The emergence of the global 2 percent inflation standard since the mid-1990s and eruption of currency war on a scale not seen since the 1930s are strongly linked events. Modern currency warriors are central bankers. They direct undeclared offensives in currency markets, camouflaged by anti-deflation rhetoric. The weapon of choice is quantitative easing, the effectiveness of which depends on empowering irrational forces in the market-place, such as the “search for yield.”
None of the currency warriors of course would admit to being such. They insist that their monetary experimentation is designed to achieve 2 percent inflation, not to influence the exchange rate. And they would protest at any analysis identifying them as key players in a currency-war high command which includes also the country’s political leadership. Indeed hypothetically a global 2 percent inflation standard (meaning that the U.S., Europe and Japan all target inflation at 2 percent year on year over the medium term) could co-exist, in some periods, with peace in currency markets. The force which opens the route to currency warfare stems from friction between a downward natural rhythm of prices and the inflation-targeting regime.
The central bankers, in their role as officials of the inflation-targeting regime, do not have a permissive attitude toward any passing episode of declining prices even though this would be consistent with monetary stability as understood in classical economics. In the regime’s authorized statements of monetary doctrine, periods of declining prices are highly dangerous. The chapter on historical folklore makes no reference to the gold standard, when prices were on a flat trend over the very long run and yet there were also phases — some lasting several years — when prices fell or increased persistently. Typically, in recessions, prices would decline to below trend so that businesses and households firm in their conviction about continuing monetary stability and a flat trend for prices in the very long-run could anticipate higher prices ahead. (Perverse expectations that prices, once having fallen, would continue to fall rather than recover figure largely in Keynesian texts and in the inflation targeting regime’s official texts, but they are not founded in history or theory).
That pro-cyclical behaviour of prices stimulated recovery as businesses and households brought forward their spending. Strong recoveries got underway without monetary experimentation.
Other examples of situations in which the natural rhythm of prices is downwards include spurts of high productivity growth, as was seen in the 1990s, or downward pressure on equilibrium real wages, as has occurred since the Great Panic in 2007. The glut in large segments of the labor market in the U.S. and Europe, reflecting obsolescence of many forms of human capital in the face of digitalization and associated globalization, means that under conditions of monetary stability many nominal wage rates and prices would have fallen for some considerable time. Central banks who combat any downward rhythm of prices by aggressive monetary experimentation feed a virus of asset-price inflation. The Federal Reserve's power is so vast as to cause this to go global.
The timing of experimentation is different for each country. The necessary condition for action is always prices lagging the inflation target. But execution depends on a whole sequence of political and economic events particular to each country. Speculation that the experiment is about to begin marks the start of the currency offensive. The U.S. currency-war machine is by far the most powerful of all — sometimes provoking other countries, which would have preferred peace, into retaliation.
That is the Japanese story. Right up to 2012 Japan had defiantly remained outside the global 2 percent inflation standard. The U.S. currency offensive of 2010-11, and the earthquake, tsunami and nuclear meltdown of March 2011 broke that defiance. In Europe the sovereign-debt crisis coupled with fears of political turmoil in France and Italy made possible a coup against the restraints of the Maastricht Treaty (initiated by the ECB president, supported by Washington which feared another Lehman-type crisis, and eventually backed by Chancellor Angela Merkel). The European currency warmongers recited the mantra of inflation being too low.
Now the global marketplace is thick with rumors of a looming currency offensive by Japan and Europe. There is speculation that the Fed could take counter-action early in 2016 if the U.S. economy stalls. So does perpetual currency war lie ahead? Optimists on peace focus on the possibilities that the next White House resident might take the U.S. off the 2 percent inflation standard, or that there is some kind of economic miracle, or that the broad decline in equilibrium real wage rates will come to a sudden stop. Without such developments and given instead a new cyclical downturn, intensification of currency war is highly plausible.