Poses

How to Prevent a Currency War

Barry Eichengreen and Douglas Irwin

BERKELEY – Three years into the financial crisis, one might think that the world could put Great Depression analogies behind it. But they are back, and with more force than ever. Now the fear is that currency warfare, leading to tariffs and retaliation, could cause disruptions to the international trading system as serious as those of the 1930's.

There's good reason to worry, for the experience of the 1930's suggests that exchange-rate disputes can be even more dangerous than deep slumps in terms of generating protectionist pressures.

In fact, it was not countries experiencing the worst economic downturns and the highest unemployment rates that raised tariffs and tightened quotas most dramatically in the 1930's. Comparing countries, there was no relationship between either the depth and duration of the output collapse and the increase in levels of protection, or the magnitude of the rise in unemployment and the extent of protectionism.

The reason why countries hit harder in the 1930's were not more inclined to respond by protecting industry from foreign competition is straightforward. The onset of the Great Depression saw a collapse of demand, which in turn led to a sharp fall in imports. As a result, levels of import penetration actually fell, quite sharply, in virtually every country. Producers had problems, to be sure, but import competition was the least of them.

The same thing happened this time: when the crisis went global in 2008-2009, imports fell faster than output. With the decline in trade, foreign competition became less of a problem for import-sensitive sectors. As a result, there was only limited resort to protectionism. The World Bank estimates that only 2% of the decline in trade during the crisis was due to increased protectionism. In the 1930's, by contrast, roughly half of the decline in world trade was due to protectionism.

Why the difference today?

The answer is currency disputes. In the 1930's, the countries that raised their tariffs and tightened their quotas the most were those with the least ability to manage their exchange rates – namely, countries that remained on the gold standard. In 1931, after Britain and some two dozen other countries suspended gold convertibility and allowed

their currencies to depreciate, countries that stuck to the gold standard found themselves in a deflationary vice. In a desperate effort to do something – anything – to defend their economies, they turned to protectionism, imposing "exchange-rate dumping" duties, and import quotas to offset the loss of competitiveness caused by their own increasingly overvalued currencies.

But trade restrictions were a poor substitute for domestic reflationary measures, as they did little to arrest the downward spiral of output and prices. They did nothing to stabilize rickety banking systems. By contrast, countries that loosened monetary policies and reflated not only stabilized their financial systems more