Uneasy Money

I start with a short autobiographical introduction. In the interlude between my brief academic career and my 25 years at the FTC, one of my jobs was as an antitrust economist at a consulting firm called NERA (National Economic Research Associates). The President (and founder) of the firm was then Irwin Stelzer who, after selling the business for a tidy sum to Marsh & McLennan, eventually relinquished day-to-day management of the firm. When I was at NERA, it actually had a reputation of being a Democratic-leaning, pro-enforcement, non-Chicago-School, firm, but, at some point after Stelzer left NERA, I began seeing articles and op-eds by him promoting a pro-Republican, pro-deregulation, agenda. He became Director of Regulatory Policy Studies at the American Enterprise Institute and subsequently Director of Economic Policy Studies at the Hudson Institute. Stelzer developed a relationship with Rupert Murdoch, writing regular columns on economic policy for a number of Murdoch publications, such as the Sunday Times and the Weekly Standard. The relationship with Murdoch has apparently made Stelzer a somewhat controversial figure in Britain, where he maintains a residence, but all details about that relationship are unknown to me. After not seeing Irwin for almost 30 years, I have recently chanced to meet him twice at concerts at the Kennedy Center in Washington, enjoying a very pleasant conversation with him, possibly even mentioning to him my new career as a blogger, and later exchanging a few emails.

I mention all this, because last night I happened to see Stelzer’s latest economic commentary in the Weekly Standard on the subject of currency wars. Given my past, and recently resumed, relationship with Stelzer, I do feel a little funny now that I am about to write somewhat critically about him, but, hey, a blogger’s gotta do what a blogger’s gotta do.

Stelzer’s first paragraph sets the tone:

Growth is the summum bonum of economic policy. Tough to arrange at home: stimulus packages don’t work very well, and monetary policy produces lots of fiat money but not very many jobs. The solution: export-led growth—the other guy will buy so much of your goods and services that your economy will grow. There are two ways to make this sort of growth happen. Lower the international value of your currency so that your output is cheaper overseas, or increase productivity at home by lowering labor and other costs and therefore the prices you need to charge foreigners. The first is painless, or so it seems initially. The second requires a politically difficult assault on benefits and union created labor market rigidities.

What we have here is a confusion of concepts and meanings. Starting with a facile identification of the highest good of economic policy with growth, where growth seems to denote growth in employment, Stelzer offers up a jejune dismissal of monetary policy, and concludes that exports are the answer. How are exports to be increased? The easy, but disreputable, way is to depreciate your currency, the hard, but virtuous, way is to cut your costs. The underlying confusion here is that between the nominal and the real exchange rate.  Let me try to sort things out.

A nominal exchange rate tells you how much of one currency can be exchanged for a unit of another currency. The exchange rate between the dollar and the euro is now about $1.33 per euro. If the euro depreciated against the dollar, the exchange rate might fall to something like, say, $1.25 per euro. For given euro prices of stuff made in Europe, a depreciated euro would mean that the prices, measured in dollars, of European stuff would fall, presumably causing European exports to the US to rise. The reduced exchange rate would work in favor of European exports. However, prices do change, and a falling euro would tend to raise the euro prices of the stuff made in Europe. If the US and European economies were in (foreign-trade) equilibrium before the euro depreciated against the dollar, prices of European stuff would keep going up until the European export advantage was eliminated. So even as the nominal euro exchange rate depreciated against the dollar, price adjustments would tend to restore the real euro exchange rate back to its original equilibrium level, thereby eliminating the temporary advantage enjoyed by European exports immediately after the fall in the nominal euro exchange rate.

That’s not to say that monetary policy cannot affect the real exchange rate, just that doing so requires more than reducing the nominal exchange rate. I discussed this a while back in a couple of posts (here and here) on currency manipulation and the Chinese central bank. The upshot of those posts was that to prevent domestic prices from rising in response to a depreciated nominal exchange rate, thereby offsetting the reduction in the nominal exchange rate and restoring the real exchange rate to its original level, a country (or its central bank) would have to follow a tight-money policy aimed at sterilizing the inflows of foreign cash corresponding to the increased outflow of exports.

Apparently Stelzer did not read my posts on the subject (tsk, tsk). Otherwise, he could not have written the following:

Until now, China has been the world’s devaluer par excellence, keeping the yuan low so that its export-led economy could continue to provide jobs for the millions of Chinese moving off the farms and into the cities.

