The world at war; the weapon: depreciation. Brazilian Finance Minister Guido Mantega has warned in remarks reported from Sao Paulo. "We're in the midst of an international currency war, a general weakening of currency," he said in remarks reported by the Financial Times newspaper. "This threatens us because it takes away our competitiveness." Japan, South Korea and Taiwan have intervened recently to pull down the value of their currencies, the newspaper noted, and the dollar has fallen by about 25 percent so far this year against the Brazilian real. Such a decline increases the price of Brazilian exports on the US market.

Barry Eichengreen provides a summary of the economic implications of currency wars. Here are a few study questions

Why is China keeping its exchange rate artifically low?

Why are the US and Europe contemplating weaker currencies?

How are these policies related to beggar-thy-neighbor effects?

What are the alternatives to beggar-thy-neighbor policies?

Who is the winner in this war? 

The newswires are abuzz with the news of the Japanese Central Bank intervention.  Some commentators realize that the ancient term for "dollar mercantilism", "neo-mercantilism", or "competitive depreciation" is simply "beggar thy neighbor" (see Chapters 19). The Economist Magazine has an interesting take on the issue. IF the Japanese intervention floods the market with dollars and IF this would lead to inflation in Japan - the effect might actually be positive for all!

Extra Credit: How would you use the large open economy Mundell Fleming Model (Chapter 19) to explain how the massive sale of yen by the Japanese Central Bank could benefit not only Japan but also the US (and other countries).  Hint: Think Liquidity Trap, and The Paradox of Thrift...

Solution: Combine 1, 2, for an alternative view (see 3, which is the "great vacation" view of the great recession. I contrasted these views before...).

Today the Japanese Central Bank intervened (for the first time in 6 years in international currency markets). BBC has the story:

Japan moves to combat rising yen 

The Japanese central bank stepped in to sell yen and buy dollars, a day after the yen hit a 15-year high against the dollar.

It is the first time in six years that the Bank of Japan has intervened, and further action has not been ruled out. A strong yen makes Japanese exports more expensive, and reduces profits when earnings are repatriated.

In early trading on Wednesday, the dollar rose to 85 yen, after hitting 83.09 yen on Tuesday. Investors welcomed the intervention, sending Japan's Nikkei share index up by 2.9% at first, with the index eventually closing 2.34%higher at 9,516.56.

Economic harm

But in a brief news conference, Finance Minister Yoshihiko Noda said: "We have conducted an intervention in order to suppress excessive fluctuations in the currency market. "We will closely monitor currency developments, and take firm action including intervention… The yen's rapid appreciation "harms the stability of the economy and finances. We cannot tolerate it."

Japanese exporters praised the intervention. "From the standpoint of aiding the competitiveness of Japan's manufacturing industry, we applaud the move by the government and the Bank of Japan to correct the yen's strength," carmaker Honda said in a statement. Honda's shares closed up4%, while Sony, another big exporter, ended 4.2% higher…  A recent government survey suggested many companies were considering moving production overseas if the yen stayed high.

The record low for the dollar is 79.75 yen, reached in April 1995. Mr Noda did not reveal the size of the intervention, although the Dow Jones news agency reported that Japan's Ministry of Finance had initially sold between 200bn and 300bn yen ($2.4bn-$3.6bn).

But who is buying the Yen? The Japanese economy has been anemic since the early 1990s (the Japanese stock index has fallen by roughly 66% in the last 20 years).

Source 

Ok, so the Chinese government has been buying Japanese bonds, but their $20 billion purchases this year, cannot be the whole story.  Reuter's makes an attempt to explain the recent movements using interest parity (yield spreads) and sterilization - none of it convincing.  The one interesting piece is that the REER has actually not moved much less than the nominal exchange rate because of Japanese deflation.

Here is a final thought: when will we hear about Japanese "Mercantilism?" 

The Wall Street Journal spells out the Love (Hate) triangle all its juicy details:

Japan is not alone in this phenomenon. China has also bought South Korea’s currency, the won. And South Korea routinely intervenes in currency markets, buying dollars to keep its currency from rising too quickly, again offsetting China’s move out of the dollar. 

Dani Rodrik expounds the virtues and pitfalls of the Chinese exchange rate manipulation. For a change, he does not focus on US-Chinese economics, but on the impact of the undervalued Yuan on poor countries. 

a) use the large open economy diagram to show how a one time reduction in the exchange rate affects China and poor countries

b) explain why the artificially weak Yuan is equivalent to Mercantilism (see page 630) and explain the exact dynamics.

Cartoonist E.W. Clay published this 1831 cartoon lampooning the "American System" as the Monkey System with this caption "Every one for himself at the expense of his neighbor!" (Source) Senator Henry Clay of Kentucky is considered the architect of the “American System,” the first US government-sponsored attempt to invigorate the national economy.  The Systemn included:

The system was an attempt to bring Alexander Hamilton’s proposals to fruition, as outlined in his 1792 “Report on Manufacturers.” As proposed under the American System, a protective tariff of 20 to 25 percent on imported goods—such as woolens, cottons, leather, fur, hats, paper, sugar and candy—would protect the nation’s fledgling industries from foreign competition.  Congress passed a tariff in 1816 that increased the price of European goods, which encouraged consumers to buy less expensive American-made goods. (Here is also the Wiki brief on Mercantilism).

Dani Rodrik has a nice summary of the recent revival of Industrial Policy (aka Infant Industry Protection in Chapter 7) across industrial and developed nations. Much of Paul Krugman's work on "Strategic Trade" for his Nobel Prize emphasizes the role of industrial policy. Economists have never really warmed up to the term and its implications, since everyone agrees that its near impossible to pick winners. Now Rodrik has a new mantra: "the standard rap against industrial policy is that governments cannot pick winners. Of course they can’t, but that is largely irrelevant. What determines success in industrial policy is not the ability to pick winners, but the capacity to let the losers go – a much less demanding requirement." 

Global Trade Alert doesn't actually cover global trade but global trade restrictions. Its an incredibly informative database

on anything and everything that could impede trade.

Its most recent report documents that the global recession not only decreased demand for imports but also increased the supply of trade restrictions. "Since the first G20 crisis-related summit in November 2008, the governments of world have together implemented 297 beggar-thy-neighbour policy measures; that is, more than one for every working day of the year. Add another 56 implemented measures that are likely to have harmed some foreign commercial interests, the total reaches 353." 

and

"During the past three months the number of state measures announced which--if implemented would likely harm foreign commercial interests--has expanded from 134 to 188. The protectionism in the pipeline keeps growing--there is no respite here. This protectionist overhang could limit the contribution of exports to economic recovery. "

The longer the global downturn lasts, the more tempting it becomes for governments to use protectionism to expenditure switch their way out of the crisis (See Chapter 15 and .

Global Trade Alert is an organization that expected exactly this trend and started to keep track of protectionist measures as the crisis unfolded. By now it has generated a rich database.

The database has become popular for news organizations to keep track of the sheer volume of tariffs and retaliations. Simon Evenett uses the database to document the "assault on world trade" ranking countries cleverly by  

- number of measures imposed (#1 Russia, 20 measures)

- number of product categories affected (#1 China, 329 products)

- percent of sectors affected (#1 Algeria, 68% of all sectors protected)

- number of trading partners affected (#1 China, 163 countries)

Test drive the web site and the database, pick your favorite country and  find out which measures were implemented, and which trading partner was affected. Can you surmise why particular countries choose protect particular industries or impose tariffs on particular trading partners?