The US Federal Reserve, the European Central Bank (ECB) and the Bank of Japan have all applied additional easing measures to their monetary policy management in the past couple of months. The Bank of England got there first with additional easing announced earlier in the year. The Swiss National Bank is printing money on a scale that is almost Zimbabwean in its volume. Are these salvos in a war to devalue currencies _ a war that must ultimately fail (for you have to have one strong currency to devalue against)? Or are central banks trying to devalue their currencies against commodities such as oil?
A number of commentators see something hostile in all of this monetary easing. It has been described as protectionist, and complaints have been levelled at the Fed in particular. Chairman Ben Bernanke is cast as someone recklessly throwing dollar bills from the roof of the Fed building onto the heads of passersby. Printing of dollars tends to engineer a special sort of concern, as the dollar remains the pre-eminent reserve currency in foreign exchange reserves, and of course because commodities tend to be priced in dollars.
However, this obsession with money supply is to miss the point. Money supply is only half the equation. The critical issue at the moment is not whether central banks are printing more money but whether there is any demand for the money they are printing.
The obvious case study for this, as it is so dramatic, is Switzerland. The Swiss National Bank has expanded its balance sheet to well over 70% of the size of the Swiss economy. The US, in comparison, has a Fed balance sheet today that is about 20% of the size of the US economy (and was less than 5% prior to the financial crisis). Surely given this level of monetary expansion, the franc should be collapsing and hyperinflation stalking the streets of Zurich.
Of course, this is not what is happening at all. The reason the Swiss National Bank is producing more francs is the demand for the currency is high and has indeed been rising. Conservative investors seek the security of the franc, and they demand cash. Left unchecked, this would produce a horrific appreciation of the franc and deflation in Switzerland. By supplying cash to meet the demand, the Swiss authorities have maintained stability. The result is the printing press has not led to a collapse in the value of the franc but merely averted its rapid rise.
Switzerland underscores how important it is to consider demand alongside supply when looking at monetary policy. This translates directly into currency markets much of the time. There is little link between central bank balance sheets (printing money) and the value of a currency, because the demand for currency ebbs and flows, as does the supply. If we look at the global economy today, it seems fairly evident the need for cash in the euro zone is rising. Banks are reluctant to lend, companies and consumers are reluctant to borrow, and the euro-zone economy seems to be becoming a more cash-based economy than before. The ECB needs to provide cash to meet that demand. This cash will not turn up in financial markets.
In the US, the level of money demand is more difficult to determine. Some parts of the US economy (middle-class consumers, for instance) are reducing their demand for cash. Other parts (small businesses are a good example) still demand cash. Internationally, the demand for dollars is rising. Thus, the Fed is supplying cash where there is a need but also may create some small surplus cash that is not being demanded.
What happens if a central bank prints money that is not in fact demanded? Then, of course, there is an excess of money in the system. Too much liquidity will tend to overflow, and there are a number of routes that it can take. Money can flow into foreign exchange markets (weakening the currency), asset or commodity markets (threatening bubbles) or domestic shops (leading to inflation). The point here is if there is excess liquidity being created, then prices will change.
So where are we in the so-called currency war? We are nowhere near a battlefield. Central banks are responding to spare capacity in their economies and a demand for cash that is quite widespread. It takes excess money to influence currencies, and there is little sign of excess money for now. For commodity prices, if investors believe printing money will work and economic growth will be better than was previously expected, then commodity prices will rise. That should not be taken as a consequence of excess liquidity but of monetary policy stabilising economic activity.
Paul Donovan is the managing director and deputy head of global economics at UBS Investment Bank.
About the author
- Writer: Paul Donovan
Position: Deputy Head for Global Economics at UBS Investment