Seen by many as a major contributor to the 1930s Great Depression, competitive currency devaluations have long been viewed in a poor light. Recently, these worries have resurfaced as the new Japanese government appears poised to stimulate its national economy partly at the expense of its trading partners. The yen has fallen in value against leading currencies, prompting criticism from French, German, and other foreign policymakers. Is the world on the brink on another 1930s debacle? Probably not — circumstances differ now.
It is worth remembering that the 1930s competitive currency devaluations had other adverse knock-on effects. Compelling analysis has shown that in the 1930s, those countries that did not follow others in devaluing their currencies — or followed later —tended to resort more aggressively to tariff hikes and other forms of protectionism. So currency devaluations not only begot copycat behaviour, but also other forms of beggar-thy-neighbour behaviour, both of which have the effect of fragmenting global markets and setting back the cause of free trade. Plenty, then, is at stake.
This time around, matters might be different for two reasons. The first is that spread of international supply chains means that countries which import lots of parts of components — like Japan — find that many of their exporters’ cost competitiveness worsens as their currency devalues. In the past, when far fewer parts and raw materials were imported, the presumption was that currency devaluations improved national export performance and put imported final goods under pressure. Nowadays, the impact of currency changes on a country’s trade balance is less clear-cut, as simulations have shown. Policymakers in Tokyo should not expect that yen depreciation would have the same impact on net exports as it might have had in the past.
Incidentally, the above argument cuts both ways: exporters in countries that are experiencing currency appreciations will face lower costs for their imported parts and components, offsetting the pressure to raise prices in foreign markets. In effect, such exporters are hedged — at least partially, and sometimes fully — against currency changes. Recent research has shown the impact that such natural hedging has cushioned the impact on exports of nations facing sharp currency appreciations.
The political significance of natural hedging — that arises from the spread of international supply chains — is that exporters aren’t harmed as much by foreign currency devaluations as before and so are less likely to encourage their governments to retaliate. Japanese yen devaluation, then, poses less of a threat to the recovery of its trading partners than in the past, contrary to this week’s assertions by president Hollande in the European parliament.
Another overlooked factor that differentiates now from the 1930s is that governments today are less likely to resort to the more blatant forms of protectionism. For sure, there have been some tariff hikes and plenty of “unfair” trade suits, but few governments have raised tariffs across the board in recent years — despite in many cases having plenty of leeway to do so under their WTO obligations. Instead governments — in rich countries and the large emerging markets — have eased the financial pressures of their firms through bailouts and other cash infusions. While most of the headline-grabbing bailouts are in the financial sector, a large amount of additional financial support given to manufacturers, farmers and non-service sector firms has gone largely unnoticed. Even when governments have been cutting their own budgets — so limiting direct payments from public coffers — financial support has been extended to firms through pliable national banking systems. The indirect and non-transparent nature of bank-driven financial support is another feature that appeals to politicians who don’t want to be seen to be abandoning the “level playing field.”
The upshot is that this time around, governments need not respond to foreign currency manipulation by copycat behaviour or by erecting trade barriers. Instead, any pleas for support for domestic firms can be pretty effectively hidden through financial infusions of one type of the other. Like tariffs, bailouts distort market forces, but in different ways. If Japan’s currency devaluation doesn’t trigger a currency war or protectionism, then that doesn’t mean that other governments have eschewed beggar-thy-neighbour policies — pressures for state action is likely to manifest itself in other forms of more murkier intervention. Politically this is very convenient for Japan’s trading partners as they can condemn Japan for its naked currency appreciation while responding in far less transparent, but still beggar-thy-neighbour manner. Such is the nature of 21st century foreign economic policymaking.
While these considerations tend to downplay the likelihood that any devaluation of the Japanese yen is likely to trigger overt retaliation, it has to be admitted that competitive devaluations touch upon raw nerves and the risk that a war of words degenerates into something worse, cannot be ruled out entirely. Still, there are good reasons to believe that a re-run of the 1930s is not on the cards.
Also published in the Financial Chronicle, February 10, 2013.
