Competitive Devaluation and the Race to the Bottom

Currency exchange boardConcerns that the world’s leading economies may be heading towards a competitive devaluation [glossary] crisis appear to be on the rise. In one respect, this is hardly a new concern—the United States has been complaining about the value of the Chinese renminbi for several years, culminating last week with the passage of a bill by the House of Representatives that would punish China if it fails to increase its currency value. But concerns seem to be spreading globally and are focused not just on China. Efforts by the governments of Japan, South Korea, and Taiwan, and Switzerland to devalue their currencies led Brazil’s finance minister, Guido Mantega, to warn that a “currency war” could emerge. Yesterday, the Institute of International Finance, an organization representing more than 400 of the world’s leading banks, issued a similar warning, cautioning that the lack of coordination could lead to greater currency protectionism. World Bank President Robert Zoellick responded optimistically, suggesting that currency “tensions,” not a “war” is the most likely outcome.

Not surprisingly, then, the recent talk of currency wars has generated significant discussion in the blogosphere. At the Economist, a robust debate has emerged, provoking a responses from Martin Wolf, Daniel Drezner, Paul Krugman, and Robert Reich.

Today, the value of national currencies is determined by the market. Countries can generally attempt to devalue their currencies either by “talking them down” (hinting of a policy to devalue their currencies, which leads investors to do the work for them), or by buying other currencies. Thus when Japan sought to devalue the yen last week, it purchased an estimated $20 billion using yen.

In theory, currency devaluation intends to make the national economy more competitive and improve balance of trade. This is one reason why currency devaluation was often a part of structural adjustment programs developed by the International Monetary Fund. When a country’s currency devalues, its exports become cheaper and its imports become more expensive in relative terms. In theory this should stimulate exports, encouraging economic growth.

But in practice, it’s often not this straightforward. Whether or not exports increase depends on a number of factors, only one of which is the real price of the good. And when multiple countries devalue at the same time, the risk of a beggar-thy-neighbor [glossary] race to the bottom intensifies.

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