The Race To The Bottom
On Monday this week (23/2) the Bank of Israel became the twentieth central bank in the world, so far this year, to make a move in the direction of easing monetary policy. That’s twenty banks in 54 days – and those 20 include countries of every shape and size: rich developed economies and poor undeveloped ones; large and populous countries (both China and India are on the list) as well as small or thinly-populated ones; every continent is represented along with governing systems of every stripe.
All these central banks have one thing in common, and that is their determination to devalue their currencies. That is their goal, whereas the actual measures – lowering interest rates, reducing reserve requirement for banks, buying bonds in the market, or all of the above – are merely means to that end.
In some cases, the reduction of interest rates is also expected to have some stimulative effect on the country’s economy: Australia can serve as an example, because its rates are still measured in whole percentage points (plural) rather than slivers of a single percentage point. In most cases, however – and Israel is an excellent example – rates were already so low that pushing them down slightly further has no practical implications for either borrowers or lenders. Depositors in banks were already getting nothing and lenders were paying next to nothing, so that a few less basis points (hundredths of a percent) is neither here nor there.
But the Israeli example – the Bank of Israel reduced its lending rate from an already record-low level of 0.25% to 0.1% — also serves to illustrate another motive behind these moves. That is to send a message to the markets and to all the participants in that country’s economic activity – the message being that “we, the central bank, intend to adopt the ‘whatever it takes’ slogan coined by European Central Bank President Mario Draghi, as the basis of our monetary policy. We are committed to pushing rates down further and further, in an effort to stimulate our economies and to prevent deflation taking root”.
The message is important, but in this case the medium is certainly not the message. With interest rates at or near zero, further marginal cuts cannot spur activity, in and of themselves. But, as noted above, that is not the real point of the move – rather, it is to weaken the national currency. Devaluation makes the products of a country cheaper and also makes imports from other countries more expensive. Boosting exports meets the goal of stimulating economic activity, while raising the price of imports helps push up inflation or, at the least, stems any move to deflation.
This policy carries costs, of course, but it is at least arguable that its potential benefits outweigh those costs – on condition the benefits are realised. However, if every country is engaged in the same basic policy, of printing money to push interest rates down and thereby weaken its currency, then every country’s currency will go down more or less in tandem – and the expected/ hoped-for benefits will be lost. In fact, in this state of affairs – which is the one that is actually occurring, as the EU, Japan, China, India, Brazil, Russia, Australia and many others (but not the US or the UK) join the fray – while the benefits will largely be dissipated, the costs will largely remain.
Thus the world is caught in a cycle of competitive devaluations which are aimed at gaining a competitive advantage for the devaluer, but in fact leave everyone more or less where they started, but with extra costs. This is self-destructive and hence insane behavior is termed in the textbooks as “beggar-thy-neighbour” policies, because they seek to attract business away from the neighbouring country by posting a cheaper price (via a devalued currency). They were prevalent in the 1930s, in a vain effort to break out of the deflationary pressures then at work – and the results were disastrous.
However, this policy is only insane from an overall global standpoint. If you look at the whole world, it’s easy to see that if everyone does it, no-one will benefit – so the conclusion is clearly that no-one should do it. But the first country to do it will gain an advantage, or at least can hope to do so. The incentive to be that first country is obvious – but once one or two countries do it, then all the others are at a disadvantage and feel – probably correctly – that they must follow suit, or else they will suffer. So they join in – not because they expect to achieve an advantage but merely to prevent themselves suffering a disadvantage. That, in fact, was the rationale behind the Bank of Israel’s move.
Students and practitioners of game theory will recognize the dynamics at work here, as will international relations experts – and professional soldiers. The dynamics of a currency war are no different from those of a real war: every move generates a response and, critically, every entity must give primacy to its immediate interests, even if it is perfectly clear that by doing so, it is damaging the general interest.
No single move is decisive, so each set of moves can only constitute a single round in a longer process. In the currency markets, that process becomes a race to the bottom – a race which no-one can win, but everyone can lose.