The European Central Bank has finally begun to engage in quantitative easing. The euro depreciated on the news, which is good for the Europeans but bad for the rest of the world, right? It's another currency war – a zero sum game leading to, at best, nothing but debased currencies . At least that's what we've been told.
Mario Draghi, President of the European Central Bank, 22 January 2015. (Flickr/ECB.)
I think that's wrong. A currency war right now will be win-win.
Let's start with the concerns about currency wars. The first worry is the beggar-thy-neighbour effect. If a country's exchange rate falls, demand is sucked from other countries for no net gain. So, concern number one is that a depreciated currency is contractionary for others.
Concern number two is completely the opposite: the spillovers, it is said, will be too expansionary. It is feared that the loose monetary policy that drives the currency down would lead to large capital outflows causing the recipient economies to overheat and suffer from asset price bubbles.
What we don't hear a lot about, however, is another effect. Currency depreciations come about because of a monetary stimulus. With easier monetary policy in the home country, demand will be stimulated. With higher demand will come more appetite for imports. That's a positive for the rest of the world, and one with no apparent twist in the tail. [fold]
There are therefore competing spillovers: one contractionary, two expansionary. The net effect? Economists have crunched the numbers and concluded that it tends to be positive. For example, last year the IMF estimated positive net spillovers.
There is still the question of whether the effects are too good; whether reversals of capital inflows will cause problems once the situation is normalised. We can look at what is happening now, as US monetary policy normalises, for some guidance. There was the taper tantrum in 2013 that suggested this path might be rocky, but since then things have proven quite smooth. And it is worth asking: is the world better off for the fact that the US employed quantitative easing in the first place? I think the answer is undoubtedly 'yes'. Suppose the US had followed the path of the ECB. While the US dollar would have been higher, I doubt the rest of the world would have been a net beneficiary.
How is it then that currency wars have such a bad name? Part of the reason, I think, tends to come from a language that talks of 'debased' currencies. It is easy to get moralistic when things are framed in such a way. There may be another reason. When people think of currency wars they often think of the devaluations that occurred during the Great Depression. In a classic paper on the topic, superstar economists Barry Eichengreen and Jeffrey Sachs concluded that the overall net spillovers in the Depression were in fact negative. Why? Under the prevailing gold standard, when a country devalued it could either suck gold from the rest of the world or release gold to it. If a country sucked in gold, it would impose a monetary tightening on everyone else. But the situation today is different; with no gold standard to tie the hands of the rest of the world, monetary policy can be eased instead.
Currency wars may also help avoid subsequent policy mistakes. Let's turn back to the Great Depression and Barry Eichengreen. A few years ago he wrote a paper with Doug Irwin, a stellar trade economist, on the rise of protectionism in the 1930s. They found those economies that did not devalue their currency during the Great Depression were more likely to embrace protection. If countries couldn't stimulate their tradables sector with a currency depreciation, they apparently did so with tariffs. When it's a choice between currency war and trade war, I know which one I would choose.
