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Basic Macroeconomic Relationships

The Quantity Theory of Money

Purchasing Power Parity

Interest Rates

Gross Domestic Product

Putting It All Together

Data for Select Countries

Exchange Rate Basics



Pros and Cons of a Strong or Weak Currency

Why Depreciate One's Currency?

Methods for Depreciating a Currency

Currency Wars

Definition of Currency War

Definition of the Currency Game

The Disadvantages of Currency Manipulation

Other Comments on Currency Wars




Currency wars have been all the rage lately. 

Paul Krugman, is an economist, a Nobelist, in fact, who I respected greatly when I was in graduate school, studying his work on international trade.  However, over the past several years, I’ve come to view him as a complete sell-out, and as someone who twists economists (both theoretical and empirical) to promote his own completely tainted viewpoint.  In his Feb 15, 2013 NYT blog entry, “Currency War Confusions”, he wrote:

OK, people have been asking me where I stand on the “currency war” issue. My answer is that it’s all a misconception, and it would be a very bad thing if policy makers take it seriously.

First of all, what people think they know about past currency wars isn’t actually true. Everyone uses some combination phrase like “protectionism and competitive devaluation” to describe the supposed vicious circle of the 1930s, but as Barry Eichengreen  has pointed out many times, these really don’t go together. If country A and country B engage in a tit-for-tat of tariffs, the end result is restricted trade; if they each try to push their currency down, the end result is at worst to leave everyone back where they started.

And in reality the stuff that’s now being called “currency wars” is almost surely a net plus for the world economy. In the 1930s this was because countries threw off their golden fetters — they left the gold standard and this freed them to pursue expansionary monetary policies. Today that’s not the issue; but what Japan, the US, and the UK are doing is in fact trying to pursue expansionary monetary policy, with currency depreciation as a byproduct. Expansionary policy is what the world needs, so why is this a bad thing?

True, Europe may feel that it’s suffering a loss of competitiveness. But there’s an answer for that: emulate the other advanced countries, and have the ECB join in the expansion. Indeed, if fear of an overvalued euro finally undermines the ECB’s monetary hawks, that’s good for everyone.

When it comes to currency depreciation, right now the only thing we have to fear is fear itself.

Personally, I couldn’t disagree more.  I believe that the current “Currency wars”, far from being “almost surely a net plus for the world economy”, instead represent a classic prisoner’s dilemma game, in which the whole world is going to end up much worse off than before, with much higher prices, much higher inflation, and much greater uncertainty in world markets.

This blog entry, “Making Sense of the Currency Wars”, makes this case.

I tried to make the dry basic economics stuff at the beginning as brief as possible, while still being comprehensible.  Like most things in life, you have to get through the dry, boring basics before you can appreciate the good stuff.  For those of you who are already familiar with the basics, feel free to skip to the latter part of the analysis.

Basic Macroeconomic Relationships

The Quantity Theory of Money

From Wikipedia:

In monetary economics, the quantity theory of money is the theory that money supply has a direct, proportional relationship with the price level. For example, if the currency in circulation increased, there would be a proportional increase in the price of goods.

The Quantity Theory of Money may be expressed by the following equation:

[1]            M × V = P × Q


            M is the money supply

            V is the velocity of money (i.e., the rate at which money is turned over)

            P is the price level

            Q is the real value of final expenditures

Basically, the Theory says that money markets and goods markets are in equilibrium, so that the total value of money supporting an economy (left-hand side of equation [1]) equals the total value of products and services produced in that economy (right-hand side of equation [1]). 

While there is general agreement that the theory holds true in the long run, whether or not it holds in the short run is subject to dispute. 

If we rearrange terms, we get

[1’]            P = M × V / Q

So, holding velocity of money and output of goods and services constant, the price level increases with the supply of money.

Equation [1’] also indicates that, holding the velocity of money, V, constant, as long as the supply of money, M, grows at the same rate as output, Q, then the price level, P, will remain stable.  If the supply of money, M, grows faster than the rate of output, Q, there will be inflation (“too many dollars chasing too few goods”).  Conversely, if the supply of money, M, grows slower than the rate of output, Q, there will be deflation (“too few dollars chasing too many goods”).

