Japanese Prime Minister Shinzo Abe has appointed Haruhiko Kuroda as the next chief of the Bank of Japan to execute his policy of rapid monetary expansion. Mr. Kuroda will follow the path charted by U.S. Federal Reserve Chairman Ben Bernanke and European Central Bank President Mario Dhraghi, using quantitative easing and other measures designed to pump more money into the Japanese economy. This will include the purchase of government bonds, corporate bonds, stocks, and possibly foreign government bonds.
Japan’s new strategy is the most recent example of developed nations manipulating their currencies under the banner of economic development. The expansionary monetary policies pursued by Japan as well as the U.S. and European nations have thus far not been accompanied by fiscal reforms required to halt deficits and the accumulation of debt, or the fundamental structural reforms required in labor and capital markets to restore long term economic growth. As these countries experience retardation and stagnation in economic growth, their aggressive monetary policies run the risk of another asset bubble similar to the one that led to the recent financial market collapse and recession.
The Japanese Yen has already depreciated sharply in anticipation of this sharp shift in monetary policy and is expected to depreciate further as the new policy is implemented. Mr. Kuroda—as head of the finance ministry’s currency policy in the early 2000s—pursued an aggressive policy to depreciate the Yen in order to make Japanese exports more competitive.
The Japanese government has frequently intervened in currency markets to hold down the value of the Yen. During his campaign, Mr. Abe argued that the Yen is overvalued and that currency depreciation is needed to make Japanese exports more competitive. In response to criticism from central bankers around the world, Mr. Abe has since backed away from that position; though he still argues that expansionary monetary policy is needed to boost Japanese economic growth.
Japan is not alone. A recent study by the Peterson Institute estimates that China alone has accumulated $3.3 billion in reserves. Meanwhile, other East Asian countries—including Japan, Singapore, Taiwan, Korea, Hong Kong Thailand, and Malaysia—have accumulated about $3 billion. The OPEC oil exporters and Russia have accumulated another $3 billion in reserves. Other currency manipulators include Switzerland, Denmark, and Israel (who intervene largely in Euros rather than dollars). The study estimates that $1 trillion of the reserves accumulated by the currency manipulators represents excessive currency intervention designed to keep their currencies undervalued.
The major casualties in this currency war are developing countries with trade deficits, such as Brazil, Mexico, and India. These developing countries often intervene in currency markets to prevent currency appreciation and its negative effects on their balance of trade resulting from currency depreciation and manipulation in other countries.
Expansionary monetary policy in developed nations like U.S. and Japan has held interest rates at or close to zero. Investment has flowed from these countries into the capital markets of developing countries in search of higher returns. Such capital flows are highly volatile, and some developing countries have imposed capital controls to limit their exposure to this ‘hot money’.
When the Federal Reserve Board published its recent meeting minutes revealing dissent regarding the current policy of quantitative easing, the stock market took a tumble. We can only guess what the response will be when the Fed actually begins unwinding the huge portfolio of debt accumulated through quantitative easing.
Unfortunately the prospects for ending the currency war are not good. Indeed, the most likely prospect is further escalation. Mr. Abe has made it clear that Japan will pursue an aggressive policy of monetary expansion regardless of the monetary and exchange rate policies pursued in other countries. Fed Chairman Ben Bernanke, who supports the new Japanese monetary policy, has stated that the U.S. will also use “domestic policy tools to advance domestic objectives.”
Other developing countries are unlikely to sit back and watch their currencies appreciate and their trade deficits deteriorate. Guido Montegna, Brazil’s finance minister, has made this very clear: “The currency war has become more explicit now because trade conflicts have become sharper.”
The currency war appears to be escalating with even greater currency depreciation, trade restriction, and capital controls. These beggar thy neighbor policies led to the collapse of world trade and capital flows during the Great Depression. If the U.S. continues to pursue this roadmap, we may again be accused of turning a recession into a major depression.
Barry W. Poulson is Professor Emeritus, University of Colorado at Boulder and Senior Fellow in Fiscal Policy at the Independence Institute, a free market think tank in Denver. This article originally appeared at Forbes.com.
