Must Europe follow the rest of the world in a currency conflict? ‘Ernst’s Economy for You’, live from BNR Newsroom, Pt II

Here is the second episode, about the live radioshow BNR Newsroom, hosted by Paul van Liempt.

Paul van Liempt in discussion with FD-correspondent Saskia Jonker
Picture copyright of Ernst Labruyère
Click to enlarge

Today’s blog will be handling the second subject of the evening: the imminent currency conflict between Japan, the tandem United States/United Kingdom and Europe.

The speakers for this subject were the sage Professor Sylvester Eijffinger of the University of Tilburg and Bart Jan Koopman of Fenedex, a private association of Dutch exporters and internationally operating companies.

I will print here again an almost integral coverage of this discussion, as I consider it very interesting for my readers. Especially the words spoken by the professor on this subject, give ample food for thought. I had also the chance to drop in a question in this discussion, which again can be found at BNR Business Radio: only in Dutch.

Paul: A currency conflict can be bad for the world economy! Are we at the brink of such a currency conflict?

Sylvester Eijffinger: At the G20 summit of last weekend, no agreement has been made. Neither on the fiscal budgets of the G20 countries for the medium-range term, which could be expected, nor on the excessive quantitative easing (QE) that has been carried out by the Japanese government in the past months.

Even when compared to the Federal Reserve and the Bank of England, the QE program of the Bank of Japan was huge. And they will continue with this program.

During the last four months the value of the Yen plumeted by 20%, due to QE and the massive speculation by the likes of George Soros.

After the G20 summit, I presume that the Japanese thought: "This went great; we were not penalized for our QE program, so lets continue this". This could lead to 30% depreciation of the Yen eventually. Then, somewhere between the 20% and 30% of depreciation, there is a tipping point where the Americans and in their trail the British must react.

That reaction is very important. When the Americans say: 'This Japanese QE-program runs too much at the expense of our own export industries', they will react. You have to realize that the Americans do much more business with Japan than Europe.

When eventually the US decide to expand their own quantitative easing program, and the UK follows their example, then the Euro-zone is the only zone that will not respond. As you probably know, the ECB doesn't have a mandate that allows QE. ECB Chairman Mario Draghi stated it today: “We have only a mandate to intervene with the interest rate or the currency, when the price-stability in the Euro-zone is under jeopardy”.

Professor Sylvester Eijffinger, University of Tilburg
Picture copyright of Ernst Labruyère
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Paul: Will the ECB than be the proverbial single sporter that plays by the rules, while all the others don't?!

Sylvester: A currency conflict isn't a solution at all for Europe. When we look at the eurozone, to start with Germany: according to an investigation by Deutsche Bank, German exporting companies are competititve until €1 = $1.80.

French and Italian firms, however, start already to experience export problems at $1.20. That explains why François Hollande is banging the drum for monetary intervention. The French automotive industry is inefficient and thus not competitive. Peugeot, Citroën and Renault are experiencing big problems currently, while the German automobile industry has nothing to worry about, in spite of the hard Euro. The Germans do not only export to the emerging markets, but also to the US. The quality of their products is that good that price is not really an issue for the premium brands. That is a fundamental difference between Germany and France, which cannot be solved through a currency policy.

Paul: Do the members of Fenedex notice the strong euro?

Bart Jan Koopman: Yes, they do. The question is, however, whether this is harming us. The answer to this question depends on the duration of this situation, in which the Euro is very strong. Swings in the exchange rates have always existed. It depends on the bandwidth and duration of these rate swings whether it will hurt us or not.

Fenedex-chairman Bart Jan Koopman
Picture copyright of Ernst Labruyère
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A strong euro has also a flipside: Dutch companies purchase many goods outside the Euro-zone for a substantially lower price, when the euro is expensive.

Paul: I understand that, but how harmful is an expensive euro in a broad sense?

Bart Jan: At short notice it is not so bad. One or two companies might lose their competitiveness, but that's all. In the long run, this might be a different story, especially when the US dollar gets involved. Then such a currency conflict could lead to substantial financial damage for Dutch businesses.

Ernst's Economy: The Netherlands is a large exporter of agricultural produce. Also to countries like Russia, where the local Ruble is closely attached to the dollar. Agricultural produce is much more price-sensitive than German cars. Could such a currency war not lead to much more damage for The Netherlands than for Germany, in comparison?

Bart Jan: That could be, but now there is only an issue with the yen. When it remains within the current spread, than everything is more or less fine in short notice. Even when the dollar would be involved, the risk is not imminent.

The Euro has had a rate of $1,44 before. When such a situation doesn't last for a long time, everything will be cool. At this moment, the Dutch companies are still competitive. The export is one of the few Dutch sectors that still shows a healthy growth.

But there might come a time, when this currency conflict could harm individual companies and whole industries. Still, Dutch companies make products (a.o. innovative seeds for the worldwide agricultural industries) that are just as unique as German cars and can't be found elsewhere.

Eline Ronner: I have a question for Prof. Eijffinger. Up to which exchange rate, the Dutch companies are still competitive?

Sylvester: Just like Germany, The Netherlands is probably still competitive until $1.70 - $1.80 per Euro. This is the reason for the current, divided factions within the ECB: the very competitive Northern countries and the not-so competitive Southern countries. Mario Draghi knows darn well that the presidents of the Northern European central banks will never agree to intervene in the exchange rates. He told this to the European parliament today.

