Currency wars: threat or hope?

Talk of a currency war - in which countries try to depress their own exchange rates - has raised the prospect of increased exchange rate volatility. Is this a good thing or not? G20 finance ministers think not. "Disorderly movements in exchange rates have adverse implications for economic and financial stability" they said last week. But Nobel laureate Paul Krugman says otherwise: "The stuff that's now being called 'currency wars' is almost surely a net plus for the world economy." So, who’s right?

My table shows some facts. It shows correlations between exchange rate volatility - defined as the 13-week standard deviation of weekly changes - and the volatility and change in the All-Share index, also over 13-week periods.

This shows that, for a long time, exchange rate volatility didn’t much matter much for share prices. Although there were generally smallish correlations between FX volatility and All-Share volatility, there was no correlation between FX volatility and the change in the All-Share index. For a long time, then - 18 years - FX volatility was generally just noise, having no net effect on equities. If you regard share prices as an indicator of the outlook for economic growth, this means that FX volatility had no significant implications for the macroeconomy. This suggests we shouldn't worry about exchange rates.

However, if we look at the post-2007 evidence, things are very different. FX volatility does matter. It has been very highly correlated with stock market volatility - so that above-average FX volatility is accompanied by above-average equity volatility. And it has also been negatively correlated with All-Share returns; high equity volatility has been accompanied by falling share prices.

Now, in part this was due to the financial crisis of 2008. That caused liquidity to dry up, forcing share prices down. And it also caused speculators to close carry trades, in which they borrowed yen and Swiss francs to buy US dollars and sterling. The result was that FX volatility rose and shares fell. But it was not the case that the former caused the latter.

However, this is not the whole story. In the past three years, there's also been a negative correlation between FX volatility and equity returns. For example, higher FX volatility in the autumn of 2011 was accompanied by falling share prices, and lower FX volatility in the summer of 2012 was accompanied by rising prices.

One possible reason for this is simply that higher FX volatility is a sign of increased uncertainty about the global economy, and such uncertainty is bad for shares. Curiously, however, one obvious source of uncertainty - the euro area's debt crisis - doesn’t seem relevant here. In the last three years there's been no correlation between €/£ volatility and share prices, in part because the debt crisis didn’t much move the euro.

But it’s possible in theory for FX volatility to cause weaker growth directly. Such volatility can deter potential exporters from entering foreign markets simply because they can’t assess the likely profitability of doing so. And slower export growth depresses economic growth generally. This is not just true for one country, but for all. If nations trade more with each other, they can better specialise in their comparative advantage and this raises productivity overall.

The post-2007 evidence, therefore, seems to support the G20. FX volatility is associated with falling share prices and - by implication - a worsening economic outlook, and there might be an element of causality in this.

So, how can Professor Krugman be right? Simple. There’s only really one tool that countries can use to weaken their currencies: monetary policy. Countries that want to force their exchange rates down will have to print more money, as Japan and the US are doing. Some of this global monetary easing might lead to faster real economic activity, and some of the extra cash could end up in stock markets. To the extent that this happens, investors benefit. If - as is possible - such a process is accompanied by 'disorderly' exchange rate moves, then FX volatility might prove good for the global economy.

Granted, this positive relationship between FX volatility and share prices isn't the dominant one that's existed in recent years. But economics is not just about the blind application of historic data. It’s also, more importantly, about mechanisms. And at least one plausible mechanism tells us that FX volatility can be associated with higher share prices and better prospects for the world economy.

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