Purchasing Power Parity

From Investopedia,

[T]he exchange rate adjusts so that an identical good in two different countries has the same price when expressed in the same currency.

Purchasing Power Parity (PPP) at the economy level may be expressed by the following equation:

[2]            P = E × P*


            P is the price level in the domestic country

            E is the exchange rate between the domestic currency and the foreign currency

            P* is the price level in the foreign country

Substituting [1’] into [2] gives us

[3]            E = (M / M*) × (V / V*) × ( Q* / Q)

That is, the exchange rate depreciates (increases) as

•  the supply of domestic relative to foreign currencies increases

•  the amount of domestic relative to foreign output decreases

Interest Rates

The real and nominal rates of interested are related by the following equation:

[4]            (1 + r) = (1 + i ) / (1 + )


            r is the real rate of interest

            i is the nominal rate of interest

             is the rate of inflation

The Fisher Equation approximates the interest rate relationship in [4] as

[4’]            i ≈ r + 

That is, the nominal rate of interest is approximately equal to the real rate of interest plus the rate of inflation.  It follows that the (expected) nominal rate of interest is

•  increasing with the real rate of interest,

•  increasing with the (expected) rate of inflation

In turn, the (expected) rate of inflation

•  increases with the size of the debt (larger debts lead people to expect government will increase the supply of money at some point in the future to devalue the debt), and

•  increases with the supply of money, M (the Quantity Theory of Money).

Taken together, inflation rate movements and equation [4’] indicate that the (expected) nominal rate of interest is

•  increasing with the size of the debt, Debt

•  increasing with the supply of money, M

Gross Domestic Product

From Wikipedia,

Gross domestic product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time.  GDP per capita is often considered an indicator of a country's standard of living.

GDP may be expressed by the following equation:

[5]             GDP = C + I + G + (X – E × IM*)


            C is private consumption

I is gross investment, which is equal to gross savings

G is government spending

X is exports

E is the exchange rate (domestic currency / foreign currency)

            IM* is imports priced in foreign currencies

Private (domestic) consumption, C, increases when

•  The unemployment rate, UR,  decreases;

•  Wages, W, increase; and

•  Domestic prices, P, decrease.

So we have

[6]            C = C(UR, W, P)

                                 –   +   –

Gross investment, I, increases when interest rates, i, decrease. So we have

[7]            I = I(i)


Government spending, G, increases (does government spending really EVER decrease???) when

•  Discretionary spending, DS, increases;

•  Non-discretionary spending, NDS, increases, which occurs when

°  The debt, Debt, increases; and

°  Interest rates, i, increase (interest on the debt and cost-of-living indexes both increase with interest rates).

So we have

[8]            G = G(DS, NDS(Debt, i))

                                +       +      +      +

Exports, X, increase when

•  Wages, W, decrease relative to foreign wages, W*;

•  Domestic prices, P, decrease relative to foreign price levels, P*; and

•  The exchange rate, E, increases (depreciates).

So we have

[9]            X = X(W/W*, P/P*, E)

                                 –           –      +

Imports, IM, increase when

•  The exchange rate, E, decreases (appreciates);

•  The unemployment rate, UR, decreases;

•  Wages, W, increase; and

•  Domestic prices, P, increase relative to foreign prices, P*

So we have

[10]            IM = E × IM*(UR, W, P/P*)

                               –               –     +     +

Substituting [6], [7], [8], [9], and [10] into [5] gives us

[11]            GDP =  C(UR, W, P) + I(i) + G(DS, NDS(Debt, i))

                                         –   +   –         –           +      +     +         +

+ X(W/W*, P/P*, E) – E × IM*(UR, W, P/P*)

            –          –       +                        –     +     +

From equation [1’] we have the price level, P, increases with the supply of money, M.  Higher wages, W, also lead to higher prices, P, since suppliers must cover the higher associated costs of production.  So we have

[12]            P = P(M, W)

                  +    +

From equation [3] we have the exchange rate, E, depreciates (increases) as the supply of domestic relative to foreign money supplies, M/M*, increases:

[13]            E = E(M/M*)


From equation [4’] we have the (expected) nominal rate of interest, i, is

•  increasing with the (expected) rate of inflation, ;

•  increasing with the size of the debt, Debt; and

•  increasing with the supply of money, M.

