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There’s a Feeling of Instability Bubbling Up

Friday 22 February 2013


There’s a back to the future feel about the global economy right now. The only question is back to what future? The obvious answer considering the events of the past week is the 1970s. There are plenty of echoes in the world today of the currency instability, rising inflation, rising unemployment and political uncertainty that marked that troubled decade.

Over the weekend, finance ministers and central-bank governors from the Group of 20 industrialized nations tried to play down fears of new currency wars that have been spooking markets since last month’s election of a new Japanese government. The Bank of England recently became the latest central bank to relax its inflation-fighting credentials by formally abandoning its long-standing objective of returning inflation to its 2% target within two years. Meanwhile European gross domestic product shrank by more than forecast in the fourth quarter, creating fresh uncertainty over when the recession will end.

But it doesn’t take much of a leap of imagination to see shadows of a very different decade: as in the early Noughties, the dominant dynamic in the markets today is a desperate search for yield that is fueling potential asset bubbles across global markets. Just as the U.S. Federal Reserve loosened monetary policy in the aftermath of the dotcom crash, central banks have been again flooding the world with easy money to try to pull the global economy out of its current malaise. And as in the past decade, there is evidence that all this liquidity is leading to asset-price inflation even as consumer-price inflation remains low, with concerns about bubbles in assets as varied as Swiss, Canadian and London real estate, emerging-market equities and the European corporate-credit market.

At the same time, some believe Warren Buffett’s proposed $28 billion takeover of Heinz may mark the start of a new giant leveraged buyout boom. On this analysis, the seeds of the next financial crisis may be being sown before the current one is over.

So which decade will the current one resemble? The reality is that talk of 1970s-style currency wars looks premature. True, the G-20 statement designed to cool anxieties was bland and unconvincing; it acknowledged that "excess volatility of financial flows and disorderly movements in exchange rates have adverse implications for economic and financial stability" and it committed governments to "refrain from competitive devaluation."

That still leaves ample scope for further devaluations so long as they happen to be the serendipitous byproduct of domestic monetary policy pursued for domestic reasons rather than efforts to "target our exchange rates for competitive purposes."

Indeed, the global currency debate is full of humbug. The U.S. was the first country to be accused of waging currency war, when Brazil objected to the Federal Reserve’s second round of quantitative easing in 2011, which was widely seen as a naked attempt to drive down the dollar.

The new Japanese government may now claim that its promise of a massive monetary and fiscal stimulus is solely designed to boost the domestic economy but it has made little secret of its desire to see a weaker yen. Similarly, Bank of England Governor Mervyn King has been open in his view that a further devaluation of sterling, on top of the 20% depreciation since the start of the global financial crisis is needed to further rebalance the economy—even while warning that other countries risk triggering competitive depreciations.

In fact, Mr. King could be said to have coined a new irregular verb: "I rebalance my economy, you competitively devalue, he has started a currency war."

Even so, there are good reasons to believe that talk of currency wars is, for the moment, just talk. First, it is hard to argue that any advanced economy has so far secured a significant competitive advantage via its exchange rate. Even after Japan’s near-20% devaluation this year, the yen is still trading within its long-term range, having been significantly overvalued over the past few years as it attracted safe-haven flows in response to the euro crisis. Similarly, the recent rise in the euro is hardly conducive to growth and has caused some anxiety in some European capitals, but the currency is still within its long-term range against the dollar.

The exception is the U.K., which has somehow escaped international censure despite the biggest depreciation of any major currency—perhaps because it has apparently derived so little benefit from it.

Besides, it’s hard these days to win a currency war. So long as global consumer-price inflation is low, estimates of spare capacity are high and central banks are willing to "look through" short-term inflation spikes, every country has access to the chief weapon needed to fight the war—ultraloose domestic monetary policy. Indeed, the yen’s previous rise partly reflects the Bank of Japan’s reluctance to expand its balance sheet as much as the Fed, BOE, or the European Central Bank. At the same time, the global prohibition on competitive devaluations appears asymmetric; countries that have intervened to prevent their currencies rising, such as Switzerland, have so far escaped censure. Goldman Sachs argues this de-facto global stand-off over currencies represents an unofficial Global Exchange Rate Mechanism.

But if the price of avoiding currency wars is even looser monetary policy, this brings risks of a different kind. How policy makers respond to possible new asset-price bubbles will be crucial in determining whether the rest of this decade is a replay of the ’70s, the Noughties or something more benign. On this score, perhaps the most interesting development last week was the Swiss National Bank’s decision to impose extra capital requirements on Swiss banks’ exposures to the domestic mortgage market. This was one of the first attempts by a central bank to try out the big new idea of the postcrisis world: macro-prudential regulation. Whether it succeeds in cooling an over-heating market remains to be seen.

Nor is it clear how ready other central banks are to use these new powers. After all, central banks have so far largely welcomed rising asset prices as a sign of restored confidence and view low yields as creating an incentive for investment.

In the absence of domestic political support, it would take a brave policy maker to argue that soaring asset prices risk creating a new debt-fueled misallocation of capital and threaten to pull away the punch bowl. But perhaps they’re made of sterner stuff these days. Write to Simon Nixon at simon.nixon@wsj.com

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