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.

First blog of mine!

After being very patient while personalising the design of this blog, due to a really slow internet connection, it's time to post my first blog.

A few small things that were on my mind last week:

• Saying "With due respect, but..." shows no respect at all. So: it's better not to use this at all. Why then do we have this saying?
• Asking whether you can ask a question is not really productive.
• Neither is "to be honest...". Aren't you honest otherwise?

Apart from these language-related issues, I read some articles on the stress testing that is to be performed on 91 European banks these weeks (a list of which banks are included can be found here). A serious stress test would have been such a good idea: confidence could be restored and uncertainty lowered, thereby perhaps lowering the interest rates Southern European governments bonds pay currently. And once clear which counterparty of banks are safe, banks can finally start lending to each other again, instead of parking their money on the ECB overnight facility at a very low yield.

Results are to be published the 23rd of July. Exciting? I'm afraid not! Although it seems quite scary that the ECB refuses to set aside capital in case markets panic after release of the testing results, and also national governments have no action plan stipulated when this happens, it is actually not so scary. Why not?

After a long time of debate on what the stress testing scenarios would look like, EcoFin decided not to include the scenario of sovereign default, while this is the utmost important scenario that investors worry about. For the stress testing results to be credible, this scenario must be included, otherwise it is not the sunlight that will bring the disinfection financial markets so desperately need (because they do what outsiders cannot do on their own: assessing the health of banks). My guess on why this extreme but still likely scenario is excluded is that it would lead to too many defaults, meaning that additional capital injections will be needed, while this is not what the ECB and governments are willing to do.

Unfortunately for Spain, the country that pushed the publication of stress testing results, the effects of the publication are likely to be minor in my view; investors will not stop worrying about the creditworthiness of EU banks. On the other hand: would we have wanted such severe stress tests that may banks would have defaulted in the tested scenarios? This seems even worse, since governments refuse to have a plan B ready if markets panic.

Perhaps in the future, when other stress tests will be done on European banks, scenarios will be severe enough, and governments will have learned to draw up contingency plans in case markets panic. But: not yet... A serious stress test could have been such a good idea: once clear which counterparty of banks are safe, banks can finally start to lending to each other, instead of parking their money on the ECB overnight facility at a very low yield. Confidence could have been restored and uncertainty lowered, thereby perhaps lowering the interest rates Southern European governments bonds pay currently.

I think in the above it has become clear why I do not believe that publication of the stress testing results would lead to a required capital injection of 100 billion euro, as stated by some analysts at the Dutch Rabobank.

Now it's waiting for publication of the results on the 23rd. In the meantime, I hope to keep you updated on other interesting stuff catching my attention.

Last but not least: the website of The Economist has been renewed. Looks quite nice now!