[14]            i = i(, Debt, M)

                             +     +      +

Putting It All Together

Finally, substituting [12], [13], and [14] into [11] gives us

Equation [15] looks kind of hairy, but now we can see how all the various fiscal and monetary policies being implemented by the US and Chinese governments are currently impacting, or will at some point in the future impact, the various economies.

Unemployment Rate, UR

Higher unemployment rates lead to decreased levels of domestic, C, and imported, IM, consumption of goods and services.

Wages, W

All else equal, higher wages enable employed citizens to consume a greater amount of domestic, C, and imported, IM, goods and services.  At the same time, however, higher wages make a country’s exports, X, less competitive.

By supporting higher union wages and establishing minimum wages, the US is

•  increasing  domestic, C, and imported, IM, consumption of goods and services by the employed people who benefit from the higher wages; but

•  decreasing domestic, C, and imported, IM, consumption of goods and services by the associated unemployed people who are laid off or cannot get a job at the higher union/minimum wage rate; and

•  decreasing exports, X, by decreasing the international competitiveness of domestic goods and services (i.e., by increasing domestic prices, P).

By encouraging low wage rates, China is

•  decreasing the rate of unemployment, UR;

•  increasing domestic, C, and imported, IM, consumption of goods and services by the employed people.  However, the very low wages mean domestic consumption, C, and imports, IM, by households is very minimal;

•  increasing exports, X, by increasing the international competitiveness of domestic goods and services (i.e, by minimizing P*).

Interest Rates, i

By keeping interest rates low, the US government is

•  encouraging investment, I, which will, in turn, create jobs (decrease the unemployment rate, UR); and

•  minimize government nondiscretionary spending, NDS, by minimizing interest on the debt and by minimizing interest rate adjustments on government transfers (e.g., Social Security.)

At the same time, however, low interest rates

•  encourage risk-seeking behavior by entities in search of higher returns on their investments, and

•  encourage government spending, NDS, by minimizing the associated costs (interest payments).

Money Supply, M

By increasing the supply of money, M, the US and Chinese governments encourage

•  decreases in the price of money, i, to encourage investments, I, which will create jobs and lower the unemployment rate, UR;

•  increases the price level, P (as per the Quantity Theory of Money);

•  increases (depreciation) in the exchange rate, E.

Higher Prices.  Due to delays until the governments’ policies take effect in the economy, prices, P, including the price of labor, W, may remain low in the short run.  However, the increasing supply of money in the economy will soon start to push up prices, P (as per the Quantity Theory of Money), assuming any growth in output, Q, associated with increases in the supply of money, M, is less than the growth in the supply of money, M.  Higher prices, P, will eventually lead to

•  a drop in domestic consumption, C, if prices rise faster than either wages increase and/or the rate of unemployment decreases;

•  a drop in foreign demand  for domestic exports, X, as exports become less competitive; and

•  a rise in domestic demand for foreign imports, IM.

Exchange Rate Depreciation.  At the same time, however, increases in the supply of money, M, will cause the exchange rate, E, to depreciate (increase), thereby leading to

•  increases in foreign demand for domestic exports, X;

•  decreases in domestic demand for foreign imports, IM.

So we see that Increases in the supply of money, M, lead to

•  Higher prices, which tend to

°  Decrease the demand for exports, X, and

°  Increase the demand for imports, IM (= E × IM*) by making foreign products priced in foreign currencies, IM*, less expensive.

•  Depreciated exchange rates, E, which tend to do the opposite,

°  Increase the demand for exports, X, and

°  Decrease the demand for imports, IM (= E × IM*) by making imports priced in domestic currencies, IM, more expensive.

If exchange rates, E, adjust to the increasing supply of money, M, more quickly than do prices, P, then the net effect in the short run will be greater exports and fewer imports, thereby increasing GDP in the short run.

As prices start to rise, however, they may very well end up swamping the impact of exchange rate depreciation, thereby leading to lower exports and higher imports (i.e., lower GDP) as time passes.


Higher inflation increases interest rates, which discourages investment, I, and increases the burden of the debt.

