The Three-Way Currency Contest

The Economist’s Buttonwood column (subscription required) poses an interesting dilemma: the managers of each of the three largest currencies in the world – the dollar, yen, and euro – would like their currency to depreciate. Yet it is impossible for all three to simultaneously depreciate against the others.

I’ve previously written a bit about why the US government wants the dollar to depreciate, particularly against Asian currencies, in order to stimulate exports, reduce imports, and thus hopefully help the US manufacturing sector.

However, Buttonwood points out that the Japan also wants its currency to fall:

Japan’s recovery started in the fourth quarter of 2001 and growth is picking up. But officials there are increasingly worried that a rising yen will choke it off. The yen is close to a three-year high against the greenback. Its rise accelerated after the recent G7 summit in Dubai, when America’s weak-dollar policy became most obvious. Yet Japan needs the yen to fall because it needs inflation to help wipe out the massive debts the country incurred both during the bubble and in trying to get the economy going again after it had popped.

But that’s not all. What about Europe? They are also facing the real possibilities of recession and deflation, so…

At some point, perhaps even the European Central Bank will wake up to the fact that the rising euro will keep the European economy close to recession. All of which is to suggest that none of the world’s major currencies is especially alluring; for one reason or another governments in all three might want them to fall. Of course, they cannot all fall against each other.

The column goes on to hypothesize that maybe what will happen is that all three currencies will depreciate against a fourth major international asset: gold.

It’s an interesting possibility, but I disagree about its likelihood. To get this effect, you’d need to think that investors, losing confidence in all three currencies simultaneously, will all flock to gold instead, pushing up the price of gold and thus the value of the three currencies down.

Far more likely, I think, is that investors will favor one or two of the three major currencies over the other(s). There will therefore be one or two winners in this currency tug-of-war, and one or two losers. The winner will get a depreciating currency, the losers an appreciation.

The net effect on each country’s economy, however, will depend on more than just the value of each country’s currency. It will also depend on whether investors simultaneously drive down asset prices in the country that they shift away from. If investors decide to move out of the dollar, for example, they could also decide to move out of the US bond market, driving up US interest rates. Whether or not that happens will depend on the confidence they have in the financial management of the US government.

Uh oh.