Central Bank Independence And The Nature Of Currency Wars

Includes: FXCH, FXY, UDN, UUP
by: Lok Sang Ho

In the last couple of months, the Japanese Yen lost over 15% against the US dollar, leading to worries about a new round of "currency war" and about the Bank of Japan losing its independence. True, this round of depreciation not only has blessings, but apparently also strong persuasion if not direct pressures, from the new Japanese Prime Minister Mr. Abe. But to me, these developments are to be welcomed rather than condemned.

In March 2011 shortly after the great tsunami hit the eastern shore of Japan, I predicted in this column that the Yen should depreciate significantly, "probably all the way to 90 yen to the dollar or lower" "in the medium term" though it could continue to climb "in the near term." Developments since then proved that I was right. However, the Yen had been strong for too long, and I wrote another article pleading that the Bank of Japan should aggressively sell the Yen to push it lower. I argued that the Yen was far too strong for the economy to grow, and was the main reason why Japan had been trapped in deflation and two "lost decades." The round of depreciation returned sense to the foreign exchange market. The Japanese economy and its export-dependent manufacturers will start seeing the light of the day once again. The recovery of Japan is certainly much welcomed for the world. After all, Japan is still the world's third largest economy.

The academic world generally takes central bank independence as very important, but this is grounded on the assumption that the professionals in central banks know best. They are supposed to make better judgment than others, while politicians have mainly their own political interest at heart and are not to be trusted. This assumption seems reasonable enough, but I have seen too often that central bankers make poor judgments. The Bank of Japan must be sleeping in its job allowing the Yen to appreciate the extent it did. Because central bankers can and do make mistakes, it is up to everybody to point out the mistakes and to present the evidence and the argument to show that they err. We certainly do not often trust politicians, but that does not mean that they cannot sometimes know better. That central bankers can make awful mistakes has been pointed out by Friedman and Schwartz in their well known treatise the Monetary History of the United States, 1867-1960, in which they argued that the Great Depression could have been avoided if the central bank had acted wisely. So central bank independence is not to be preserved even if the central bankers are foolish; central bank independence must be seen as being predicated on sound professional knowledge and judgment.Another issue is the subject of currency wars. Often currency wars are taken as equivalent to competitive devaluation, which is sometimes equated with "beggar thy neighbor policy." I offer a new perspective on this hot subject. Depreciating a currency to reflate the economy so it may achieve full employment is NOT beggar thy neighbor. Every economy deserves to be in full employment, and central banks have a responsibility to do their part. I cannot name any episode in which a country devalued its currency and hurt other countries by achieving full employment. Fully employed economies are typically good for their trading partners. However, currency wars are possible and happen from time to time. Currency wars are targeted at specific foes whose currencies are forced to appreciate so much that their economies are almost ruined. I see Japan as a victim of such currency wars, and China as a potential victim. Fortunately the People's Bank of China resisted succumbing to excessive currency appreciation. Otherwise it will fall victim to yet another currency war.

With the Japanese Yen finally falling back to earth, Japan's economy is finally going to see a real recovery. The main uncertainty is now its soured relations with China, which seem unlikely to recover any time soon. While some doubt the often-expressed view that Japan will suffer more than China, over the longer run the damage to Japan is almost certainly greater than the damage to China, because Japan will be losing the chance to benefit from a fast-growing market, while China will be able to source its supplies from alternative sources and to seek markets elsewhere. After all, Japan as a market will be relatively stagnant while China as a market will certainly continue to grow at a rapid pace. The fact that China is well aware of the dire consequences of an overvalued currency also suggests that the RMB is unlikely to appreciate much more and that China's future growth trajectory is more likely to continue.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.