Well, to begin with, China has not been keeping the nominal yuan low. For a long time, the yuan was pegged at a fixed exchange rate against the dollar. More recently, the yuan has been appreciating against the dollar. However, the Chinese central bank has been sterilizing inflows of foregin exchange and preventing domestic price increases that would have slowed the growth of Chinese exports and encouraged Chinese imports. In other words, the Chinese central bank has been printing too little money. Let’s follow Dr. Stelzer a bit further.

Now, Japan’s new prime minister Shinzo Abe has joined the war, pressuring his central bank to print money and drive down the value of the yen to rescue Japan from “the strengthening yen.” From Mr. Abe’s point of view, so far so good: the yen has fallen about 15 percent against other currencies, making Japanese cars and other products considerably cheaper overseas; the Nikkei share price index is up about 35 percent; and U.S. importers are again ordering Japanese products that they discontinued in the stronger-yen era.

Stelzer is also afraid that Brazil and Great Britain under the new Governor of the Bank of England are going to follow the bad example of China and Japan. This has him really worried.

It should be obvious that the currency war is a trade war by other means. The use of traditional weapons—tariffs to keep out imports and thereby increase demand for homemade products and create jobs—was outlawed by mutual consent of the warring parties when they agreed to abide by the rules of the World Trade Organization. So a new weapon of trade destruction has been rolled out—the printing press. Run the presses, flood the markets with your currency, and later, if not sooner, your currency will depreciate, giving you an edge in world markets. Until trading partners respond.

I’m sorry, but this is all wrong. Trade war, Chinese style, involves reducing the nominal exchange rate to gain a competitive advantage and tightening monetary policy, i.e., not running the printing presses, repeat, not running the printing presses, to prevent the increase in the money stock that would normally follow from an export surplus. The depreciation of the nominal exchange rate in response to money printing makes everyone better off, because it raises the home demand for imports while increasing the foreign demand for exports.

Last February, I published a post about Ralph Hawtrey’s take on currency wars, aka competitive devaluation, quoting at length from Hawtrey’s excellent book, Trade Depression and the Way Out. I reproduce the last three paragraphs of the passage I quoted in my earlier post.

In consequence of the competitive advantage gained by a country’s manufacturers from a depreciation of its currency, any such depreciation is only too likely to meet with recriminations and even retaliation from its competitors. . . . Fears are even expressed that if one country starts depreciation, and others follow suit, there may result “a competitive depreciation” to which no end can be seen.

This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . . .

The picture of an endless competition in currency depreciation is completely misleading. The race of depreciation is towards a definite goal; it is a competitive return to equilibrium. The situation is like that of a fishing fleet threatened with a storm; no harm is done if their return to a harbor of refuge is “competitive.” Let them race; the sooner they get there the better.

I would have been happy to end the post here, having a) clarified an important, but often overlooked, distinction between the nominal and the real exchange rate, b) made the important analytical point that currency manipulation or trade war via monetary policy, requires tightening, not easing, monetary policy, and c) concluded the whole discussion with a wonderful quote from R. G. Hawtrey. Unfortunately, my work is not yet complete, because Stelzer writes the following in the penultimate paragraph of his piece.

The U.S. and the UK, among others, have already deployed that weapon, and the new head of Japan’s central bank is likely to be chosen by Abe from the warrior class. Germany, not overjoyed with Draghi’s hint that he might take up arms, continues to insist that the ECB remain a non-combatant. Angela Merkel has made it clear that the long unpleasantness that followed Germany’s decision to run the money presses overtime in the 1930s is still etched in Germans’ minds, and that she agrees with Vladimir Ilyich Lenin that “the surest way to destroy a nation is to debauch its currency,” a view on which John Maynard Keynes put his stamp of approval: “Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.”

OMG! Something has gone very, very wrong here. I repeat the critical passage to make sure it sinks all the way in.

Angela Merkel has made it clear that the long unpleasantness that followed Germany’s decision to run the money presses overtime in the 1930s is still etched in Germans’ minds

I can’t tell if Stelzer’s memory has failed him, and he is misrepresenting what Mrs. Merkel believes, or if — and this is an even more frightening thought — Mrs. Merkel actually believes that Hitler came to power, because Germany ran the money presses overtime in the 1930s. But the plain facts are that the German hyperinflation occurred in 1923, and Hitler came to power in 1933 when Germany, after years of deflation, austerity and wage cuts imposed in a futile, and self-destructive, attempt to remain on the gold standard, was still wallowing in the depths of the Great Depression. If Chancellor Merkel’s policy is now premised on the presumed fact that Hitler came to power, not because of the misguided deflationary policies of 1929-33, but the hyperinflation of the previous decade, I tremble at the thought of what disasters may still be waiting to befall us.