Federal Reserve Bank?
- What factors determine the likely success of foreign exchange market intervention by central banks?
- What will determine how speculators will react to the Bank of Japan’s actions?
- Discuss the following quote from the second The Economist article above: “A bit of inflation in Japan wouldn’t just be a good thing. It would be a really, really great thing. And if other countries react to Japan’s intervention by attempting to print and sell their own currencies in order to toss the deflationary potato to someone else, well then so much the better.”
- If all countries seek to achieve export-led growth, is this a zero-sum game?
- Why has the price of gold been rising?