Reasons a currency war could still be on the horizon

Reasons a currency war could still be on the horizon

In February, G20 finance ministers and central bankers announced they would avoid currency devaluations and similar beggar-thy-neighbor policies. 

On the surface this might lead one to think that governments would now restrain from policies designed to deflate their currencies.  In reality, however, the agreement may pave the way for continued devaluation in some nations and could prove wholly inadequate in stopping a currency war.

English: Japanese Prime Minister Shinzo Abe at...

Japanese Prime Minister Shinzo Abe at the G8 summit in Heiligendamm. (Photo credit: Wikipedia)

The communiqué did not directly name Japan, which has come under increasing pressure on this issue since the election of Shinzo Abe as Prime Minister.  Instead, it called for movement towards a “market-determined exchange rate system” and “exchange rate flexibility.” Thus, the communiqué discourages any direct intervention in national currency but does not speak to indirect intervention like that being pursued by Japan’s new aggressive monetary easing policy.  Already, prominent economists in China and Ford CEO Alan Mulally have spoken out strongly against the new policy.

Yet Japan is not alone in pursuing policies designed to depress its currency. French President François Hollande recently called for the Eurozone to set a medium term target for its exchange rate.  This idea is also popular with struggling economies in southern Europe which could greatly use a boost in exports.  The idea is a non-starter in Berlin, but it does not preclude leaders from using informal mechanisms to talk down the Euro.

South Korea has already seen its currency slide significantly this year (albeit due to a variety of factors) and China’s deputy central bank governor recently said that China was “fully prepared” for a currency war.  The undervalued nature of the Chinese currency was a hot topic in America’s last presidential election and if China were to further weaken its currency it would undoubtedly provoke the ire of American politicians. There has also been talk of loosening monetary policy in Australia, whose benchmark interest rate is currently 2-3% higher than most other OECD countries, and in England, where George Osborne has been promoting a policy of “fiscal conservatism and monetary activism.”

When you put all of this together, the G20 communiqué looks fairly toothless.  Still, countries are facing a massive collective action problem.  The best scenario for every country is that they devalue their currency while other countries do not.  The worst scenario is that they do not devalue while others do.  In essence, it is the classic prisoners dilemma – nobody wants to be the sucker.  Traditional game theory tells us that in the absence of an effective enforcement mechanism to ensure cooperation, the rational course of action is for each country to defect (in this case to devalue).  So while countries might be saying the right things, don’t be surprised if currency devaluation continues to be a hot economic and political issue this year.

Categories: Asia Pacific, Economics

About Author

Evan Abrams

Evan was previously a strategy consultant with Anant Corporation, where he helped companies streamline and grow their online operations. He has interned at the United States Senate, the U.S. Department of Commerce, and SRI World Group. He is particularly interested in international monetary and trade policy. Evan also closely follows the private space sector, on which he completed a master’s thesis. He is currently pursuing a Juris Doctor at the Georgetown University Law Center. He holds a master’s degree in international relations from the London School of Economics and a bachelor’s from Georgetown University’s School of Foreign Service.