Will politicians be able to avert prisoners’ dilemma outcome amid pressures? Currency war debated.

During the last days, attacks on Chinese exchange rate policy (regarding the undervalued Yuan) have become more intense. After the U.S. had ignited the debate by introducing a Currency Bill that would give the U.S. the right to levy import tariffs over Chinese products that are too cheap due to the export subsidy in the form of the undervalued Yuan, other countries were asked to join the debate. Once the Currency Bill has passed Congress and Obama put its signature on it, China can take the case to the WTO. Then, it might take months before the issue is settled, and in the mean time, other countries might have followed the U.S. example, damaging Chinese exporters. Since the chances that the Currency Bill will not be condemned by the WTO are much higher if other countries follow the U.S. example, the EU has strengthened its tone vis-à-vis China to make its exchange rate regime more flexible in practice (currently, it’s only flexible in theory). (Asking the Europeans to introduce an equivalent to the U.S. Currency Bill is perhaps a bit too much.)

But the Chinese are not stupid; they offered Greece a Marshall Plan II whereby China is buying Greek bonds (while saying they strongly believe in the good economic fundamentals of the country and the Euro zone) in return for Greece buying Chinese products. By supporting the weaker countries in the Euro zone, they ensure the strength of the euro, and thereby they retain an investment alternative to the U.S. dollar and an export market. Moreover, it implicitly tells the EU that it should not complain. The EU has gotten one cookie, it should not ask for another one. So now the EU is said to back off when it started complaining about the Yuan weakness.

So this move by the Chinese was very clever, in my opinion. However, do they really have a right to ignore global complaints about the weakness of their currency? IMF studies, and other ones, agree that they Yuan is 20-40% undervalued. If that’s not an unfair export subsidy, what is?

More and more countries seek to devalue their currency by intervention and/or loose monetary policy. Research has provided ample evidence unsterilised intervention is only working when accompanied by a loose monetary policy (and sterilised intervention is actually never working, perhaps only in the short run, and it can even be counterproductive, due to signalling effects). However, it is not always possible to loosen monetary policy. Japan has loosened monetary policy for years and is at or near the zero interest rate bound for years now, without having lifted Japan out of its period of (near) deflation.

Furthermore, it just is a very bad idea to try and weaken your currency, if all your neighbour countries have the same idea. When visitors on the first row of a concert start standing on their toes to have a better view, visitors on the second row have to come up with something better. Maybe jumping does the trick for them. But the ones at the back row really have a problem. This is the outcome of the well-known prisoners’ dilemma: nobody will have an advantage from it (the ones at the first row will start experiencing aching toes after some minutes and will regret their actions).

This is obvious: if each country seeks to lower its currency, flooding the market with liquidity, no country will succeed to lower its currency relative to the other countries. Except, of course, if one country takes such extreme measures that this immediately wipes out the value of its currency. Hyperinflation will prevail. Perhaps it is good – albeit only relatively good – if one country would follow this course, just to set the (bad) example.

Luckily for us Europeans, it is unlikely that the ECB will be the first one setting the bad example; the ECB is farthest from all central banks of the weaker countries to engage in extreme further quantitative easing, although the ECB did admit banks were addicted to their liquidity provisions such that the ECB has seen its exit doors (their path to tighter policy) being blocked.

The big question is, however, how far countries will go. There is a slight chance that central bankers and politicians do not realise the game they are playing is a very nice example of this prisoner’s dilemma. One step in the wrong direction, and the prevailing outcome will not be likened. In the end, every country will be worse off. Political pressure to purposefully devalue currencies, unfortunately, is enormous. I (being an optimist) do not believe central bankers will be so naïve (read: stupig) to underestimate the dangers going “all out” and continue the road (downhill) of extreme QE and currency devaluation.

But perhaps I am just being optimistic, believing in the wisdom of politicians and central bankers. And that is perhaps not so wise.