Yesterday in The Economist, there was an interesting article arguing in favor of currency interventions: Monetary Policy: Beggar, then Sneakily Enrich, Thy Neighbor.
The basic thrust of the author’s position is that Asian currency interventions will create inflationary pressures, which would allow world economies to slowly escape recession. Currency interventions are also favorably compared to eliminating the gold standard during the Great Depression.
Unfortunately, the author might be missing the underlying reason why the elimination of the gold standard allowed for economic recovery in the Depression. Instead, the currency interventions might be better compared to the disastrous Smoot-Hawley Tariff Act in the United States.
It wasn’t merely that the elimination of the gold standard created inflation. The underlying issue was that the gold standard created arbitrary and inflexible monetary policy during the Depression. By doing this, it prevented market forces from operating and money supply was artificially suppressed. As money supply was distorted, the market was deterred from reaching an optimal growth result.
There were only two ways to fix the imbalance: (a) discover a large amount of new gold deposits and mine them or (b) eliminate the gold standard. As gold is a scarce good and world population was rapidly rising in the late 19th and early 20th Centuries, (a) was becoming an increasingly difficult proposition. For this reason, elimination of the gold standard was the only real solution. And it worked magnificently, as every economy that eliminated the gold standard was able to greatly ease the Depression. In fact, China, which was on the silver standard, was almost able to miss the Depression entirely.
The current situation has a lot of parallels, unfortunately. Mercantilistic currency interventions artificially constrain money supply, just like the gold standard did during the Depression. More importantly, the interventions fuel large trade imbalances.
It's not simply a matter of "creating inflation" in one nation --- the issue runs much deeper than that. By not allowing market forces to operate, some nations run massive current account surpluses (e.g. Japan, China) while others run massive current account deficits (e.g. US, UK, Spain).
Essentially, we're cheating the free market. It doesn't matter if an American or Spanish firm can more efficiently manufacture widgets than a Japanese or Chinese firm --- by intervening in the currency markets, it is arbitrarily dictated that the Japanese or Chinese firm wins out. However, the issue with this is that it produces inefficiencies. It might even be creating negative growth because more efficient firms are being pushed out of the market in favor of more inefficient firms.
On the other side of the equation, the currency interventions are actively harming Asian consumers. While these interventions can help create GDP growth, they do so at the expense of Asian wage-workers. Wealth is redistributed primarily to two groups: (a) American consumers and (b) the owners of capital of Chinese and/or Japanese exporters.
Or in other words, these currency interventions create over-consumption in the US and under-consumption in East Asia. Equilibrium is not allowed to occur and sub-optimal growth (or even economic contraction) results as economic efficiencies are destroyed.
Just to make things worse, the constant tug of war between market forces and the interventions creates greater economic instability that produces huge bubbles and busts. While Alan Greenspan and Congress should be given some credit for helping to create the housing bubble in the US, Chinese currency policy also deserves its share of the blame, as the constant currency interventions artificially lowered interest rates in America, helping provide more fuel to the housing boom.
It's worth noting that in spite of Chinese and Japanese currency interventions, both nations have eventually run into a brick wall where they have deprived their consumers of so much of their 'earnings', that they simply cannot afford it any more. This is happening in China right now, as Chinese workers are forced to demand greater compensation in order to deal with rising costs-of-living It also appeared to occur in Japan in the mid-80’s before the Plaza Accord, as Japanese economic growth had been waning after a nearly three-decade long boom.
For these reasons, the currency interventions might be more like the Smoot-Hawley Tariff than the elimination of the gold standard. Smoot-Hawley attempted to fix global trade imbalances by promoting trade barriers that created more imbalances. Inevitably, European nations retaliated against the United States and the tariff only exacerbated the crisis.
While currency interventions have a different economic effect, the end result is the same: economic efficiencies are deterred and sub-optimal growth becomes more likely. Until the international currency system is reformed and these mercantilistic trade wars in Asia are eliminated, we may continue to see a poor worldwide economic environment.
Disclosure: No positions in any currencies or national ETFs.
About the author: H.J. Huneycutt
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