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Currency Warriors Need a Dose of Tough German Love

European Central Bank (ECB) headquarters in Frankfurt, Germany.
Hannelore Foerster | Bloomberg | Getty Images
European Central Bank (ECB) headquarters in Frankfurt, Germany.

As central bankers to the economic systems representing 40 percent of the world economy, it is obvious that policies conducted by the U.S. Federal Reserve and the European Central Bank (ECB) to support their economies also have a positive impact on jobs and incomes well beyond the U.S. and euro area borders.

Working against gale force headwinds of tightening fiscal policies, these two central banks managed last year to keep their domestic demands strong enough to purchase an estimated $5.2 trillion of goods and services from the rest of the world. That was by far the largest contribution to the well-being of the global population.

Does it make sense, then, to accuse the Fed and the ECB of spurring global currency wars when they are stimulating economic growth so that the U.S. and the euro area can lead the world to greater prosperity? And they are doing that at the cost of their combined trade deficit of more than $600 billion.

(Read More: What Currency War? Move Along, G-20 Leaders Say)

At closer look, it seems that the purveyors of currency war slogans are complaining that upward pressures on their currencies are frustrating their attempts to extract more export-led growth from the Fed and ECB efforts to keep the world economy afloat.

Learning to Love Strong Currencies

The remedy, though, is very simple. Currency warriors should do just what the markets are pushing them to do: Let their currencies appreciate. That could help them to (a) control inflation with better terms-of-trade, (b) spur their consumer spending by raising real household incomes, (c) get more growth from domestic demand and (d) stop living off their trading partners.

And if the currency warriors still want to push their exports, they might use Germany's tough love advice to its heavily indebted euro partners: Improve competitiveness by cutting production costs and budget deficits. That might throw some incumbents out of power, as it did in a number of euro area countries, but is sure to slash unit labor costs. That is what happened in Greece, Ireland, Portugal, Spain, Italy and even France. The average unit labor costs in this group of six euro area countries are now falling at an annual rate of 1 percent, while they are rising in Germany at an annual rate of 1.9 percent.

(Read More: Spain Is the 'Next Germany,' Says Morgan Stanley)

Does that mean that Germany will now be joining the currency war crowd? Well, think of this: Germany's Chancellor Angela Merkel was the first world leader to strongly denounce what seemed like Japan's competitive devaluation. And when the French President Francois Hollande complained a few weeks ago about the strong euro, Chancellor Merkel rushed in to tell him that it was not a good idea to stray into the ECB's policy domain.

True to the old German tradition, Chancellor Merkel likes the strong currency, because that forces the corporate sector to defend market shares through rigorous cost management, productivity gains and technological innovations. Such a policy keeps German companies away from blind alleys of devaluations and destructive price hikes. With the world's largest trade surplus – a whopping $220 billion -- Germany remains a formidable export power house.

And Germany even got some latter day converts. Last week, Spanish Finance Minister Luis de Guindos reassured his euro area colleagues that his country's exports were growing in spite of the strong euro. A resounding proof, if one was needed, that German ministrations were doing their magic: Spain brought down its unit labor costs at an average annual rate of 2 percent since 2010, and the country's falling borrowing costs are showing that markets are getting the message.

Fed and ECB Ignoring Currency War Chatter

Hopefully, the G-20 meeting of finance ministers and central bank governors in Moscow on February 15 and 16 has put an end to the loose talk of currency wars with the pledge that "we will not target our exchange rates for competitive purposes."

(Read More: Lagarde: Currency War? More Like Currency Worries)

At any rate, investors would be well advised to focus instead on what the Fed and the ECB are doing. How – and when - these two institutions intend to exit their current phase of monetary easing is an infinitely more important investment strategy issue.

Here are some thoughts on that.

Given that (a) 82 percent of the U.S. economy (household consumption and business and residential investments) is growing strongly, (b) the core inflation rate is at 2 percent and (c) inflation expectations keep pushing up bond yields, the Fed will be the first to begin a gradual withdrawal of its exceptionally large monetary stimulus.

As always, the timing of the Fed's tightening move will be data driven. But don't expect the policy shift to wait until the unemployment rate comes down to the Fed's target of 6.5 percent (from last month's 7.9 percent). Such labor market changes are the lagging indicators of economic activity, and the Fed won't want to be behind the curve. Also, the steepening term structure of interest rates will make the Fed's effective money market rate of 0.16 percent untenable.

(Read More: Fed Policy Put 'Pedal to the Metal' in 2013: Bullard)

The ECB case is much more complicated. But it is not going out too much on a limb to say that a tightening move is unlikely to happen this year. The euro area's domestic demand will remain quite weak, an already high 11.7 percent unemployment rate will get worse and a lingering recession will make it difficult to raise tax revenues to meet even newly relaxed budget deficit targets. Plunging euro area unit labor costs suggest strong underlying deflation pressures, despite the fact that market rigidities continue to keep inflation at 2 percent. The ECB will also be very careful not to encourage any sustained gains in the euro's trade-weighted exchange rate.

Investors should pay no attention to discredited views of the euro area breakup. To be sure, euro squabbles are part of the political process, and many unsettling events lie ahead: the terms of the Cyprus bailout, Greece's resurgent extreme left (and right) parties, Italy's enduring political imbroglios and Spanish corruption scandals. But markets are taking all that in stride, as shown by the most recent successful refinancing rounds of Spanish and Italian debt.

Indeed, investors should keep in mind that the euro's strong political support in all member countries of the monetary union is backing up the ECB's pledge to do "whatever it takes" to protect the common currency.

(Read More: Overnight Borrowing from ECB Drops to Zero)

Currency Warriors Won't Like Stronger Greenback Either

Still, the euro is likely to be the weaker part of the dollar-euro tandem. An accelerating U.S economy and the prospect of Fed's credit tightening will tend to steer capital flows toward dollar-denominated assets.

The irony is that after having complained about the weak dollar, currency warriors will also find it difficult to deal with a stronger dollar.Most developing economies are already experiencing considerable inflation pressures created by loose monetary policies to prevent exchange rates from rising.

A stronger dollar and declining currencies will make inflation worse. Tighter capital controls will come too late to be of great help. Ultimately, the German prescription of price deflation will become inevitable.

(Read More: The Dollar Will Stay Weak Until 2019: HSBC)

My earlier investment advice stands: I don't like fixed income markets, except those in some euro area countries where I expect the yields to come down from default-like levels. I like equities and commodities. I also see a sustained demand for gold from some major developing countries, which are apparently expecting that, at some point in the future, the yellow metal could play a reference role in the international monetary system.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.

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