I learnt during many years of working at different central banks - also the Bank of Japan as a matter of fact - that the best intervention is no intervention! Interventions are useless most of the time. The whole currency market has a value of several trillions of dollars. A large intervention goes to the tune of a 10-20 billions of dollars. It is a drop in the ocean. I saw this during my stints at the central banks: the effects of such an intervention are a short blip at your Reuter's screen.

Paul: The Bank of Japan warned that they will deploy an aggressive currency policy anyway. They didn't listen to you?!

Sylvester: It is a mistake to think that the BoJ is independent, like most of the other Central Banks in the western world. They receive their orders straight from the Japanese Finance Ministry. According to employees of the BoJ itself, it is nothing but an agency that must follow orders, concerning currency market issues. The Finance Ministry and the Ministry of International Trade and Industry give the orders for exchange rate interventions and the BoJ carries them out. No questions asked. The Japanese growth is almost exclusively generated by exports, just like in China nowadays. However, Japan already acts in such a way for forty years in a row now. You can only maintain such a policy when the market value of the yen is lower than the intrinsical value. However, at this moment they are outdoing themselves with these interventions. And this will probably go on for a while.

Paul: Will the Japanese not step into a negative trap?!

Sylvester: The G20 didn't punish the Japanese for their behavior. At the last summit, the G20 didn't want to step in yet. They will wait for half a year. The next G20 summit will be in St-Petersburg in September. When things run out of hand – for instance when the exchange rates of the Yen drop by 30% and the Federal Reserve and Bank of England step in with expansion of their own Quantitative Easing programs – then the time is right for an exchange rate agreement. This has been always the way that things worked. If you look at the last 40 years, there have always been periods in which things went the wrong way. Afterwards an agreement was made. Now is not the time for such an agreement yet.

Bart Jan: We must not forget that this policy has not been very succesful for Japan. There has not been much growth in Japan during the last twenty years. Consequently, there is not much reason for The Netherlands to be afraid of Japan. This is an isolated case, that will require a small correction, sooner or later.

However, when the whole world, including the dollar block, is going to move and we get larger swings in exchange rates for a longer period of time, than The Netherlands and Europe might have a bigger problem. When the exchange rate for the dollar would be $1.80, I would be scared.

Paul: What would happen in such a situation, when this scenario becomes true?

Bart Jan: I don't think that such a situation will occur. In the 25 years of hindsight that I have, all large exchange rate swings have been settled before great damage could be done. This didn't hit the structural competitiveness of The Netherlands.

Paul: Aren't we perhaps too optimistic? The last great currency war was in the 30's of the last century. People could think that such a thing couldn't happen again.

Sylvester: The last period of great instability that I can remember was in the eighties, the time of the 'Plaza-Louvre' agreement. In those days, the relations between the FED, the Bundesbank and the Bank of Japan were very disturbed. There was no normal course for the exchange rates anymore. Things got so out of hand, that even the Japanese were willing to get into the cartel of an exchange rate agreement: first the Louvre agreement and afterwards the Plaza-agreement. This was very unique and didn't last very long. Most cartels only exist as long, as they remain in the interest of all the particpants; such a period is mostly half a year. Afterwards, parties start creating their own set of rules again.

What I fear most, is when the Fed and the Bank of England step in and even further expand their balance sheets. Remember, the balance of the Fed is already $3 trillion(!). Of course, this could be expanded some more.

The biggest problem, however, is that the debt positions of the central governments got out of hand everywhere. Now you can see, that the normal budget policies of individual countries can't solve these excess debt situations anymore. Governments now try to inflate themselves out of misery. This is financial repression. You must realize that there has been negative interest in almost every currency around the world, for almost five years. That is exceptional. And this situation will continue.

 Governments do this financial repression to inflate the state debt away in nominal terms. As long as their inflation is higher than the interest rates they are charged with, the debt vaporizes. You could call this a ‘crowding out’ scenario at the expense of Small and Medium Enterprise and citizens with a savings’ account. This is a condemnable situation. The governments can follow this policy as long as the real interest rate (nomal interest vs inflation) remains negative and the banks prefer state debt for safety.

 Especially in countries with a difficult financial situation, like Japan, Italy or Spain, banks are pushed by the government to buy state debt, through Moral Persuasion.

"If you don't buy our debt, we can be a pain in the butt for you".

The underlying problem is, that the exchange rate policy could be used as an instrument for stimulus. This policy is then used as a drug to keep the real problems in an economy under control. In this way, an exchange rate policy suppresses the need for restructuring the economy in such a country. Consequently, economies remain ill much longer than strictly necessary. “The easy way out is not the best way out.”

If the ECB would follow in this exchange rate conflict, this would immediately diminish the need in the South of Europe, including France, to restructure the economies. That would be a really bad solution.

It was again a very fruitful evening at BNR Newsroom. I was impressed by the knowledge and experience of Sylvester Eijffinger. With him I hope that the ECB will not follow the example of “inflating yourself out of misery”. Private savers and pension funds will pay the price for this reckless monetary policy. 

This doesn't change the fact, however, that something needs to be done about the excess debt and economic problems in Southern Europe. I will come back to that soon.