Hegemony and Currency Wars

Apologies for the lack of posts lately. Real work has gotten in the way.

Over the past few weeks I've been thinking about the Fed's actions over the past few years. At the height of the crisis the Fed moved to shore up the integrity of the banking sector and immediately lowered the funds rate to practically 0%. It also engaged in a first round of quantitative easing -- by increasing the size of its balance sheet -- and qualitative easing -- by increasing the riskiness of its balance sheet. Most observers agree that these actions prevented the Great Decession from becoming another Great Depression.

Since early-2009, the recession has worsened but the Fed has mostly kept policy stable. This has led to complaints from many ideological corners; Scott Sumner and Paul Krugman don't agree on much, but they do agree that the Fed isn't doing enough. Some have expressed bemusement that "Helicopter Ben" Bernanke, student of the Great Depression, hasn't done more to prevent the worsening of the recession. After all, he famously said of the Fed's role in abetting the Depression:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton [Friedman] and Anna [Schwartz]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

So why has he let the U.S. economy stagnate? Why has he let other countries devalue their currencies with no U.S. response? Why hasn't he learned from history?

Perhaps he has. I have no reason to think this is true, but perhaps Bernanke is influenced by another scholar of the Depression - Charles Kindleberger. Kindleberger argued that the Great Depression became a cataclysmic international event because of the unwillingness of the U.S. and inability of the U.K. to supply public goods to stabilize the international system. Those public goods include maintenance of a system of stable exchange rates and open markets:

"As with exchange depreciation to raise domestic prices, the gain for one country was a loss for all," Kindleberger writes. "With tariff retaliation and competitive depreciation, mutual losses were certain."

In other words, perhaps Bernanke is acting as the world's central banker. If Bernanke believes that a U.S.-led currency war would have adverse consequences for the global economy, then perhaps he is willing to prolong the U.S. recovery in order to prevent a large global downturn. Such a deterioration of the global economy would also affect the negatively affect the U.S. of course. So while, ceteris paribus, a dollar devaluation would help the U.S., ceteris is not paribus. A U.S. devaluation would prompt a series of actions in Frankfurt, Tokyo, and Beijing. The resulting exchange rate instability would spook financial markets and hamper trade. Cries for protectionism would grow louder, and the net effect would be sharply negative.

Faced with that scenario, perhaps Bernanke has opted instead to try to stabilize markets and defuse an explosive global political economy by allowing other countries to beggar the U.S. some in the short run. Again, I don't know if this is the case, but it seems more persuasive to me than "Bernanke doesn't understand the monetarist lessons from the Depression".

It should be noted that Barry Eichengreen disagrees with Kindleberger about devaluations. Eichengreen argues that while competitive devaluations in the 1930s did beggar neighbors in the short run, they also constituted a large international monetary stimulus that helped pull the global economy out of the depression (after several years). More recently, Eichengreen has argued that this process is best done through multilateral policy coordination so as to avoid swings in exchange rates. Unfortunately this sort of coordination is basically impossible right now. The Prisoner's Dilemma that incentivizes beggar-thy-neighbor devaluations also incentivizes defection from a coordinated monetary policy.

Given that, perhaps Bernanke has chosen to follow Kindleberger's advice: provide as much liquidity as he can, work to maintain an open trading system and relatively-stable exchange rates, and allow other countries to devalue without U.S. reprisal. Perhaps that will cost the U.S. in the short run, but it can benefit the global economy over the longer run.