Data for Select Countries

The World Bank provides data on consumption, C, investment, I, exports, X, and imports IM, as a percent of GDP by country by year.  I took these data and used equation [5] to calculate government spending as a percent of GDP, G, as a residual.  These GDP distribution data are presented for select countries in Figures 1, 2, 3, 5, 6, and 7.

Figure 1

Figure 1 shows that the US consumes a much greater portion of its domestic output than do other developed nations.  In contrast, Japan, Switzerland, and Germany rely much more on imports and exports than the US.  This reflects the fact that the US is much larger, more diverse, and more self-sufficient than most other developed nations.

Figure 1 also shows that China’s GDP distribution is very different from other developed nations.  In particular, China consumes a relatively small portion of its domestic output, where the differential in consumption as compared with that in the US is put toward investment.  A significant portion of this difference may be accounted for the fact that most Chinese citizens have little to no safety net from the government (e.g., health care, social security) to rely on.  As such, they tend to save more than Americans do, to prepare for future needs (see, for example Raman Ahmed and Heleen Mees, “Why do Chinese households save so much?”).

US and China

For many years, China has been buying up dollars to keep the yuan weak against the dollar, so as to encourage Chinese exports to the US (see, for example, James Parker, The Dollar Trap: China’s Misunderstood Foreign Exchange Reserves”).  In recent years, the United States has been increasingly vociferous about China’s manipulation of the yuan, that is, China’s refusal to let the yuan appreciate against the dollar. 

Figure 2 shows that the US’s trade balance (exports less imports) has increased slightly (become more favorable) in recent years, while Figure 3 shows that China’s trade balance has decreased.  Based on this information alone, it would appear that the US dollar should have appreciated against the yen (see Exchange Rate Basics below for more explanation on this conclusion). 

Figure 2

Figure 3

However, Figures 2 and 3 provide aggregate information for US and China trade with the rest of the world.  What we really need is information on the China-US trade balance, that is, the status of China trade with the US, to see what’s been going on.  Figure 4 provides this information.

Figure 4

Figure 4 makes it clear that the China US trade balance (Chinese exports to the US less Chinese imports from the US) has grown significantly over the past decade.  The large increase in the China-US trade balance, in the face of a small increase in the two countries’ relative price levels, provides fairly definitive information that the China-US exchange rate should have appreciated substantially over the period.  Yet, as Figure 4 shows, the China-US exchange rate scarcely budged.



Japan has recently embarked on an active program of quantitative easing.  Japan denies that its purpose has been to depreciate the yen, and instead claims its purpose is to boost the Japanese economy.  See, for example, “DJ: Shirakawa Says BOJ's Monetary Easing Not Aimed At Manipulating Yen.”

Figure 5

Figure 5 shows that while Japan’s economy has been showing some upward growth in real GDP over the past few years, its exports have recently dropped in favor of increases in domestic consumption.  Japan thus has an incentive to depreciate the yen to encourage exports.  Regardless of what Japan’s primary motive for quantitative easing is, it will likely have an impact both on stimulating the economy and on depreciating the currency.



Switzerland, too, has recently embarked on a program to depreciate the franc, as the strong currency threatens Swiss exports.  See, for example, Zoe Schneeweiss, “Swiss Ministers Seek More Depreciation of ‘Strong’ Franc.”

Figure 6

As can be seen in Figure 1, exports represent a relatively significant portion of Swiss GDP, as compared with that in other countries.  As such, any threat to Swiss exports, such as a strong franc, will have a significant impact on decreasing the country’s GDP. 

Furthermore, as can be seen in Figure 6, Swiss exports have been falling in recent years as a portion of GDP. Taken together, these two facts make Switzerland’s recent actions to encourage exports understandable.



Since the beginning of the Eurozone crisis, Germany has been fighting hard to keep the Eurozone intact.  See, for example, Martin Wolf, “Return to Health and Reform Vital to Euro Zone.”

Figure 7

As seen in Figure 1, like Switzerland, German exports contribute significantly to the German economy relative to their contribution to other countries’ GDPs. At the same time, from Figure 7, it is apparent that Germany has recently seen its exports increase, especially exports to other European nations (see, for example, “Why Germany Is The Economic Powerhouse Of The Eurozone”).  The fact that Germany relies on inter-Eurozone trade for a large and growing portion of its output thus explains its strong advocacy for keeping the Union intact.

