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Currency Wars

Mises Daily: Thursday, January 22, 2004 by

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We have seen the temperature rise along the corridors of power in recent days as finance ministers, central bankers, and others have clamored to have their say on the current disruption in international capital and goods markets. This disruption has its roots in America's Military Keynesianism and the Asian Mercantilist response it has elicited.

For example, much has been made of the fact that ECB chief Jean-Claude Trichet—Chairman of the central banker's cabal, the Group of Ten—said, somewhat tautologously, that "excessive volatility" and "brutal moves" in currencies were "inappropriate."

Undoubtedly, some Euro politicians are keen to go a step further and secure an agreement on a schedule of joint interventions at February's G7 meeting, but it seems highly unlikely that Karl Rove would act to annoy the domestic industrial lobby in an election year, or that the US neocons would cooperate to alleviate any Gallic misfortune.

Rather, Trichet seems to be offering a coded warning that while the central banks will not give the markets a definite target at which to aim, dollar bears—who have only learned to scorn all the Bank of Japan's billions this year—should not reckon on an uninterrupted reign, especially if the dollar's decline becomes, in a buzzword, "disorderly."

Indeed, Trichet's replacement at the Banque de France and former ECB VP, Christian Noyer, largely confirmed this view when he told France 2 TV:  "We shouldn't over-dramatize this problem with the dollar. If you ask an American what a dollar is worth, he will say it's worth a dollar. In the same way, we Europeans must say that a euro is worth a euro."

He went on to add that it was "true that very sudden moves between the biggest currencies are never good for global growth" before he obliquely blamed Washington with his injunction that "all those concerned need to ensure, as far as they can, the maximum stability between currencies, by having well-conducted monetary policy for central banks and budget policy for governments."

In fact, Noyer received a little unexpected support from Japanese Finance Minister Sadakazu Tanigaki, who—in a rare display of backbone when dealing with the occupying power—told a Tokyo press conference, "We will have to ask the US to do something about its twin deficits," since these have been "cited as a source of concern in the currency markets."

Asked if the ECB would buy dollars to halt the euro's gains, Noyer responded half-heartedly that "intervention is something that's always available as a policy tool for the central bank," but this was, naturally, "never announced in advance."

Though calls for "something to be done" grow increasingly vociferous, Italian European Union Affairs Minister Rocco Buttiglione echoed the views of many in blending a note of resignation on the chances of meaningful success through foreign exchange manipulation with a call for an offsetting rate cut:  "What effect do interventions to sell currencies have? Can they really stop such a strong market trend? I don't think so." … "[But] we have interest rates that are significantly higher than those of the dollar. Lower interest rates wouldn't hurt, especially in a moment like this one."

Dealing with just this point, Noyer limited himself to observing that "The ECB's interest-rate policy is never decided by one thing alone, such as the exchange rate."

Though politics may yet trump sound economics on this issue, the Europeans know they are being blackmailed by the US into pursuing dangerously loose monetary policy (to add to the loose fiscal policies already being practiced by some of their governments).

Thus it has ever been, from the 1944 Bretton Woods agreement through the numerical mish-mash of G-5s, 7s, 8s, 10s and 20s and so on (note the inflation at work here, too!) in the floating exchange rate era that has held since 1973.

The biggest global spendthrift—usually the US—always expects his creditors to cut their own pockets so he can settle his bills with the coins falling out of them.

To see what the ECB really thinks of this, listen to what its Chief Economist, former Bundesbank bruiser Otmar Issing told VWD, a major German newswire:  "The best contribution the Euro Zone could make in lessening world imbalances is to foster durable and inflation-free economic growth."

Issing cautioned that the G-7-Finance ministers and central bank governors should not "consider creating an artificial bubble of demand through expansive financial and monetary policy," for, "from such a momentary flame, little can be expected but more inflation."

Indeed, he went on, the world economy already has "sufficient bad experience of such initiatives," most notably in late 1980s Japan where "the wrong policy was pursued and the bubble only strengthened, from the consequences of which—the ensuing collapse of both property and equity markets—the Japanese economy suffers to this day."

This is a lesson completely lost on today's Fed.

Greenspan was at his smug, infuriating best recently in arguing that the US external deficits were not yet a problem, as there is "little evidence of stress in funding U.S. current account deficits" partly because inflation, "the typical symptom of a weak currency, appears quiescent."

Hmmm. With export prices now rising at their fastest in over eight years; with core crude PPI up by a third in just two years; with unfinished import prices up 20% in that time; and with finished import prices up 6.7% annualized since the start of spring—again, nearly a 9-year high—that quiescence must be limited to the registers to which Greenspan chooses to listen.

And with his usual circularity in relying for justification on signals generated by the actions of those very same financial market participants who can frequently either be misled by, or can choose to exploit, the Fed's own prior willfulness, Greenspan can hear no Cassandras warning of the Greeks inside the Horse:

"Inflation premiums embedded in long-term interest rates apparently have fluctuated in a relatively narrow range since early 2002. More generally, the vast savings transfer has occurred without measurable disruption to the balance of international finance . . . credit risk spreads have fallen, and equity prices have risen, throughout much of the global economy."

