Currency Wars the Great Destabilizer
By: Professor Steve Hanke
Dr.
Karl Schiller, West Germany’s Economics Minister between 1966 and 1972,
pithily pronounced that: “Stability is not everything, but without
stability, everything is nothing.” I agree. In the economic sphere,
instability is usually a “bad”, not a “good”.
The
world’s great destabilizer is the United States. How could this be? In
the post-World War II era, the world has been on a U.S. dollar standard.
Accordingly, the U.S. Federal Reserve is the de facto central banker
for the world.
But
you would never know it by looking at the statements and actions of the
Fed. Indeed, the world’s central bank functions, for the most part, as
if it is operating in a closed economy – one in which the rest of the
world doesn’t exist. The Fed’s disregard for the rest of the world
results in policies that send huge hot money flows to and fro. These
flows create an enormous amount of instability – a “bad”, not a “good”.
Prof.
Ronald McKinnon captured this picture in his most recent edifying book:
The Unloved Dollar Standard: From Bretton Woods to the Rise of China
(Oxford University Press, 2012). In addition to identifying the U.S. as
the great destabilizer in the international monetary system, Prof.
McKinnon shows why China has been a major stabilizing force. China has
injected stability into the international sphere by smartly, and
ironically, linking the Chinese yuan (more or less tightly) to the U.S.
dollar since 1995. China has coupled this yuan-dollar currency link with
a successful counter-cyclical financial policy. Whenever there has been
a potential bump in the road (read: slowdown), China has expanded bank
money and the economy has sailed over the bumps. In consequence, since
1995, the annual rate of real GDP growth in China has ranged from a low
of 7.6% (1999) to a high of 14.2% (2007) – the greatest boom in world
history.
We have
recently witnessed a changing of the guard at the Fed. Prof. Janet
Yellen has just taken over the reins from Prof. Ben Bernanke. Will
policies change? In her initial testimony before the U.S. Congress,
Prof. Yellen went out of her way to indicate that she was going to
follow in the footsteps of her predecessor. Like Prof. Bernanke, the
unspoken Fed mantra will be a closed economy. No doubt, Prof. Yellen
will not change Bernanke’s dashboard to include what is arguably the
most important price in the world: the USD/EUR exchange rate (or any
other exchange rate for that matter).
Yes,
the Fed will stay lashed to a totally unrealistic (read: wrong) closed
economy model. And, yes, the Fed will continue to ignore the obvious:
that by manipulating interest rates, it fuels great hot money flows
which create boom-bust cycles throughout the world.
If
that wasn’t bad enough, it appears that Prof. Yellen will tighten the
regulatory vise on the banking system even more tightly than Prof.
Bernanke did. Prof. Yellen has indicated that she favors higher
risk-based capital ratios, higher leveraged-based capital ratios and
higher liquidity ratios for banks. In short, she embraces regulatory
changes that will force banks to continue to deleverage.
Since
about 80% of the nation’s money supply (M4) is produced by banks, this
means that the money supply will remain tight. Recall that the Divisia
M4 measure of money, which is computed by the Center for Financial
Stability, is only growing at a paltry year over year rate of 2.0%
(December 2013). Such a tight monetary stance in the face of economic
weakness amounts to a wrong headed pro-cyclical approach.
Prof.
Yellen’s monetary stance is not only wrongheaded but schizophrenic.
When it comes to the big elephant in the room – bank money – she is very
tight. But, when it comes to state money produced by the Fed, she is
loose.
One thing
Prof. Yellen was clear about in her maiden voyage to Capitol Hill as
leader of the Fed was that the Fed bore no responsibility for the
boom-bust cycles in emerging markets. Indeed, she didn’t venture into
the debate about the so-called currency wars. These are ably handled in a
chapter, “Currency Wars”, in Prof. Eswar Prasad’s new book The Dollar
Trap: How the U.S. Dollar Tightened It’s Grip on Global Finance
(Princeton University Press, 2014). The so-called currency wars erupt
when the Fed artificially pushes interest rates to levels below what
would be their market or natural levels. In search for yield, the hot
money flows to higher risk, higher interest-rate environs. This tends to
strengthen the local currencies relative to the greenback. It also adds
to the recipient countries’ foreign exchange reserves and boosts their
domestic money supplies. Asset booms and inflationary pressures follow.
It was exactly this sequence that prompted Brazil’s Finance Minister
Guido Mantega to pronounce on 27 September 2010 that “We are in the
midst of an international currency war …”. The same sentiments were
echoed in November 2010 by China’s Vice Finance Minister Zhu Guangyao,
when he stated that the U.S. “has not fully taken into consideration the
shock of excessive capital flows to the financial stability of emerging
markets.”