Exchange Rate Basics

After having reviewed the basic macroeconomic relationships in the previous section, understanding exchange rates, the topic presented in this section, should be relatively straightforward.


Exchange Rate: E = Domestic Currency Units / Foreign Currency Units

•  Strong Currency       = Few domestic currency units buy many foreign currency units

      = Low E

•  Rising Currency       = Currency Appreciation

     = Increasing Strength

     = Fewer Domestic per Foreign

     = Decreasing E


In “Macroeconomic Determinants of Real Exchange Rates,” William H. Branson indicates that

The literature of the 1970s has identified three macroeconomic variables that influence movements in exchange rates. These are

•  money supplies,

•  relative price levels, and

•  current—account balances [exports less imports],

where increases in money supplies lead to weaker currencies (as per the Quantity Theory of Money), increases in price levels lead to weaker currencies (as per the Quantity Theory of Money), and decreases in current account balances all lead to weaker currencies.  The exchange rate dynamics for the current account are as follows: As exports fall relative to imports, the demand for domestic currency falls relative to the demand for the foreign currency, to pay for the excess imports, causing the exchange rate to depreciate (E to increase).

These three factors suggest (see, for example, “6 Factors That Influence Exchange Rates”) that countries with strong currencies may be characterized by

•  Low rates of inflation ();

•  Current Account surpluses:  Exports exceed Imports;

•  High confidence in the domestic economy;

•  Low levels of public debt (high public debt leads to expectations of future inflation); and

•  Political stability and good economic performance.

Pros and Cons of a Strong or Weak Currency

Strong Currency

From Peter Schiff “The Biggest Printers Will Be the Biggest Losers”:

Productive nations generate excess goods and services that can be sold abroad and their growth and stability attract investment funds from abroad. These conditions will tend to increase demand for the nation's currency, thereby pushing up its price. A strong currency keeps capital and raw materials costs low, enabling more productive workers to earn higher real wages. . But according to most economists, a strong currency will bring down an economy because it destroys international competitiveness.

•  Pro

°  Low costs of borrowing;

°  Low costs of imports in general;

°  Low costs of imported raw materials in particular;

°  High wages, which lead to high domestic consumption; and

°  Encourages foreign investment.

•  Con

°  Discourages Exports.

Weak Currency

Again, from Peter Schiff:

It is true that the country with the zero value currency will tend to see full employment and strong exports. The relative low cost of labor will mean that the locals could be easily employed in even the most marginal activity. But since holders of other currencies will be able to outbid the domestic population for all of their production, everything produced will be exported. Imports will be zero as the local population would be unable to afford anything produced in countries with more valuable currencies. As a result, actual consumption would be extremely low…

•  Pro

°  Low real wages, which lead to low rates of unemployment; and

°  Encourages exports.

•  Con

°  High costs of borrowing;

°  High cost of imports in general;

°  High costs of imported raw materials in particular;

°  Low wages lead to low domestic consumption; and

°  Discourages foreign investment.

Why Depreciate One's Currency?

The analyses presented in the previous sections — "Putting It All Together" more generally, and "Pros and Cons of a Strong or Weak Currency" in particular — suggest that, overall, currency depreciation has many more disadvantages than advanatges, and in the aggregate, especially in the long run, the disadvantages significantly outweigh the advantages.  If so, then why do it?  Why are governments currently actively involved in depreciating their currencies??

Governments live and die with public perception.  The public will be happy when interest rates are low, inflation is low, and the rate of unemployment is low. 

Governments also live and die in the present.  As such, policies tend to focus on the here and now, generally at the expense of the future.

Putting these two truisms together means that governments are focused on making the current state of their respective economies seem as good as possible, (almost?) in complete disregard to what may happen in the future.

More specifically, in an attempt to improve public perception of the economy, the US government (and most assuredly other governments) has been manipulating statistics on the state of the economy (for more accurate estimates, see, namely, the rate of inflation, , and the rate of unemployment, UR, to make them seem more favorable that they actually are.

