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By Root 840 0

currency war had begun. Of course, the events and pressures that gave rise to Mantega’s declaration were not new or unknown to these elites. International tension on exchange rate policy and, by extension, interest rates and fiscal policy had been building even before the depression that began in late 2007. China had been repeatedly accused by its major trading partners of manipulating its currency, the yuan, to an artificially low level and of accumulating excess reserves of U.S. Treasury debt in the process. The Panic of 2008, however, cast the exchange rate disputes in a new light. Suddenly, instead of expanding, the economic pie began to shrink and countries formerly content with their share of a growing pie began to fight over the crumbs.

Despite the obvious global financial pressures that had built up by 2010, it was still considered taboo in elite circles to mention currency wars. Instead international monetary experts used phrases like “rebalancing” and “adjustment” to describe their efforts to realign exchange rates to achieve what were thought by some to be desired goals. Employing euphemisms did not abate the tension in the system.

At the heart of every currency war is a paradox. While currency wars are fought internationally, they are driven by domestic distress. Currency wars begin in an atmosphere of insufficient internal growth. The country that starts down this road typically finds itself with high unemployment, low or declining growth, a weak banking sector and deteriorating public finances. In these circumstances it is difficult to generate growth through purely internal means and the promotion of exports through a devalued currency becomes the growth engine of last resort. To see why, it is useful to recall the four basic components of growth in gross domestic product, GDP. These components are consumption (C), investment (I), government spending (G) and net exports, consisting of exports (X) minus imports (M). This overall growth definition is expressed in the following equation:

GDP = C + I + G + (X − M)

An economy that is in distress will find that consumption (C) is either stagnant or in decline because of unemployment, an excessive debt burden or both. Investment (I) in business plant and equipment and housing is measured independently of consumption but is nevertheless tied closely to it. A business will not invest in expanded capacity unless it expects consumers to buy the output either immediately or in the near future. Thus, when consumption lags, business investment tends to lag also. Government spending (G) can be expanded independently when consumption and investment are weak. Indeed, this is exactly what Keynesian-style economics recommends in order to keep an economy growing even when individuals and businesses move to the sidelines. The problem is that governments rely on taxes or borrowing to increase spending in a recession and voters are often unwilling to support either at a time when the burden of taxation is already high and citizens are tightening their own belts. In democracies, there are serious political constraints on the ability of governments to increase government spending in times of economic hardship even if some economists recommend exactly that.

In an economy where individuals and businesses will not expand and where government spending is constrained, the only remaining way to grow the economy is to increase net exports (X − M) and the fastest, easiest way to do that is to cheapen one’s currency. An example makes the point. Assume a German car is priced in euros at €30,000. Further assume that €1 = $1.40. This means that the dollar price of the German car is $42,000 (i.e., €30,000 × $1.40/€1 = $42,000). Next assume the euro declines to $1.10. Now the same €30,000 car when priced in dollars will cost only $33,000 (i.e., €30,000 × $1.10/€1 = $33,000). This drop in the dollar price from $42,000 to $33,000 means that the car will be much more attractive to U.S. buyers and will sell correspondingly more units. The revenue to the German manufacturer of €30,000 per car