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Would a Currency War Be Helpful?

What effect would a currency war have on the U.S. and other economies? As discussed below, some people argue that the currency war of the 1930s actually helped economies around the world. Is there any chance it could be helpful once again?

Let me start with the currency policy of an individual country, and then move to the more general topic of currency wars. When an individual country such as China lowers its exchange rate, the price of its goods become cheaper on international markets. This gives its exports a boost. However, while the policy may be good for the individual country, at least in the short-run, it comes at the expense of other countries who are placed at a competitive disadvantage. In China's case, the main impact is probably on workers in other developing countries where labor is also relatively cheap. That's not to say that there's no impact at all on the U.S. economy, only that we shouldn't expect too much if China revalues its currency.

There may be good reasons for a developing country to use currency policy to peg its exchange rate. For example, a stable exchange rate may promote a more stable economy. Pegging the exchange rate at a low enough level can also promote export led development, and allow the accumulation of reserves that might be needed to hold off a speculative attack on the currency.

In a recession, there is also an incentive to lower the exchange rate as a means of stimulating the economy, something that is usually accomplished by expanding the domestic money supply. So long as only a few countries do this, it should have the intended effect.

The problem is that in a recession, other countries also have an incentive to lower their exchange rate. In addition, the bad domestic conditions make countries very sensitive to the perception that they are being harmed through exchange rate manipulation. This can create ill will, or enhance resentments over currency policy that already exist. Thus, if one country is perceived to be taking unfair advantage, other countries are likely to retaliate by imposing tariffs or by lowering their own exchange rates to re-level the playing field.

If a currency war ensues and everyone lowers their exchange rate, then, in the end, no country will gain an advantage relative to others (though there will be variation along the way as some countries move faster or slower than others). But, it will have the effect of expanding the world money supply.

Will the expansion in the worldwide money supply be helpful? Paul Krugman argues that if short-term interest rates were above the zero bound, as they were in the 1930s due to the adherence of many countries to the gold standard, it could be. As interest rates fell around the world with the expansion of the worldwide money supply, that would stimulate more consumption, more investment, and more international trade. But with interest rates at the zero bound, as they are for most countries right now (net of risk premia), an increase in the world wide money supply will not have much of an impact on interest rates and hence won't do much to stimulate economies.

However, while the positive effects a currency war produced in the 1930s are unlikely to reappear, there is a chance of large negative effects such as a simultaneous trade war or the breakdown of the international monetary system, so let's hope a currency war can be avoided.

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