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The Road to Trade War Runs Through QE, Currency
By Nouriel Roubini
The rising risk of currency and trade wars around the world stems from a game of competitive devaluations most economies are now playing. These tensions have the following source: over-spending countries—such as a the U.S. and other adherents of the “Anglo-Saxon model”—over-leveraged themselves, running current account deficits for the last decade that now force these economies to save more and spend less on domestic demand to reduce their debt. In effect, to maintain growth they need a nominal and real depreciation of their currency to reduce their trade deficits. Meanwhile, over-saving countries—China, other emerging markets (EMs), export powers Japan and Germany, all of which ran current account surpluses during the same period, now resist the nominal appreciation of their currency that would reduce their current account surpluses. They feel unable or are unwilling to reduce their savings and increase their domestic consumption demand to sustain their growth via greater domestic rather than foreign demand.
This problem is exacerbated by the fact that, within the eurozone, Germany runs current account surpluses and can live with a stronger euro while the current account deficits of the PIIGS (Portugal, Italy, Ireland, Greece and Spain) require a sharp depreciation of the euro to restore growth during the implementation of painful fiscal austerity and other structural reforms, all of which further reduce growth in the short run.
Thus the world we live in today is one where currency tensions have reached a boiling point. Over-spending countries need to reduce domestic demand to deleverage and thus need net exports to improve to maintain growth. Over-saving countries which are addicted to net exports as a source of growth refuse to reduce their reliance on net exports because they are unable or unwilling to increase domestic demand. To put faces on the dilemma: the U.S. needs a lower dollar to grow its exports; Japan needs a weaker yen to grow its exports; the UK needs a weaker pound to grow its exports; the eurozone—especially the PIIGS—need a weaker euro to grow their exports; even Switzerland is intervening to weaken the franc; China resists via massive intervention the appreciation of its currency to maintain its export-led growth; and now most EM economies also worry about their currencies becoming too strong because, if China does not move, they don’t want to lose competitiveness in third markets where they compete with China or in their own markets where import competing industries are threatened by cheap Chinese goods. So, aggressive intervention in currency markets or the imposition of capital controls has swept across the EMs, too.
Push Me, Pull You
The trouble, of course, is that not all currencies can be weak: If one weakens another must, by definition, strengthen. Everyone desires a weaker currency to sustain growth via net export improvement. But the total of the world net exports, by definition, equals zero. Not all economies can have a net export improvement. This zero-sum game in currencies and net exports means one country’s gain is some other country’s loss, and a competitive devaluation war has ensued.
This first salvo of this war has been fought via foreign exchange intervention: To diversify away from dollar assets while maintaining its effective semi-peg to the U.S. dollar, China started buying yen and won, damaging the Japanese and South Korean competitiveness. South Korea started intervening aggressively to slow down the appreciation of the won even if—given its chairing of the G20—it pretends not to intervene to keep the face of international statesmanship. Next, Tokyo first complained about Chinese purchases of JBGs (a form of verbal capital control) and then intervened to weaken the rising yen. So far, this intervention has been too small and uncoordinated to be effective. The Japanese intervention also leans against the wind rather than into it, and additionally, it’s sterilized (i.e., even if when policy rates are zero the difference between sterilized and unsterilized intervention is partly semantic). Still, this Japanese intervention then upset the EU as it put further upward pressure on the euro at a time when the European Central Bank (ECB) is on hold while the Bank of Japan (BoJ) and the Federal Reserve are easing further with more QE. This rise in the euro will soon cause massive pain to the PIIGS as their recessions will deepen and their sovereign risk will rise to a breaking point. The Europeans have thus already started verbal currency intervention and may soon be forced to go to formal intervention; but this intervention will be unlikely to stop the rise of the euro if—as likely—it would be sterilized and small scale.
In the U.S., these events, along with the anemic U.S. recovery and looming election, have influential voices such as Fred Bergsten of the Peterson Institute proposing that Washington should respond to China’s massive accumulation of dollar reserves by selling an equivalent amount of dollars and buying an equivalent amount of RMB. Of course, this U.S. FX intervention would be constrained by the fact that China imposes capital controls on inflows and the small and shallow nature of the market for RMB-denominated debt. Others go as far as suggesting that the U.S. should restrict the ability of China to buy U.S. Treasuries in the primary market (a form of capital control); this would be ineffective as China could buy such Treasuries in the secondary market. In the meantime, China and most of the EMs accelerate their FX intervention to prevent more appreciation; reserve accumulation by China and EMs is accelerating toward an annualized rate close to US$1 trillion with about three-quarters of it going into dollar assets.
