In October 2010, the Brazilian Finance Minister Guido Mantega made news by claiming an "international currency war" had broken out.
According to Mantega, countries worldwide were simultaneously attempting to force down the value of their money in order to reduce the price of their products sold in foreign markets.
Central banks in Japan, South Korea, and Taiwan had recently intervened in currency markets to control their currencies' appreciation. The Bank of England, similarly, had encouraged the pound to fall since 2008. The Swiss National Bank had intervened in foreign exchange markets as well.
For Mantega, such maneuvers signaled that these and other countries were entering into a competitive spiral of devaluations in an effort to export their way out of the ongoing economic slump.
And the inescapable conclusion for him and other finance ministers was that no country could gain if all countries devalued their currencies at once. They feared that such fiddling with currency would only serve to damage those countries most dependent on exports (such as Brazil), and increase political tensions worldwide.
The term "currency war" promptly became a global buzz phrase. Commentators and public officials—like Dominque Strauss-Kahn, the head of the International Monetary Fund, and his counterpart at the World Bank, Robert Zoellick—warned about the dangers of conflicts over money. Such wars, they argued alarmingly, had proven disastrous historically and, most chillingly, had worsened, if not actually caused, the Great Depression.
Despite the hyperbole, currency wars as described by Mantega--where the world's leading economies race together to depreciate their currencies--are, in fact, exceptionally rare historically.
Currency manipulation and selective devaluations to promote exports, growth, and employment, however, are not. Nor are the fears of established economic and political powers that perceived up-and-coming rivals will unseat them from their economic thrones.
Since the end of World War II, the United States has enjoyed the "exorbitant privilege" (in the words of France's 1970s President Valery Giscard d'Estaing) of having the dollar as the world's default currency. And the U.S. government has held the position that it is the responsibility of other countries to adapt to the perceived needs of the United States, rather than vice versa.
As the then Secretary of the Treasury John Connally famously put it to European officials critical of the inflationary effects of U.S. currency policy on their own economies in the early 1970s, "The dollar is our currency, but your problem."
International tensions surrounding currency competition, and the dollar's privileged status, were apparent at the G20 Summit in Seoul in November 2010.
In advance of the summit, the U.S. central bank--the Federal Reserve--announced that it would be purchasing government bonds in a maneuver called "quantitative easing."
This policy entailed multiplying the number of dollars in circulation in order to buy these bonds, with an end result of depreciating the dollar relative to other currencies. It also meant that excess dollars would likely flow to foreign markets such as Brazil, China, and Korea adding to price inflation and financial instability in those countries unless they acted to block the inflows.
In addition, the Obama administration hoped to use the Seoul G20 Summit to wage its own form of "currency war" by applying pressure on China to increase the value of its currency--the renminbi--and thus, indirectly, cause the dollar to depreciate. The U.S. has long argued that China itself was a currency warrior, which had fired the first shots in the money wars by consistently undervaluing the renminbi.
Rather than addressing this highly sensitive political issue directly, the U.S. administration sought to establish new international rules requiring countries to limit their trade surpluses.
Effectively such rules would mean that surplus countries like China would have to institute policies to cause their currencies to appreciate relative to the dollar. American officials hoped that this would increase U.S. exports, growth, and employment without the United States having to make economic or budgetary changes of its own.
The idea that other countries were to be charged with ameliorating conditions in the United States has been at the heart of U.S. international currency policy since the 1960s. In particular, it mirrors American proposals concerning its trade deficits with Japan in the 1970s-1990s.
Not surprisingly, the U.S. proposal went nowhere in Seoul. Countries ranging from Germany to Brazil denounced the effects on their own economies of the Fed's quantitative easing and dollar depreciation. Chinese officials joined in, short-circuiting U.S. efforts to build consensus on pressuring China.
But, in the media and political parlance, here were the rumblings of the onset of a global currency war.
The Appeal of Depreciation
Historically, depreciating one's currency relative to other countries has been a standard tool in seeking to promote economic development.
This was true in the late-nineteenth century when the rising powers of the age--such as Germany, Japan, Russia, Argentina, and the United States--sought currency systems most favorable to exports and domestic growth. It was true in the 1970s and 1980s when the United States devalued its currency relative to Japan and West Germany. It is true today when China intervenes to keep its own currency from appreciating.
In broad strokes, depreciating currency aids exporters--and industries that rely on exports--by decreasing prices of exported goods in foreign currency. Depreciation also makes goods imported from foreign countries more expensive in local currency, thus discouraging the purchase of those goods from abroad.
There are copious examples of the negative economic effects when money appreciates in value. Appreciating currency, which damaged exports, helped spark the economic crises in Thailand and the rest of Asia in the late 1990s and Argentina in the early 2000s.
