The myth of currency manipulation

Koichi Hamada TOKYO – This month, the Japanese yen’s exchange rate against the US dollar fell below ¥125, a 13-year low, before rebounding to nearly ¥122 following a statement by Bank of Japan Governor Haruhiko Kuroda that he did not expect further depreciation. But, as Kuroda later clarified, Japan’s monetary policymakers do not seek to predict, much less control, exchange-rate movements. Instead, the BOJ’s goal – like that of any effective central bank – is to ensure the right combination of employment and inflation. Of course, a country’s monetary policy does affect exchange rates in the short term. But it does so only in relation to monetary policy in other relevant countries. In the case of Japan today, the exchange rate is being determined less by its own monetary expansion than by America’s move toward monetary tightening, following a period during which massive quantitative easing (QE) by the US Federal Reserve put upward pressure on the yen. A country can also influence the short-term exchange rate by intervening directly in the foreign-exchange market. But such interventions are complicated – not least because they must account for the relationship between the country’s monetary-policy approach and that of other relevant countries. Moreover, if, for example, the United States aims for ¥100 per dollar, while Japan aims for ¥120 per dollar, the result could be not only rising tension between the US and Japan; incompatible exchange-rate targets could also trigger broader market volatility, with spillover effects on other economies. Given this, monetary policy remains the most effective driver of exchange-rate movements. The key to ensuring a satisfactory exchange-rate balance is for countries to pursue policies aimed at ensuring a desirable combination of domestic inflation and employment. If, for example, meeting domestic inflation and employment targets requires greater monetary expansion – which will place downward pressure on the local currency, bolstering the economy’s international competitiveness – other countries may have to pursue their own monetary expansion to maintain optimal domestic inflation and employment rates. That is precisely what happened after the global economic crisis. The US, in an effort to prevent deflation and stem rising unemployment, initiated a massive QE program, with the United Kingdom following suit. At first, the Bank of Japan hesitated to adjust its monetary policy accordingly, allowing the yen to appreciate – a decision that drove the country’s long-stagnant economy into recession. Fortunately, when Prime Minister Shinzo Abe came to power in 2013, he recognized the need for monetary expansion, making it one of the three “arrows” of his strategy – dubbed Abenomics – for economic reform and recovery. Thanks to this change in approach, Japan was able to arrest the yen’s appreciation and move toward stronger growth, without undermining the ability of the US or the UK to advance their own monetary-policy objectives. The capacity for such adjustments is the hallmark of the flexible exchange-rate system; indeed, for more than four decades, it has proved time and again to be the key to global macroeconomic stability. As long ago as the period following World War I, countries that adopted an independent monetary policy recovered faster than those that remained locked into the gold standard. Yet some economists and journalists fear that countries, in attempting to gain an advantage in global markets, will engage in competitive devaluations, triggering large-scale inflation in the process. Such concerns have even made their way into debates about the mega-regional free-trade agreements – namely, the Transatlantic Trade and Investment Partnership between the US and the European Union, and the Trans-Pacific Partnership – that are currently being negotiated. Many are now calling for the inclusion of enforceable provisions prohibiting so-called “currency manipulation.” Including such provisions would be a mistake – not least because exchange-rate issues are intrinsically irrelevant to trade deals. In fact, such an approach – which has the potential to derail agreements that would bring considerable benefits to the economies involved – is based on a fallacy. Unless countries are using direct intervention to pursue contradictory exchange-rate goals, a “currency war” that generates widespread inflation is highly unlikely. If each country tailors its monetary policy to domestic macroeconomic objectives, exchange rates will settle naturally in a state of Pareto (or maximum) efficiency. The economist Jeffrey Frankel has called currency manipulation a chimera, declaring that “linking efforts to prevent currency manipulation to trade agreements has always been a bad idea, and it still is.” He is right. Doing so would controvert the most fundamental rule of a flexible exchange-rate regime: that each economy can set – and pursue – its own monetary-policy goals. The writer is Special Economic Adviser to Japanese Prime Minister Shinzo Abe. Copyright: Project Syndicate

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The myth of currency manipulation