Repeating errors of bad old days


By George Kerevan

We are at war – a currency war, that is. The world is in danger of repeating the mistakes of the Great Depression when nations tried to “export” their unemployment through competitive devaluations of their currencies. In 2008, the major industrial nations reacted sensibly to the banking meltdown by agreeing a collective fiscal expansion. This was engineered through low interest rates, printing money to restore bank liquidity, and state borrowing to replace private contraction. So far, so good.

However, things started to go wrong. The need to bailout private bank excesses in the eurozone overwhelmed the fiscal capacity of countries such as Ireland, Portugal and Spain. Germany imposed austerity on the whole eurozone, rather than allowing the European Central Bank to pump in unlimited liquidity. That brought the European economy to a halt.

The UK had its own mini-austerity programme, coupled with a sneaky plan by the Bank of England to ignore its legal duty to maintain price stability in order to inflate away public and private debt. Unfortunately, this strategy has backfired. Austerity has combined with higher prices and falling real wages to smash down consumption and eliminate growth. Oops!

America and China were left to pump cash into their economies in a bid to expand the global economy. But lack of export orders from the West, coupled with a domestic wage explosion, has forced China along a dangerous path. The new Chinese leadership is subsidising its inefficient state-owned companies to maintain employment while waving the nationalist flag at Japan to divert the masses.

Meanwhile, a robust American capitalism has used the crisis to upgrade productivity spectacularly. Unfortunately, with the rest of the global economy grinding to a halt, this productivity miracle means the US needs fewer workers for its export industries. That unemployment problem won Barack Obama re-election but don’t count on President Hillary (Clinton) being nice to Europe come 2016.

With the world economy in stasis, it was only a matter of time before people started cheating by devaluing their currencies. This currency war started in earnest last year, when the Swiss central bank moved to stop hot money escaping the eurozone from driving up the value of the Swiss franc, so wrecking Swiss exports. The canny Swiss printed unlimited amounts of their francs and used the cash to buy UK and European government bonds. Printing excess francs lowered the exchange rate while locking the new money away as bonds held by their central bank avoided domestic inflation.

If it had just been the Swiss, no-one would have bothered. But next up was Japan, the world’s third-largest economy. A year ago, Japan elected the charismatic Shinzo Abe as prime minister. He pledged himself to reverse Japan’s economic stagnation. His plan is simple: force the nominally independent Japanese central bank to print money and crash down the value of the yen. Since November, the yen has fallen by a fifth against the US dollar, cutting Japanese export prices by that amount. The yen is also down against the euro by 10 per cent since the start of the year.

At the weekend, finance ministers from the G20 countries met in Moscow to discuss the growing currency war. No-one was admitting in public that there is such a war – Japan’s divided Western allies want the problem to go away, while the developing economies want Japanese aid. Don’t be fooled. On Monday, Abe announced an even bigger programme of purchasing foreign bonds (Swiss-style) to devalue the yen still further. Expect the rest of the world to retaliate. Central banks have dramatically increased their gold holdings – a sure sign they are worried about the value of paper currencies.

Even the UK has joined in. The latest Bank of England minutes show that demob-happy Governor Sir Mervyn King voted to print another £25bn of sterling despite rising inflation. The markets were shocked, though I don’t see why. Sir Mervyn wants to print money to devalue sterling and he is signalling he does not care about the inflationary consequences – a cheaper pound means dearer imports, especially of fossil fuel.

The problem with his strategy is twofold. First, rising domestic inflation is crippling consumer demand and retarding economic growth. Second, a cheaper pound is not boosting UK exports because British firms have not used the recession to boost productivity. They are hanging on to workers and obsolete machines instead.

Take one example: last year Britain had record car exports. But don’t cheer. If you look at our trade in automotive products as a whole then Britain actually has a deficit of some £10bn. Without productivity improvements, a cheaper pound will only raise the cost of these imports, worsening the trade deficit.

There’s more to come. If Chancellor Osborne does not pull some economic growth rabbits out of his red box, Britain’s credit rating will be downgraded. That will signal a market sell-off of sterling, sending inflation rocketing up. Perversely, this will cut consumer demand and growth further. Expect hedge funds to start selling sterling short (ie: betting on a devaluation) even as we speak.

It’s not too late to escape a global currency war provided nations don’t engage in instant tit-for-tat retaliation. There are other technical things we could do: a fiscal loosening in the UK and Europe to encourage growth, coupled with a modest rise in interest rates to discourage hot money flows, would help.

But there are signs that patience is wearing thin. South Korea, for instance, has started to growl about the Japanese devaluation. The biggest worry is that any retaliation comes in the form not of counter-devaluations but in economic protection. That could spell an end to free trade. Worse, it could lead to armed conflicts, as it did in the 1930s.

Courtesy of George Kerevan and the Scotsman newspaper