The beggar’s opera

Is global inflation in the offing?

Are nations about to beggar their neighbors?

The question arose when the Group of 20 met in Seoul in November, ostensibly to forge an agreement between the United States and China over a yuan that Americans regard as too weak. Is the most critical undervaluation in Beijing -- or in Washington, D.C.? Dollars newly created by the Fed -– the “Quantitative Easing II” in today’s headlines -– might someday reduce the foreign value of a dollar, just as an increase in the supply of toothbrushes tends to lower their price so that people will buy the new toothbrushes.

Under a pact of the International Monetary Fund –- the Jamaica Agreement of 1976 -– a country should not devalue to try to make its exports cheaper than those of its neighbors, since they could respond by devaluing as well. Beggaring the neighbor could lead to global inflation, in two ways. Since Home’s exports are now cheaper, in terms of foreign currency, foreigners will buy more of them, driving up their prices at Home. Second, the devaluation raises the cost of imports to consumers at Home, so they will buy more Home goods instead, bidding up these prices again. That scenario can occur in every country that plays the beggar. Kazakhstan may worry that a weak yuan can undermine demand for its manufactured exports.

In the long run, an episode of inflation might not matter much. When workers and machines are idle, the natural tendency is to put them to work eventually, regardless of whether most prices are low or high. Over the long haul, the price is just a number on a pricetag. But in the short run, prices that rise more rapidly for some products than for others -– which is what inflation entails for a while -– confuse buyers and sellers alike. They won’t make their best decisions. Global confusion could reduce global output.

Clobber thy neighbor

These days, however, observers worry about a new way to beggar thy neighbor. Return for a moment to the Fed’s “quantitative easing.” Expanding the dollar supply will likely lower the price of holding a dollar. This price is the U.S. interest rate, since the holder of the dollar forgoes the interest payment. In order to express the purchasing power of this payment foregone, let’s adjust the interest rate for changes in product prices. As this “real” interest rate falls in the U.S., interest-bearing assets in other countries will look more attractive to financial investors than before. Why settle for a 1% return on an American bond when you can get a 2% return on a Korean one? Money will flow into South Korea.

This may look delightful for the Koreans, but it isn’t. The extra money will lead to more spending on products in Korea, pushing up prices in an economy that had already been growing 5% annually early this year. To avoid inflation, the Korean central bank might raise its interest rate in order to discourage production -- funded by borrowed won -- that might overheat the economy. But the rise in Korea’s interest rate will make the won look all the more attractive. As financial investors bid higher for the won, its foreign value will increase. Thanks to the Fed, the dollar weakened 8% against the won last year, according to the New York Times. That’s bad news for Korean exporters, since it raises the cost to foreign buyers of their products.

“The recent Korean recovery was mainly due to export growth,” writes Sang H. Lee, an associate professor of finance at KIMEP who studies money supply. “The exporters' margin will be squeezed by the undesirable appreciation of the won.

“Should the Korean government implement restrictions on capital inflows and be blamed as a protectionist? Or should it manage the exchange rate?”

Holding back the tide

Beyond the argument over whether the government should intervene in currency markets, lies a more troubling one: Can intervention work? Its effects are usually ephemeral, because the private foreign-exchange market -– exceeding two trillion dollars of trading each day -- swamps their attempts. If intervention can succeed, then surely it would have done so in 1995, when the two major players in the dollar-yen exchange -- the U.S. and Japan – coordinated to try to shore up the dollar. The U.S. had wanted to avert inflation; Japan had wanted more exports. That August, while speculators were on vacation, the dollar rose for a while; but by September, they were selling dollars on the hunch that the stimulus had ended and thus the yen value of the dollar had peaked. That prophecy fulfilled itself.

Intervention, carried to its logical extreme, implies adopting one monetary rule around the world, such as a gold standard. Global markets have had no such standard since the early 1970s, when the United States abandoned the Bretton Woods system, in which the dollar was backed by gold and other currencies were backed by the dollar.

Under a gold standard, banks would buy and sell gold, and a currency backed by it, at a fixed rate -– say, $500 for an ounce of gold. The central bank’s reserves of gold would limit the amount of paper money that it could issue, since otherwise speculators could exchange worthless paper for gold until the bank ran out of ounces. So constrained, the bank would no longer be tempted to print money and hand it over to the government so that it could buy more than before. (That is, the government could buy more until prices rose to reflect the increase in money supply, reducing the government’s purchasing power to its original level).

Gold can restrain inflation -- brutally. Suppose, with the world on a gold standard, that prices suddenly spike in Kazakhstan. Since the country’s goods become more expensive than before, compared to other goods around the world, global consumers will stop spending gold on Kazakhstan’s products and spend it elsewhere. Kazakhstan’s supply of gold will fall.

To maintain the given rate of exchange between gold and tenge, the National Bank of Kazakhstan will have to withdraw tenge from circulation. If the Bank’s gold supply falls by half, then the Bank must withdraw half of the tenge in circulation. With fewer tenge and ounces of gold making the rounds, product prices in Kazakhstan must fall, reversing the initial inflation.

This is not an arid exercise. The deflation will raise real debt owed by firms and so will bankrupt some of them. Workers at these firms will lose their jobs. Other firms, seeing their output prices falling but unable to cut wages accordingly, will lay off employees. Stabilizing prices can hurt.

John Maynard Keynes pointed this out in 1925, when the Chancellor of the Exchequer, Winston Churchill, decided to strengthen Britain’s pound sterling until it was worth as much gold as before World War I. This implied that the pound would be able to buy more goods than before -– i.e., that product prices would fall. For this to happen, production costs would have to fall, or producers would go bankrupt. The largest cost of production was for labor. But English unions would resist wage cuts. Firms would be forced to lay off employees. Churchill’s deflation would bring about a depression. And it did. In fact, it may have raised the curtain on the Great Depression. –- Leon Taylor, taylorleon@gmail.com


Good reading

Sewell Chan and Martin Fackler. Currency move changes S. Korea plan. The New York Times. November 9, 2010

John Maynard Keynes. Essays in persuasion. New York: Palgrave Macmillan. 2010.

Roy Ruffin and Paul Gregory. Principles of macroeconomics. New York: Pearson. 2001. The seventh edition includes a clear introduction to currency markets and briefly discusses the 1995 intervention.