Why countries are clashing over their currency prices?

Monday, 29 November 2010 00:01 -     - {{hitsCtrl.values.hits}}

This month’s G-20 meeting of industrialised countries was rife with talk of potential “currency wars,” in which states try to devalue their currencies to help their economies. While a central tension is the United States’ unhappiness with China’s undervalued yuan, the issue is really hydra-headed: One country’s actions can create many reactions globally.

Currency policies are a particularly hot topic because the United States can no longer try two traditional remedies for a sluggish economy: government spending, because the political tide has turned against it, and lower short-term interest rates, because they’re already effectively at zero.

As a result, this month the Federal Reserve announced a new round of quantitative easing, in which the government puts cash into circulation by buying back its own bonds. Intended to encourage business activity, the move could also drive down the dollar. But that should actually boost the U.S. economy: a weaker dollar would make U.S. products more affordable globally, increasing U.S. exports, income and employment.

Because the Chinese yuan is undervalued, as a July report by the International Monetary Fund concluded, it allows China to be a net exporter of goods. Experts believe that China’s government engineers this by using yuan to buy foreign currencies; this puts more yuan in circulation and keeps down their value. In June, China announced it was resuming a “flexible” currency policy, letting the yuan float on world markets, as the dollar does; but the yuan has barely risen since then. Meanwhile, a potentially weaker dollar affects the United States’ interactions with many other countries.

After all, a lower dollar hurts exports from Europe, too. “If the euro starts to appreciate relative to the dollar, it is more difficult for Germany and the other Euro-Zone countries to compete in world markets,” says David Singer, an associate professor of political science at MIT, who has written about the political dimension of exchange rates. German officials have already lambasted the new round of U.S. quantitative easing. “It’s inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money,” said German finance minister Wolfgang Schauble.

American policies also affect developing countries, especially in South America and Asia. The low interest rates in the U.S., and low returns on U.S. bonds, mean that investors looking for better opportunities have been pouring money into emerging markets, which are generally growing faster than advanced economies. But investors must make purchases — whether for stocks, bonds or real estate — in local currencies. That increases demand for those currencies, raising their values and making it harder for the issuing countries to export goods, slowing their growth.

Officials in developing countries dislike a declining dollar; it was Brazil’s finance minister, Guido Mantega, who declared in September that an “international currency war” was breaking out. “These countries with emerging markets are also trying to adjust to the global economic contraction,” notes Singer. "They want competitive exports, and they’re seeing the value of their currencies appreciating with all this capital flowing in.”

Some developing countries combat demand for their currencies by imposing capital controls, such as taxes on bonds, on foreign investment. But why don’t all emerging-market countries intervene directly in currency markets, like China? A few countries do, actually. But printing more currency to sell on exchange markets has a potential downside: inflation.

 “Inflation is the tradeoff that the Chinese face in keeping their currency artificially depreciated,” says Singer. However, the Chinese government has more political insulation from the consequences of inflation than their counterparts in democratic countries, he adds. “Most of the Latin American countries have histories of bad bouts with inflation. They know it can bring down a government and wipe out middle-class savings.” Those countries, as well as the U.S., Germany and some other European states, are “more wary of inflation than are some of the Asian countries.” So they tend not to print money to lower their currency values.

How the currency disputes will unfold is hard to forecast. But they do make clear how international tensions can arise when states seek to protect their own interests in a deeply globalized economy.


Defining recessions

It’s not what conventional wisdom holds, as an MIT economist — who heads the bureau charged with identifying U.S. downturns — makes clear.

The recent recession, the longest since The Great Depression, lasted from December 2007 until June 2009, according to a 20 September announcement from the National Bureau of Economic Research (NBER), the pre-eminent group calibrating the duration and depth of U.S. downturns. The way the NBER renders such verdicts, however, is often overlooked.

Recessions are commonly said to occur when an economy contracts for at least two consecutive quarters, in terms of real Gross Domestic Product.  

While that may be a good rule of thumb, the genuine NBER definition of a recession does not hinge solely on GDP, but instead identifies “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales,” as a bureau fact sheet stated. Moreover, the bureau calculates economic activity based on monthly statistics, not just quarterly figures. This approach is used in other countries as well; Statistics Canada, the Canadian statistical agency, uses a similar methodology.

By using several metrics, not just real GDP, and by dating recessions in months, not quarters, the NBER is better able to assess the full complexity of the country’s economic ups and downs. “Two consecutive quarters of very modest declines in real output might not constitute a significant decline in economic activity — but the popular rule would indicate that they represented a recession,” noted James Poterba, MIT’s Mitsui Professor of Economics, and the current president of the NBER. Conversely, Poterba explained, “A period of alternating sharp quarterly declines and very modest upturns, however, would not meet the ‘two-quarter’ test, but might represent a significant and long-lasting decline in economic activity.”

Indeed, some recessions do not include two consecutive quarters of real GDP decline: The downturn lasting from March 2001 until November 2001, which the NBER considers a recession, never had more than one formal quarter of contraction in a row. The monthly statistics also allow the bureau to paint economic history in sharp relief. The Great Depression, as the NBER sees it, consisted of a 43-month downturn from August 1929 to March 1933, followed by a 13-month slump from May 1937 to June 1938. The most recent recession lasted 18 months.

In evaluating the nuances of the economy’s recent path, the NBER dated the start of the recession to December 2007 even though GDP actually rose slightly into early 2008. But employment peaked in December 2007, which, among other factors, helped guide the NBER’s evaluation.

Before pinpointing the end of the recession, the bureau weighed 10 separate metrics, including multiple estimates of monthly GDP; Gross Domestic Income (GDI) and a related but separate measure known as real personal income; manufacturing and trade sales; and three different employment estimates. Five of the 10 indicators bottomed out in June 2009, and the NBER decided that the bulk of the evidence was sufficient to show that the economy began recovering after that month.

The NBER’s definition of a recession thus involves a more deliberative process, when it comes to identifying substantial downturns, than conventional wisdom implies. The bureau’s eight-person Business Cycle Dating Committee, comprised of leading macroeconomists, meets at periodic intervals (in person or by conference call) to discuss the data. In April 2010, the committee met and decided the data was too fuzzy to warrant a verdict. This month, the verdict was clear — although as Poterba noted, that hardly means the NBER is saying the economic situation is rosy.

 “Today, 15 months after the economy began a slow recovery, unemployment remains far higher than its historical average, which suggests that there are still substantial underutilised resources in our economy,” said Poterba, responding to questions by e-mail. “It is possible for the economy to be on a slowly improving trajectory, as it has been since June 2009, even when the unemployment rate is well above its historical average. The key distinction is between the level of economic activity and its rate of change — the rate of change can be positive, but the level can be low, which is the current situation.”