Furthermore, global governments' (the US, Europe, China, and Japan, to name a few) historically high recent rates of money creation (“quantitative easing”) are an attempt to pump up the current state of respective economies, partly by depreciating the domestic currencies  against foreign currencies, to encourage exports. The governments may very well succeed at doing this – at least in the public’s perception – to some point in the short run.  However the future costs of the current quantitative easing – rampant global inflation – will be very high indeed.

Methods for Depreciating a Currency

Quantitative Easing

How it works: The domestic government purchases financial assets from domestic banks.  This increases the supply of the domestic currency in circulation.  Holding constant the supply of foreign currencies, the exchange rate will depreciate (increase).



•  By increasing the supply of the domestic currency, quantitative easing affects the exchange rates of the domestic country with respect to all other countries.

•  This method is inexpensive in the sense that printing money is inexpensive. 

•  This is the method being employed by the US, Europe, Japan, and, to some extent, China.


Purchase Foreign Currency

How it works: the domestic government purchases supplies of a specific country’s currency (i.e., the government acquires foreign reserves).


•  By decreasing the supply of a specific foreign currency, this method affects the exchange rate of the domestic country with respect to a specific foreign country.

•  This method is expensive in the sense that it requires the domestic government to hold large quantities of a foreign currency.

•  This is the primary method being employed by China to keep the value of the yuan low relative to the value of the US dollar.

General Notes on Exchange Rates

•  Large Imports and/or Exports

Exchange rate movements become more important as the amount of a country’s imports and exports (relative to GDP) increase.

•  Large Imports of Raw Materials

For countries with relatively large imports, exchange rate movements are more important for countries that import a significant portion of their raw materials, as opposed to countries that import a significant amount of final goods and services.

In particular, as Japan continues to depreciate its currency, it will suffer increasing costs of energy and other raw materials imports.

•  Government Policy

A government policy of supporting a weak currency so as to encourage exports is benefitting a particular group of producers – those involved in the export sector – at the expense of the wider economy (see Cons of a Weak Currency above).

A policy that would benefit the same group of people with fewer widespread costs would be to subsidize particular exports.

•  Domestic Hard Times

Exchange rate issues become more contentious during hard times.

As a case in point, China has been actively supporting a weak yuan with respect to the US dollar for at least two decades, so as to encourage Chinese exports to the US.  However, it is only recently, since the Great Recession, that China’s weak yuan policy has become a front-burner issue in the US.

More generally, both the currency wars during the 1930s and the current currency wars were preceded by “periods of prolonged economic pain…”

From Tyler Durden “Lessons From The 1930s Currency Wars”:

As in every crisis, events were and will always be highly non-linear, with domestic conditions the most likely cause: It was painfully high unemployment that was the main driver of the devaluation of sterling. Although unemployment had been painfully high for a while, it was only a few months prior to the devaluation [in September 1931] that market fear really ratcheted up.

And from A. Gary Shilling's “Insight”

In periods of prolonged economic pain, notably the 2007-2009 global Great Recession and distinctly subpar revival that has followed, international cooperation suffers in favor of an every-nation-for-itself attitude. Protectionism is the economic policy manifestation of this attitude, and a number of countries are now pursuing competitive devaluations in order to spur exports via a cheaper currency and retard imports.

•  Government Policy

Recent articles have tried to justify government policies of currency depreciation by claiming that currency depreciation in a secondary effect, where the primary purpose of government in pursuing policies of quantitative easing is to “boost stagnant economies”.  For example, Matthew Boesler, “Goldman Sachs Has The Perfect Response For Anyone Who Talks About 'Currency Wars” indicates (emphasis mine)

"Currency wars" are all the rage right now.

In Japan, Switzerland, and the U.K., currencies are rapidly falling, and many are accusing these countries of purposely depressing their currencies in order to boost exports at the expense of other nations…

However, reality may be decidedly less exciting… these countries are simply trying to boost stagnant economies via monetary easing…

It's true that a side-effect of these monetary actions is, of course, a weaker currency – but that's only a secondary phenomenon.

The real story is the attempt by various countries (notably Japan) to lower real interest rates…

It's true that monetary easing in developed economies is causing currency depreciation. However, to characterize global policymakers as engulfed in a "currency war" is missing the point about what these countries are trying to do.

