Andrew Wilkow and I discussed currency wars on his radio show Friday. I received a couple of emails asking for more on how a currency war could affect the U.S., so I decided to post more info here.
Last month Japan’s central bank started buying Japanese bonds to devalue the yen; as with most devaluation schemes, they claim the intent is only to prevent deflation. In terms of currency exchange, the effect is already being felt. Compared to the dollar, the yen has declined about 10% since December, making anything produced in Japan 10% cheaper in the U.S. and American goods 10% more expensive in Japan. The Japanese are attempting to gain a comparative advantage in terms of production costs, and they will enjoy one in the short term if other countries don’t match them. Although the benefits of devaluation come with long term costs, Keynesians focus on the short term. Because most countries are run by Keynesians, its likely that others will counter the move in Japan, potentially igniting a currency war.
Left-leaning economists like Paul Krugman have made the case for a weak dollar for years, arguing that it boosts exports and deters imports. As with most Keynesian schemes, however, this argument is fraught with several problems:
- A weak dollar only makes exports less expensive when they are denominated in other currencies. About half of U.S. exports are denominated in U.S. dollars or currencies like the Chinese yuan tied to the U.S. dollar, so the effect on costs of these exports would be limited.
- A weak dollar is inflationary because imports cost more, thereby reducing real spending power. It resembles an indirect tax on Americans because their dollars won’t go as far in the marketplace.
- A weak dollar makes the U.S. currency less attractive and encourages U.S. and foreign investors to invest outside of the U.S. Remember, foreigners are funding much of our $16+ trillion debt. If we have to raise interest rates to attract foreign investors, our budget deficit will skyrocket. A 1% increase in interest paid on the debt would cost an additional $16+ billion annually.
- Strong economies compete more on quality and less on price/cost anyway, the logic behind promoting exports by cutting costs is questionable.
- Even if there are advantages to a weak dollar, there is no reason to believe that other countries will allow us to benefit at their expense.
China is already retaliating to Japan and other nations seem to be following suit. If the U.S. gets involved in the fray, then we’ll have a full blown currency war with most economies attempting to weaken the relative value of their currencies. Because such attempts tend to cancel each other out, a global currency war would yield no significant cost advantage to any country and would ultimately have the same effect as a coordinated global currency devaluation. Some economists might like to see this occur, as it serves as an huge indirect tax and would lessen the value of government debt at the expense of cash holdings, including those at corporations and in retirement accounts. I’m convinced Obama wouldn’t mind it either.
This could be a serious problem, but–like many others–it’s only getting back page coverage in the mainstream media.