Posted by:
Andrew Bell

14 March 2011

Left to their own devices, currencies are useful mechanisms for compensating for economic policies or events which significantly change the relative performance of different countries’ economies. Unfortunately, the involvement of politicians, frequently with other motives or shorter term horizons can complicate this stabilising mechanism. Examples include Chinese policy on the Renminbi, the Euro’s foundation, and sterling’s volatility in the past 25 years. The consequences of misaligned exchange rates cannot be escaped but economic damage is often caused by ignoring reality. A tobacco plant when growing and reacting to local conditions is generally harmless but takes on a different dimension when processed for consumption. Similarly currencies under political direction should be sold in plain packaging with wealth warnings.

A country which persistently loses cost competitiveness either has to make adjustments to reverse those losses or its currency will be sold by investors to trade at a lower level. In the days of the gold standard, increased cost inflation had to be reversed by periodic deflations. Democracies have generally proved unwilling to make such sacrifices (“not a minute on the day, not a penny off the pay” was the call in the 1926 General Strike), so fixed currency links have tended to break down, except in areas with a single government (such as the USA). The 1930s were the death knell for the gold standard as well as a consequence of countries adhering to it beyond their political structures’ ability to play by its rules.

Different states within the USA have experienced wide economic divergences, yet their single currency (the dollar) has not come under question – people can migrate or the (commonly elected) government acts as an instrument to compensate for the states’ differing fortunes.

The same cannot be said for Europe, where Nation States with different structures, cultures, languages and governments were assumed to have irreversibly converged to a point where they could share the same currency (thus removing a key economic adjustment mechanism). Sufficient interdependence was created to make the resulting imbalances a shared problem but insufficient political unity was forged to achieve agreement on the solution. So successive Euro-potentate summits are forced to move in the direction of economic reality (e.g. that a failure to prevent Spain defaulting would ultimately result in having to rescue the German and French banks) without producing a comprehensive solution.  The latest decision is a typical stopgap compromise -  to increase the resources of the financial stability fund while constraining the European Central Bank’s [ECB] flexibility in using it, and to reduce the interest rate charged to Greece, while haggling over the conditions for reducing the rate charged to (less profligate) Ireland.

Unhelpfully, Europe seems happy to see the Euro rise in value (thus losing trade competitiveness). A weaker Euro is one way for the beleaguered countries which have lost competitiveness to endure the austerity required of them. The focus on Germany’s economic success may be blinding some heads of government to the deflationary risks arising from fiscal tightening elsewhere. If the Euro is to master its current internal turbulence, loose monetary policy is appropriate. If that results in overheating in Germany, perhaps Germany should raise taxes rather than hijacking a monetary policy designed for the whole zone to address (possibly) over-buoyant conditions in Germany.  Austerity elsewhere is required but loose monetary policy (and a competitive level for the Euro) would help offset the deflationary impact.

The problems of developed economies have created an unfortunate conjuncture whereby they all need weaker currencies. The UK and the US need to rebalance away from over-reliance on consumption and Europe needs a politically realistic balance between retrenchment and prosperity. Japan, which for some years has suffered low economic growth in the aftermath of its 1980s financial bubble, now has the much greater immediate problem of recovering from the destruction caused by the recent earthquake.

If everyone wants a weaker (or at least competitive) level for their currency, how can this happen? One solution is that emerging economies, which do not have such problems and need to rein in inflation, are likely to see their currencies rise (either in absolute terms or to rise in real terms as a result of their costs rising faster). This may well be seen as more palatable than further interest rate rises, especially if global growth loses momentum under the effects of rising oil prices and the destruction in Japan.

The other way everyone can enjoy weaker currencies is, regrettably but probably inevitably, via inflation. It is 30 years since investors felt they had to buy real assets to preserve their savings from inflation (in the aftermath of losses suffered in the 1970s) since cash and bonds delivered positive returns for most of the subsequent period. However, if central banks preside over levels of inflation higher than the returns on cash (which may remain low for many years) then owning real assets will be essential for preserving the value of savings.  

Comments or feedback are always welcome at theblog@witan.co.uk

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