I find this argument disingenuous.  Regardless of the primary intention, the end result is the same: forced depreciation of currencies.  It’s like saying “I didn’t mean to emit carbon emissions – my primary purpose was to generate electricity.”

Currency Wars

Definition of Currency War

From Wikipedia

Currency war, also known as competitive devaluation, is a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their own currency. As the price to buy a particular currency falls so too does the real price of exports from the country. Imports become more expensive. So domestic industry, and thus employment, receives a boost in demand from both domestic and foreign markets.

Definition of The Currency Game

The management of domestic currencies by countries across the globe is a defines agame as

The interaction among rational, mutually aware players, where the decisions of some players impacts the payoffs of others. A game is described by its players, each player's strategies, and the resulting payoffs from each outcome. 

In the Currency Game,

•  Players: Countries (country policymakers) are the players;

•  Actions or Strategies: Each country can let its exchange rate float (move freely with changes in countries’ economies), peg (fix) it to another currency, or actively intervene to manually appreciate or depreciate its exchange rate; and

•  Payoffs: The payoffs to countries are the values of exports and imports that result from the countries’ joint actions with regards to their respective currencies.

The Disadvantages of Currency Manipulation

Manipulated Markets Are Destabilizing

Free markets are stabilizing, by providing negative feedback effects to the economy.  Specifically, when there is excess supply or a shortage of demand, price falls, bringing supply and demand back in line.  Conversely, when there is a shortage in supply or excess demand, price rises, bringing supply and demand back in line.  More generally, when there is misalignment of supply and demand, negative feedback effects work to adjust the price so as to realign the misalignment.

In contrast, manipulated markets are destabilizing, by providing positive feedback effects to the economy.  That is, imbalances, such as the China-US trade imbalance illustrated in Figure 4, are not allowed to correct themselves (in the China-US case by letting the yuan appreciate against the dollar), but rather, they are encouraged to grow, until the system becomes completely out of whack.  The end result is generally some sort of forced resolution conducted under a lose-lose scenario, such as that being played out as we speak in the Eurozone.  (Note that the insolvency of the PIIGS countries in Europe are, in effect, a result of currency manipulation:  the currencies of the troubled nations were not allowed to depreciate against the currencies of the stronger nations.)

Currency Manipulations Result in Zero-Sum Games

Free trade generally promotes benefits for everyone.  That is, it is a positive sum (or “win-win”) game, in which all participants end up better off than they would have been without free trade. 

Currency manipulation, on the other hand, tends to be a zero-sum (that is, “win-lose”) game, in which the manipulating country gains at the expense of some other country’s loss.  (See next section on retaliatory action for more explanation.)

From James Gruber “Who Will Win the Currency Wars?”

the currency market is a zero-sum game – as one currency declines, another must go up

From Charles Hugh-Smith, “Why Competition Between Global Players Is Heating Up”

When the global financial pie is expanding, there's plenty of swag for everyone, so competition is limited and cooperation is rewarded…

when the expansion ends, competition heats up as sovereign nations and global corporations alike battle for a slice of stagnant markets and shrinking profits…

We now see why nations are resorting to outright currency devaluations: their ability to service rapidly rising debt is decaying along with global profits. The competition for global capital is heating up, as every major player faces a Hobson's Choice: they can print or create debt-money to fund their debt and risk inflation strangling their economy, or they can raise interest rates to attract global capital. This increases the costs of their debt service, crimping further borrowing.

Currency Manipulation Triggers Retaliatory Action

When one country intervenes in the markets to devalue its currency, the action generally leads other countries either (i) to retaliate, such as by implementing tariffs on imports of the currency manipulator’s products, or (ii) to intervene to depreciate their own currency so as not to suffer drops in exports.  From  James Gruber, “Who Will Win the Currency Wars”

Japan is also a major exporter competing with South Korea and Taiwan on high-end electronics, auto and industrial goods.

Think about the potential impact on South Korea for a moment. Exports account for 52% of GDP there ... South Korea and other countries won’t allow their exporters to become totally uncompetitive against their Japanese counterparts though. They’ll join the fight to trash their currencies in order to help their exporters.”

There is also the possibility that starting a currency war will eventually lead to a hot war (see, for example, George Washington, “Currency Wars Often Lead to Trade Wars ... Which In Turn Can Devolve Into Hot Wars”).

