Friday, October 22, 2010

A note on QE2 and the looming "currency war"

According to Brazil's finance minister, and almost every major US news source, a currency war is here or is at least imminent.

The US Fed is about to release QE2 which means that, among the won, twd and yen, more US dollars will soon be floating around the world. What is the cause for concern, and what could turn this into a war?

Firstly to prevent any sillyness (volitility = bad) between the G3 nations, the respective central banks ought to coordinate. Yes, coordination is the name of the game. If they do not coordinate, volatile currencies will disrupt economies further and protective tariffs could be slapped up all over the place. (China already slapped one on US poultry.) This is what they mean by war.

To avoid catastrophe, everyone (BOJ, ECB and Fed) should let it be know exactly what policies they will pursue so currencies can move together and we can all happily export to each other! It is a well documented point that coordinated policies have huge spillover effects and are therefore much more effective.

A cheaper currency means cheaper exports from the G3, it is akin to an export subsidy. This is good for the G3 but bad for everyone else. Should everyone else start launching attacks, i.e. start interfering in the currency market?

Countries that allow their currencies to appreciate with respect to the G3 currencies will endure the exact opposite of a subsidy. Their exports will become more expensive on the world market and their economies will suffer. This could provoke tariff wars.

Countries that follow the G3 down run a serious risk of over-heating (inflation, asset bubbles etc.), an equally disruptive result. With the new appetite for emerging markets since the crisis and more money floating around the globe, many countries are in danger of running a bubbly economy.

So what should they do? Well, it's a tough situation. At the very least, a little industrial policy could help. Nations should to protect their key manufacturing sectors by propping up domestic demand for them, and bow quietly out of the war.

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