Adding another two cents' worth, his colleague Mark Olson—equally sanguine about events overall—also displayed a hint of cynicism when he noted that the US owed so much, it would never have to pay up (or words to that effect). As Reuters reported it:

"[Olson] saw no problem with relying on foreign investors for its finance. 'There's always some risk there, but if seems to us that it is not a significant risk,' he said, noting that China and Japan rely heavily on U.S. debt instruments. 'It doesn't seem to us that that is an immediate threat.'"

Even the normally level-headed Cleveland Fed President, Susan Pianalto, displayed a similar level of insouciance, remarking, "Given a broad measure of the dollar's movement, it's declined by about 14 percent since its peak. There have been larger declines. So far the depreciation has been orderly. It's difficult to know why the dollar is depreciating."

There are one or two people who can clue you in as to why, Susan, if you really can't work it out for yourself!

But if Europe is the region feeling most of the strain of Washington's inflationary blackmail, are there at least any prospects that the Americans might do less harm than good, at least domestically, and so give the lie to Issing's admonitions to them?

To see what we think of this, let us bring two disparate quotes together and draw what seems the inescapable conclusion from them.

First, Ms. Pianalto:  "We are in the third year of an economic recovery, but the lack of employment growth has made this a very unusual recovery. Unfortunately, employment growth in this phase of the current cycle is the slowest in 50 years, a situation that remains something of a puzzle. Businesses often require some time to restructure their operations to take advantage of new technologies. In the process, we may find that there is a mismatch between the skills required by sectors of the economy that are growing and the skills of our current labor force. The very slow growth in employment that we are seeing could be indicative of this type of restructuring, even while other indicators of economic activity appear satisfactory."

Then this from South Korea, where the world's fourth largest steel maker, Posco, was sharing its outlook for 2004 and was warning that operating profits might only rise by around 4% this year, in contrast to last year's 67%.

But how can this be? If world demand for steel is stronger and prices are rising as a result, why is profit growth likely to be so meager?

Because, as Posco Chairman Lee Ku Taek told analysts and investors: "What matters for steelmakers this year will be how to secure enough raw material rather than how much more they have to pay for it. There may be some Chinese steelmakers that will be forced to stop operations after failing to secure raw material."

The two inferences to be drawn from this are first, as Pianalto correctly points out, if there is a mismatch between the skills available in the labor market and the ability to satisfy a given demand, only a painful process of readjustment, relocation, and retraining can help redeploy the people endowed with them.

If this is true of jobs, it is true of the businesses which gave rise to those jobs: If productive capacity and capital in general have been wrongly structured or malinvested—even if this becomes apparent only in hindsight—these too must be redirected, reassembled, or scrapped altogether.

It should thus be obvious that no amount of blind monetary inflation or fiscal activism can do more than delay or disguise the reality of the need to move and restructure substantial resources.

Second, as the Posco example shows, the result of most such attempts at "stimulus" is often not to promote activity in those areas where capital and labor have been over-invested in the boom—and which may be widespread enough to depress the statistical aggregates on which the mainstream fixates—but, conversely, to reveal where there is all too real a shortage of specific capacity, a deficiency that the extra stimulus will transform into an inflationary bottleneck and an impediment to structural change.

What the Posco example also shows us is the verity of John Stuart Mill's principle that "the demand for commodities is not the demand for labor"—something the grasp of which, Hayek contended, was the test of true economic insight. For here, because of differing elasticities of demand and the varying uses that come into play at either end of the production process, the rising price of raw materials is serving only to raise the steelmakers' input costs more rapidly than they can increase their prices.

The underlying meaning here is critical: The indiscriminate provision of extra "purchasing power," or the artificial boosting of "effective demand," is inimical to heightened returns on capital, and hence to increases in income, jobs, investment, and further material progress.

Inflation is no panacea, and even when it does help—in rare times of such a deep dislocation of production and consumption that monetary factors are compounding real side woes—it is arguable whether simply addressing those real side factors with proper dispatch and with no concessions to vested political interests might not effect a more well-founded and equally rapid recovery.

Yes, Greenspan was right to note that economic "flexibility" is needed for the shock of the rough times ahead. This is, after all, simply another way of describing the oft-repeated calls for "structural reform" for the reliance upon which the much less inflationist ECB has so often been derided by the Anglo-American Avatars of Easy Money.

Where Greenspan is wrong—foolishly, hubristically, perilously wrong—is in his assumption that the hegemony exercised today in the US by big government, legal vulturism, organized labor, corporatist militarism, and Marxist miseducation over entrepreneurship has left the economy with enough of this essential flexibility. The US may someday find itself unable to cope with the frictions and stresses of rapidly changing circumstances with which it inevitably will be confronted.

Where he is also wrong is in using the fall of the dollar and the continuance of the negligently lax monetary policy which has contributed to this long-sought decline to force his errant remedies on other nations.

Before anyone protests, keep in mind that most European and Asian economies have far less "flexibility" in the production of real wealth than the US, despite all its rulers' errors of policy and prescription. This makes Greenspan's sin all the more heinous.

So hang in there, Jean-Claude. We need you!

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Sean Corrigan is a principal of  www.capital-insight.com, a London-based economic consultancy. He is also comanager of the Bermuda-based  Edelweiss Fund. See his Mises.org  Articles Archive, or send him  MAIL. See also the  Study Guide on Business Cycles.