QE2 Steams Out of Port
The next stage of this currency and intervention wars is more quantitative easing—QE2. The BoJ has already announced it, the Bank of England (BoE) is likely to do it soon, and the Fed will certainly announce a large scale form of it at its November meeting. In principle, there is little difference between monetary easing—lower policy rates or more QE—that leads to currency weakening and FX intervention. Actually, the former is a more effective tool to weaken a currency as the latter is usually sterilized (even if the difference between sterilized and unsterilized intervention is minimal when policy rates are zero).
Indeed, expectations of aggressive QE by the Fed have already weakened the dollar and raised serious concerns in Europe, across the EMs and Japan. What’s more, the U.S. pretends not to intervene but is actively intervening to weaken the dollar via more QE. In the QE game, the U.S. has the upper hand as the ECB remains on hold—even talking about raising rates (see the recent statements by Stark and Weber) while even the BoJ’s QE is too timid compared to the deflationary risks in Japan.
Still the fact that the BoJ, and soon the BoE¸ are following the Fed is putting even more pressure on the euro. The stubborn ECB would rather kill any chance of the PIIGS recovery rather than consider further QE, which it finds unacceptable, citing the threat of a rise in inflation. This, from RGE’s view, is a phantom risk: Deflation, not inflation, is the risk which plagues the PIIGS.
Can Trade War Be Far Behind?
As these currency, intervention and QE wars are unfolding the specter of trade wars is rising. Currency wars eventually lead to trade wars, as the recent U.S. trade legislation threatening China shows. With the U.S. unemployment rate at almost 10% and Chinese growth at almost 10%, it is no wonder that the drums of trade wars are beating harder.
If China, EMs and other surplus countries prevent their nominal currency appreciation via intervention and successfully prevent a real appreciation via sterilization of this intervention—thus preventing a rise in domestic inflation—the only way deficit countries can achieve a real depreciation is via a persistent deflation that will lead to a double-dip recession, debt deflation of private and public debts and even larger and unsustainable fiscal deficits and debt.
This depressionary and deflationary bias is exacerbated for the PIIGS, which badly need a nominal and real depreciation of the euro. Instead, the monetary policy of the ECB and the tight fiscal policy of Germany strengthens the euro and encourages more recessionary deflation in the PIIGS that are already slumping. This deflationary dilemma is even worse for stagnating Japan, which faces more deflation and thus needs a weaker yen, yet runs a large current account surplus, which tends to lead to a stronger yen.
At the end, if nominal and real depreciation (appreciation) of the deficit (surplus) countries doesn't occur, the falling domestic demand of deficit countries and the failure to reduce savings and increase consumption in the surplus countries will lead to a global lack of aggregate demand at the time of a glut of capacity.
A serious asymmetry exists in the adjustment process for global imbalances in the international monetary system: Current account deficit countries eventually must adjust as they run out of foreign exchange reserves and/or bond vigilantes impose market discipline (a partial exception being the U.S., which benefits so far from its "exorbitant privilege"). But surplus countries feel little pressure to adjust, to reduce their current account surpluses or to stop intervening to prevent their currencies from appreciating. So the international monetary system has a serious asymmetry flaw; this situation leads to a lack of global aggregate demand when imbalances fester for too long. Since deficit countries spend less and save more when they are forced to adjust, while surplus countries cannot be forced to reduce their savings and pump up consumption, more global aggregate demand can be lacking following the burst of bubbles that forced debtor countries to deleverage. This was a problem in the 1930s which the IMF’s founding document, the 1945 Articles of Agreement, failed to resolve. To this day, the IMF has no leverage on the surplus countries and/or on the large deficit countries (U.S.) that don't need its financial support.
Therefore, following the bursting of asset bubbles, which force deficit countries to deleverage, a depressionary and deflationary bias can develop in the global economy. The real depreciation of the deficit countries may occur via deflation rather than nominal depreciation if surplus countries successfully resist a nominal and real appreciation; this eventually causes more global deflation and private and public debt defaults (or coercive debt restructurings) in debtor countries that end up suffering from debt deflation; these debt defaults and/or restructurings ultimately hurt the growth and wealth of saving and creditor countries.