Currency Manipulation Doesn’t Address the Underlying Problem

Using currency manipulation as a means of stimulating one’s economy does not address the problem that caused the weak economy to begin with.  It is thus possible that after the currency depreciation (and potential subsequent currency war) takes effect, the economy at issue may end up back where it started, for failing to address the original, underlying problem.  Regarding Japan’s recent actions that have led the yen to depreciate, Jim Jubak, in “Lets’ Play Global Currency Wars”, notes

But as effective as a weaker yen might be in the short term in increasing exports by Japan-based manufacturers and at increasing the profits at these companies, it does nothing to address the structural problems in Japan's economy or the country's long-term demographic challenge.

Currency Manipulation Leads to a Prisoners’ Dilemma

When currency manipulation on the part of one country leads to retaliatory actions and/or currency wars by other countries, then the end result is a classic prisoner’s dilemma game.  In the ensuing non-cooperative currency wars, everyone ends up worse off -- with higher prices, less consumption, and more uncertainty.  However, if the game were a cooperative one, in which each country were able to commit to not depreciating its currency, then everyone would end up better off—with lower prices, less inflation, and less uncertainty.

Other Comments on Currency Wars

Winners and Losers of a Currency War

•  In the short run, currency depreciation

°  “Pushes unemployment overseas”,

°  Leads the export sector to export more (exporters win), and

°  Leads consumers to pay higher prices for imported goods (consumers lose).

•  In the long run, currency depreciation

°  Leads to inflation and uncertainty, higher cost of capital (society loses); and

°  Leads to higher prices for all goods (consumers lose)

Currency Devaluation Does Not Solve Country’s Underlying Problems

As mentioned earlier, using currency manipulation to stimukate an economy does not address the underlying cause of weakness in the economy.  From Jim Jubak, “Let’s Play Global Currency Wars”

But as effective as a weaker yen might be in the short term in increasing exports by Japan-based manufacturers and at increasing the profits at these companies, it does nothing to address the structural problems in Japan's economy or the country's long-term demographic challenge.

Creating Jobs Is Not an End in Itself

From Peter Schiff, on using competitive currency devaluations to weaken a country’s currency so as to provide jobs for local citizens:

The problem is that economists now believe that the goal of an economy is to provide employment, not goods and services. They see a job as an end in and of itself, rather than as a means for people to get the things they really want.

From Stratfor, “Creating a Chinese Consumer Base”, on how China’s extremely low wages, which precluded domestic consumption by workers, was acknowledged “as an acceptable temporary price to pay for an otherwise successful economic model”:

Sustained competitiveness in exports meant two things for Beijing: capital inflows (in the form of trade surpluses with China's major export partners, as well as savings deposits from coastal workers) and employment. Continued expansion of the export sector provided more room to absorb surplus labor from the interior, while the unending flow of cheap, young labor from the interior guaranteed continued growth and competitiveness in the export sector. Declining average household consumption expenditure (as a reflection of low wages, high savings and abundant labor) was seen as an acceptable temporary price to pay for an otherwise successful economic model. That model served a concrete economic end -- the accumulation of capital by the state -- and enabled Beijing to maintain its promise of employment and a modicum of prosperity to the Chinese people…

Lessons from Past Currency Wars

From “Lesson from the 1930s Currency Wars” by Tyler Durden

Lesson 1: As in every crisis, events were and will always be highly non-linear, with domestic conditions the most likely cause: It was painfully high unemployment that was the main driver of the devaluation of sterling. Although unemployment had been painfully high for a while, it was only a few months prior to the devaluation that market fear really ratcheted up.

Lesson 2: Markets punish policy uncertainty: Needless to say, there were dramatic movements in the exchange rate of the countries that devalued. However, with the devaluation out of the way, market and economic pressure as well as policy uncertainty shifted to the ‘gold bloc’ economies. For investors, it became a matter of when, rather than whether, the gold bloc economies would be forced to respond.

Lesson 3: Early movers benefited at the expense of the gold bloc, a ‘beggar-thy-neighbor’ outcome: From an economic standpoint, the sharp improvement in competitiveness of the early movers stood them in good stead against the gold bloc economies who stuck to the regime.

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