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This is what a currency war looks like

This morning (early afternoon Frankfurt time), Mario Draghi, the president of the European Central Bank, took his seat in front of gathered reporters and took questions. Among other things, he said this: “The exchange rate is not a policy target, but it is important for growth and price stability. We want to see if the appreciation is sustained, and if it alters our assessment of the risks to price stability.”

And with that, the euro fell more than half a percent against the dollar—even though Draghi was really more stating a fact from Economics 101 than signaling some major new policy plans by the central bank.

Mario Draghi worries the rising euro could further crimp the European economy. (Hannelore Foerster/Bloomberg)

So this is what a currency war looks like. Not terribly dramatic, is it?

A currency war, as an increasingly breathless line of media coverage calls it, is a series of events in which nations try to devalue their currencies in order to advantage their exporters and strengthen domestic economic growth.  The Federal Reserve announces open-ended purchases of bonds in September 2012, and the dollar falls. The Bank of Japan matches with open-ended bond purchases in January 2013, and the yen falls. Maybe, just maybe, eventually the ECB will cut interest rates further and/or the Bank of England will undertake more bond purchases of its own, and in the process reverse the run-up in the euro and the pound against the dollar and the yen.

In the case of Draghi’s press conference today, the euro fell because the ECB president seemed to acknowledge reality—that Europe’s already ailing economy is damaged further by the runup of the euro against other currencies. The euro has risen from $1.23 in early August to a recent high of $1.36 on Feb. 1, a 10.6 percent rise that has made exporters in Germany and France and Italy 10.6 percent less competitive in global markets. While no interest rate cuts or other steps to ease monetary policy seem on the horizon from the ECB, merely by acknowledging that a rising euro could dampen growth prospects, markets were assuming that this means Draghi will be open to those steps in the future if the euro rise continues.

Alarmists would tell you that this process puts us on the road to perdition, that the only outcome of a series of currency devaluations will be hyperinflation for us all. I don’t buy it.

It is true, of course, that all the world’s currencies cannot decline relative to each other at the same time. The flip side of one country’s currency falling is others rising. But even if they can’t devalue relative to each other, the result of the easing actions would be inflation.

It is also true that two of these central banks have indicated new flexibility in terms of allowing more inflation: The Bank of Japan said it will aim for 2 percent inflation, up from the 1 percent it was previously aiming for. The Fed has kept its 2 percent target, but has said it wouldn’t raise rates unless it expected inflation to exceed 2.5 percent temporarily (or the unemployment rate fell below 6.5 percent). The ECB and Bank of England are sticking with their 2 percent targets (though that may change as Mark Carney takes the helm of the Bank of England this summer).

But the term “currency war” sheds more heat than light on what happens when central banks try to ease policy. Inflation has been exceptionally low in all of these major developed economies except Britain for the last five years. The central bankers show every sign of reversing course the minute that changes. They are speaking with each other constantly, including over long dinners every other month in Basel, Switzerland, understanding each others’ views and attuned to the risks that they will overreach and let inflation exceed their targets.

In other words, until we see evidence that the central bankers are genuinely engaged in competitive devaluations and are willing to allow inflation well above their historical targets to get it, there’s not a whole lot to worry about. Rather, it is a bunch of nations trying to set their monetary policy in ways that make sense given the circumstances they face—low inflation and high unemployment.

If this is a war, it is one with few casualties, quite a few potential benefits, and one in which the generals are enjoying good wine together six times a year.



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Neil Irwin · February 7, 2013

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