The
Fed-facilitated hot money flows and associated troubles they create are,
of course, thrown into reverse when the Fed starts to tighten up.
Countries that embrace sound economic policies mitigate the damage that
can be thrown up by destabilizing hot money flows. This conclusion has
been most recently reached in studies by the Organization for Economic
Cooperation and Development in Paris. In short, the best mitigation
protection is a combination of balanced budgets, low debt levels and
free-market institutions.
Since
last summer, Argentina and Venezuela have been in economic intensive
care wards. My Johns Hopkins – Cato Institute Troubled Currencies
Project estimates that the annual implied inflation rate in Venezuela is
306% – over five times the official inflation rate. And Argentina’s is
64%. That’s more than double estimates made by private observers in
Buenos Aires. But that’s only one indicator of an economic malfunction.
The
World Bank produces an annual report that paints a pretty good picture
of a country’s vulnerability to shocks – like hot money flows. The World
Bank’s Doing Business 2014 report calculates the ease of doing business
and ranks 189 countries by making careful measurements of the following
items: starting a business, dealing with construction permits, getting
electricity, registering property, getting credit, protecting investors,
paying taxes, trading across borders, enforcing contracts and resolving
insolvency (see the accompanying table).
World Bank Doing Business Rankings
|
|
|
|
|
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Venezuela
|
Argentina
|
Indonesia
|
Brazil
|
Turkey
|
2013
|
180
|
121
|
116
|
118
|
72
|
2014
|
181
|
126
|
120
|
116
|
69
|
Source: The World Bank, Doing Business 2014, Economy Rankings. Prepared by: Steve H. Hanke, The Johns Hopkins University
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Not
surprisingly, Venezuela is a bottom feeder. Indeed, even Zimbabwe has a
higher score. Argentina is also weak and becoming weaker. As for
Brazil, the first country to complain about hot money flows; it’s weak
and vulnerable, according to the World Bank’s ease of doing business
metric. Indonesia, another country that has been under pressure since
last summer, is also vulnerable. Turkey, too, has been under the gun,
with the Turkish lira putting in one of the world’s worst performances
in 2013. What characterizes all five of these countries is the fact that
they failed to make hay (read: reform) when the sun shined (read: the
hot money flowed in). In consequence, they are all vulnerable, in
varying degrees, to the current hot money outflows.
Some
people think this state of international monetary affairs will be
solved by digital currencies – like Bitcoins. These are private
currencies passed directly between two people without the need for a
trusted third party. So, even though electronic, they resemble
banknotes. While private digital currencies may yet have their day in
the sun (read: in the international financial system), it won’t be
tomorrow. As the accompanying chart shows, Bitcoin is a highly volatile
speculative asset. It’s missing a necessary ingredient required to push
the U.S. Dollar aside: stability.
What
to do? The world’s two most important currencies, the dollar and the
euro – should, via formal agreement, trade in a zone ($1.20-$1.40 to the
euro, for example). The European Central Bank would be obliged to
maintain this zone of stability by defending a weak dollar and the Fed
would be obliged to defend a weak euro.
The
East Asian dollar bloc, which was torpedoed during the 2003 Dubai
Summit, should then return – with the yuan and other Asian currencies
tightly linked to the greenback. As for other countries (Argentina,
Brazil, and Venezuela, for example), they should adopt currency boards
linked to either the dollar or euro, or, they should simply adopt the
greenback or the euro.
Let’s
put an end to the “currency wars”. When it comes to exchange rates,
stability might not be everything, but everything is nothing without
stability.
By Steve H. Hanke
Twitter: @Steve_Hanke
Steve
H. Hanke is a Professor of Applied Economics and Co-Director of the
Institute for Applied Economics, Global Health, and the Study of
Business Enterprise at The Johns Hopkins University in Baltimore. Prof.
Hanke is also a Senior Fellow at the Cato Institute in Washington, D.C.;
a Distinguished Professor at the Universitas Pelita Harapan in Jakarta,
Indonesia; a Senior Advisor at the Renmin University of China’s
International Monetary Research Institute in Beijing; a Special
Counselor to the Center for Financial Stability in New York; a member of
the National Bank of Kuwait’s International Advisory Board (chaired by
Sir John Major); a member of the Financial Advisory Council of the
United Arab Emirates; and a contributing editor at Globe Asia Magazine.
