Is monetary and fiscal stimulus a weapon for hurting rival nations? It depends who you ask. The conjugation goes like this: I am helping the economy; you are engaging in competitive devaluation; he is starting a currency war. It's a discouraging difference of perception, particularly as weaker currencies often do not boost growth.
As the conjunction suggests, no government or central bank of a developed economy is currently pursuing a policy of devaluation. Switzerland comes closest: Its central bank is using the exchange rate as a policy tool. However, the goal is not devaluation, but to avoid a rapid appreciation. For Japan, the United States and the United Kingdom, lower currencies are a side effect of expansive monetary policies designed to stimulate domestic economic activity.
Still, that side effect is often welcomed, and can be dramatic. Since August, the dollar and the yen have fallen by 9 and 19 per cent, respectively, against the euro. The threat of further moves will remain as long as economies stay weak enough for the authorities to print more money.
The irritation caused by this side effect is completely justified. A unilateral approach to domestic policy is inappropriate for countries which participate in the global economy. Even if the devaluation is unintentional, it is like a cloud of toxic smoke blown across a national border: the stimulating or emitting nation bears some responsibility. In addition, while authorities may be willing to take their chances on the possible inflationary effect of cheap money and big deficits, foreign creditors rightly see an experiment in which they have more to lose than to gain.
Economically, the case for competitive devaluation is much less strong. The effect of currency values on the economy is subtle – and mixed.
There is excellent empirical evidence that relatively cheap currencies are good for poor nations. Leading development economists such as Dani Rodrik and Surjit Bhalla have shown that it is much easier to nurture exports and attract foreign investment if the exchange rate is low enough to make things cheaper for foreigners.
There is also good evidence that extreme and rapid currency appreciation distorts economies, and that a reversal can speed growth. The yen's 40 per cent rise against the euro in three months in 2008 was a severe blow to Japan's exporters. Even after the recent decline, the yen is still 8 per cent more expensive against the euro than the average since 2003.
More often than not, however, moves in the freely floating currencies of rich countries have little effect. The response of the U.K. economy to the 20-25 per cent drop of the pound against the euro and dollar in 2007-8 is not unusual. Both exports and imports have increased since, but the trade deficit has not narrowed. True, the deficit might have been wider with a stronger pound. But it does not look like the change was enough to reverse the decline in the U.K.'s trade position which started around 1998.
Broader research confirms devaluation is no panacea. A 2008 study by four Turkish economists, published in the International Research Journal of Finance and Economics, showed devaluation had a modest long-term negative effect on output in six countries and a small positive effect in three. Using a slightly different methodology, Michael Hoffman, who now works for the U.S. government's Center for Economics, concluded in 2005 that there is "very little, if any, relationship" between the value of the dollar and trends in the U.S. current account.
This should not be surprising. Countries with strong economies usually have strong currencies. Countries looking for currency advantage often have economies with structural weaknesses which limit the advantages of devaluation. For example, domestic wages often rise to compensate for higher import prices, reducing the export price advantage.
In addition, trade among developed economies is rarely a matter of "built here and delivered there." As much as half the price of technically sophisticated products reflects sales and service expense in the destination country. Another significant fraction comes from imported components. Even when currency provides a price advantage, it's often not enough to compensate for a quality disadvantage.
Authorities looking for a quick export jolt from a falling currency should be careful what they wish for. Good short-term news serves as an excuse for not making long-term helpful reforms. Besides, when the exchange rate drops because of weakening faith in a country's ultimate solvency, the gain is bought at a high price.