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America's Losing the Currency War

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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U.S. hedge fund manager Ray Dalio pointed out in Davos yesterday that talk of purposeful currency devaluation to make up for an economy's inefficiency -- the engine of currency wars -- is a "conversation that is not polite to have." He is, perhaps, a little behind the times. World leaders increasingly feel comfortable talking openly of their plans to drive down exchange rates.

Italian Prime Minister Matteo Renzi told The Wall Street Journal this week that his "dream" was parity between the euro and the dollar. Italian exports have been growing lately, averaging 33.2 billion euros ($37.4 billion) in the first 11 months of last year, 1.7 percent higher than in the same period of 2013, but Renzi hopes more support from the European Central Bank can make up for the fact that labor productivity in his country is just 72.8 percent of the U.S. level.

No wonder the phrase "currency war" is now part of the mainstream discourse, not just one of Dr. Doom Nouriel Roubini's stock scares. In Davos, Goldman Sachs President Gary Cohn said this week that the world has been in a currency war since Japanese Prime Minister Shinzo Abe's policies started pushing down the yen's rate two years ago. After that, Europeans felt the pinch and started devaluing the euro. Now the ball is in Japan's court again, and the U.S. is "just sitting here watching, being the one country whose currency is rallying because everyone else is trying to devalue." Only recently, Switzerland has joined the U.S. "We're happy to have them on that side of the ledger," Cohn said sarcastically.

Economic data broadly bear out Cohn's view of the competition dynamics. Japanese exports (shown here in billions of yen) slumped in 2011 and 2012, then rallied spectacularly since Abe's devaluation:

Japan ministry of finance

Euro area exports have stagnated as the ECB hesitated to introduce more stimulus:

Economics ministry of France

So far this year, according to Bloomberg's correlation-weighted indices, the U.S. dollar has gained 2.83 percent against a basket of other developed nation currencies, and the yen has gained 4.77 percent. The euro is down 4.88 percent, and the ECB's QE program hasn't even started yet. Even the mere talk of quantitative easing has made European exporters much more competitive. 

According to the January 2015 edition of The Economist's Big Mac index, which uses the price of the McDonalds staple in various countries as a measure of purchasing power parity, the euro is already undervalued compared to the U.S. dollar, while in July, the index showed that it was overvalued. That standard isn't definitive, of course, but it does give reason to wonder whether the ECB's plans for additional might be on the overaggressive side. Europe might improve its export competitiveness at the expense of inflation.

In 2013, as Abenomics got into full swing, the U.S. Treasury was openly and vocally worried about Japan starting a currency war. "We will," it said in the April, 2013 edition of its currency rates report to Congress, "continue to press Japan to adhere to the commitments agreed to in the G-7 and G-20, to remain oriented towards meeting respective domestic objectives using domestic instruments and to refrain from competitive devaluation and targeting its exchange rate for competitive purposes."

Now, as Europe makes its competitive move, the U.S. government is acting relaxed. It's not making any more threatening references to gentleman's agreements among world leaders to prevent currency wars. In the latest version of the report, which came out last October, Treasury raised no red flags about any countries that might be devaluing their currencies competitively. Last month, U.S. Treasury Secretary Jack Lew said it was "wrong to get into exchange-rate competition" but added: "On the other hand, we have called on many countries in the world to take decisive action to get their economies to grow."

It's true that, in order to keep growing at its current rapid pace, the U.S. needs a boost in global demand. But its complacency about the scale of planned ECB action may nonetheless be misguided. If the euro does sink toward parity with the dollar, European manufacturers will take advantage of U.S. growth, but American ones will become uncompetitive in Europe.

Other central banks -- those in India and Canada, among others -- have been cutting rates and weakening their currencies, too. Dalio predicted the moves could lead to a "short squeeze" on the U.S. dollar like the one seen in the 1980s, which required concerted action from central banks to curb the dollar's rise and prevent the U.S. economy from tanking. This time, however, such action is far less likely because countries such as Italy see QE as their big chance to restore growth. It's certainly easier to print money than to raise productivity closer to the U.S. level.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
Cameron Abadi at cabadi2@bloomberg.net