Various studies have found that currency appreciation played a role in Japan's "lost decade" of the 1990s (either by itself or by prompting Japanese attempts to combat appreciation that, in turn, led to Japan's asset bubble of the late 1980s and the subsequent bust). Rapid appreciation of the yen relative to the dollar since late 2008 has exacerbated the effects of the global economic crisis for Japanese companies and industries relying on exports.
Today, countries on the periphery of Europe have found themselves constrained by a euro that was designed for the German economy and is currently too strong for these countries to expand exports and bolster their economic growth. Indeed, countries such as Spain, Ireland, Portugal, and Greece have found their ability to re-inflate their economies in response to the current financial crisis limited because, as members of the euro zone, they have been unable to devalue their currencies. [Read here for more on the euro in the Czech Republic and Slovakia]
Similarly, in the 1930s, many countries, in Europe and elsewhere, found themselves having to take austerity measures that only worsened their ongoing depressions in order to support fixed exchange rates with gold.
The more important exports are to a given country, the more damaging currency appreciation can be. Brazil, which relies heavily on exports, has seen its currency, the Real, appreciate by some 40% over the past two years. Brazil has also seen its exports contract at the same time that the appreciating Real has attracted inflows of foreign capital, adding to fears of financial instability and inflation. It is thus not surprising that it has now begun to implement new reserve requirements, taxes on foreign exchange transactions, and other measures meant to stop the Real's appreciation. [Read here for more on the recent history of Brazil.]
Appreciation and depreciation work a little differently for the United States, which saw its manufacturing jobs largely shipped overseas in the 1980s and 1990s. There, the issue of currency values is more one of political optics than a matter of economic life or death. [Read here for more on the impact on Detroit of this export of manufacturing jobs.]
Past appreciation of China's currency has had little effect on U.S. exports. In China, most U.S. products compete against European or Japanese ones meaning exchange rates with the euro and yen are more important.
There are also relatively few Chinese and American products that compete against each other in third countries. The two countries simply produce different goods. And, if U.S. firms decide to move their factories from low-wage China, they are more likely to go to lower wage Southeast Asia than they are to return the United States.
But as a matter of U.S. politics, it is easier to criticize China and Chinese currency policies than it is to criticize the management of Apple, General Electric, or Hewlett Packard for manufacturing in China, retailers such as Wal-Mart for selling products manufactured in China, or American consumers for ultimately buying those products.
The issue of China's currency has assumed nationalistic importance, then, even if its economic importance for the United States is marginal.
What the United States has been calling China's "currency manipulation"--fixing the value of its currency to the dollar as countries in Latin America and Asia regularly did in the 1990s--has become a symbol for Americans of a strategic threat from China, which refuses to play by American rules or, more fundamentally, might become economically stronger than the United States.
Barack Obama's use of the phrase "Sputnik moment" in his January State of the Union address none too subtly portrays contemporary China as analogous to the Soviet Union of the 1950s.
The Historical Normality of Strategic Currency Policy
Competitive devaluations were around long before the phrase "currency war" popped up last October.
Since the onset of the modern, global economic system, states have regularly intervened in currency markets. Individual nations have manipulated their currencies (and where possible those of other nations) to gain competitive advantage over others. Some ideal "free market" in currency--untouched by government interference--has never truly existed.
Such currency engineering has come in many forms. It may be as simple as the repeated statements from American officials in the 1990s that they favored a strong dollar, thus making clear to those around the world that the United States would view appreciation of the dollar favorably. Just as currency depreciation helps ease deflation and recessions, currency appreciation can help keep domestic inflation in check.
More commonly, though, currency intervention aims to cause currencies to depreciate and means central banks selling domestic currency and purchasing key foreign currencies.
States may also take steps similar to those recently taken in Brazil, Korea, and China to impose reserve requirements, transaction taxes, or other restrictions on currency speculation. Shortly after Dilma Rouseff's inauguration as Brazil's new President in January, for instance, the Finance Ministry under Mantega announced new reserve requirements meant to control the Real's appreciation.
Prior to the nineteenth century—with the formation of modern nation states and national currencies—currency exchange worked quite differently from today and in a much less systematized manner, with a reliance on precious metals to back the value of currency.
Before the nineteenth century, it was typical to have transnational currencies whose value depended on the amount of gold or silver they contained. Trade in East Asia was fueled in part by silver coins from Mexico. Prior to the Meiji Restoration of 1868 in Japan, a variety of currencies from Asia and Latin America circulated within Japan. The early United States had no centralized currency, with private banks emitting their own currencies.
The global monetary system experienced some standardization with the advent of the "gold standard," in which countries fixed their exchange rates to a given amount of gold. This meant that their national currencies were thus indirectly fixed relative to each other.
Britain started using a gold standard after the Napoleonic Wars in the early 1800s. Germany, France, and other European countries followed in the 1870s and 1880s. And by the 1890s and early 1900s, countries worldwide began pegging their currencies to gold as well.
This latter period is commonly called the classical age of the gold standard. It has also been called a first age of globalization, with the gold standard being a largely market-based system free from the state control of later years.