In the recent years, almost all of the world’s Central Banks pursued highly accommodative policies to prevent deflation, i.e. curb up inflation and improve economic conditions. Part of the idea was that as a consequence of an expansive policy, the country’s currency should weaken. A weaker currency would lead to an increase of exports, since products would become cheaper for costumers abroad. A number of Central Banks, for instance the Reserve Bank of Australia and the Swiss National Bank, and off course Bank of Japan for several years, even ‘talked the currency down’ to achieve this goal. Now a recent study by the Financial Times (FT) reveals that the so called ‘race to the bottom’ does not improve export volumes of individual countries. On the contrary, all countries suffer from lower trade.
Two studies, one thought In a paper prepared for the Jackson Hole symposium last weekend, Harvard Professor Gita Gopinath argues that in a world where the larger part of trade is against USD-prices, exports are not sensitive to a weaker currency. However, a weaker currency may lead to inflationary pressures since imports are based in USD and thus become more expensive. As a result, trade may suffer. This is the same conclusion as the FT study draws. The ‘race to the bottom’ may lead to only losers.
Change in Mindset
The big question is whether these studies are able to provide a basis in changing the mindset of policymakers. The ‘beggar thy neighbor’ approach proves to hurt both houses and works counterproductive. From this perspective, policy makers should have a clear incentive to stop pursuing a weaker currency. However, the traditional line of thought that products in own currency are traded at favorable prices, could be difficult to change since it looks very compelling in comparisons. Policymakers should dig deeper into trade dynamics, which is a different field of research. But there’s an additional argument why Central Banks should be very reluctant to pursue a soft currency.
Import of Inflation
As shown in the study of Gopinath, a weaker currency leads to higher sensitivity of external inflationary pressures. Imported goods are more expensive and imports prove to be very inelastic to price changes. Most of the products are imported since domestic producers are not capable of producing the goods, for instance commodities, or simply lack competitiveness to producers abroad. The latter problem can be solved by better conditions for the industry, for example by removing red tape or lower taxes. Increase import taxes is no solution, since that will increase the costs and hence import inflation. This however requires intensification of reforms by governments, which is a very delicate issue. President Draghi of the ECB keeps noting in press conferences and speeches that governments should push ahead with public and labor market reforms to improve competiveness, raise potential growth and generate employment opportunities. But as always, reforms are contested by those who fear to lose influence to the other. The US, but not exclusively, proves this point by the obstruction of many bills by various lobbyists groups. So decisive action is needed.
Strong case for removing trade barriers and pure inflation targeting
Central Banks should not pursue a weaker currency. Instead they should focus on inflation and if mandated, economic activity. A weaker currency imports inflation and thus the country gets affected by external shocks with no adequate answer in policy change available. In addition, authorities across the globe, that is central banks and governments, should encourage international trade and prevent a race to the bottom. This is the only way to improve not only ones own backyard, but that of the whole neighborhood.
