Currency Wars

It’s Starting To Look A Bit Too Much Like 1931

JOHN HANCOCK warns:

History may not repeat itself, but the parallels between the world economy in the 1930s and the world economy today are becoming hard to ignore. Then, as now, the world was in the grip of a severe economic downturn and painfully high unemployment. Then, as now, governments tried to restore growth and exports by devaluing their currencies and carving out trade blocs, risking a chain reaction around the world. Then, as now, the system was rudderless, unstable, and insecure – which persuaded countries to protect their own national interests, even at the expense of the collective good.

The world has not yet plunged into a full-scale currency war, but the trends are not good. This fact was implicitly acknowledged by G7 finance ministers meeting last Tuesday who went out of their way to renounce “targeting exchange rates,” only to sett off a new and even larger wave of currency volatility. China continues to rebuff pressure to end the fixed and undervalued Yuan, exacerbating global imbalances and fuelling accusations of beggar-thy-neighbour trade strategies. The U.S. continues to drive down the dollar and flood the world with capital through successive rounds of quantitative easing. Brazil, Switzerland, and others continue to intervene aggressively intervene in markets to arrest their currencies from appreciation.

The latest salvo is Japan’s decision in December to pursue a radically expansionary monetary policy, which is both pushing the yen to new lows against all major currencies and dramatically ramping up global currency tensions. Korea is threatening “an active response,” Russia is warning of reciprocal devaluations, Venezuela has just announced a massive devaluation, soon to be followed by Argentina, while the euro zone is again split between France, which is demanding immediate action to weaken a fast-rising euro, and Germany, which is so-far resisting political interference in the European Central Bank. Not without reason, Jens Weidmann, Germany’s Bundesbank president, warned last month that the growing politicization of exchange rate policy was unleashing a global “race to the bottom.”

Recent actions on the trade front, though less volatile, are just as worrying. For the first time in history, the United States and Europe are talking seriously about forming a vast transatlantic free-trade bloc, encompassing half the world’s economic output. This follows the United States’ equally ambitious strategy to link ten or more “like-minded” Pacific Rim economies in a Trans-Pacific Partnership Agreement. Both initiatives are clearly aimed as much at restoring the West’s dwindling leverage vis-à-vis China and other recalcitrant emerging giants as at increasing intra-bloc trade. As Joao Vale de Almeida, the EU’s ambassador to Washington, recently put it, “if we get the [transatlantic] agreement right, we can call the shots around the world.”

These trade trends also have historical echoes. The Great Depression entered its most virulent phase not during the financial crisis of 1929, but during the trade crisis that followed, when the U.S.’s infamous Smoot-Hawley Tariff of 1930 set off an escalating global trade war and splintered the world economy into rival regional blocs. World trade collapsed, falling by an astonishing two-thirds between 1929 and 1932.

To repeat, 2013 is not 1931. Global economic integration is deeper today, trade and capital flows are greater, and governments have less scope to manipulate exchange rates or even tariffs in the face of powerful market forces. Policy-makers have also presumably learned from past mistakes. The current international economic system – composed of the International Monetary Fund, the World Bank, and the World Trade Organization (formerly the General Agreement on Tariffs and Trade) – was specifically designed to prevent a replay of the competitive devaluations and trade battles that caused the economic chaos of the 1930s and, ultimately, the outbreak of war. The fact that G7 finance ministers are clearly conscious of the currency war threat shows that the world has made progress.

Is it enough? In his seminal The World in Depression, Charles Kindleberger argued that the root problem in the 1930s lay less in countries’ “mistakes” than in their collective lack of faith in the possibility of an international solution and the absence of an actor powerful enough to provide leadership. In 1929, the old hegemon, Britain, “couldn’t” stabilize the global economy and the new hegemon, the United States “wouldn’t,” Mr. Kindleberger observed. This left countries scrambling to protect their narrow national interests, with the result that “the world public interest went down the drain, and with it the private interests of all.”

Widespread financial instability and volatility, lack of trust in international co-operation, and a diminishing global hegemon with no obvious successor…it all sounds a little too familiar.