Begun, The Currency Wars Have
For several years now the US and some other countries have been pressuring China to allow its exchange rate to appreciate, thereby making Chinese goods relatively less competitive in the global economy and, so the thinking goes, assisting the US and other heavily indebted economies with a necessary economic rebalancing away from consumption and imports toward investment and exports. In September, the US House of Representatives began formal debate on a proposed measure to label China a “currency manipulator” and impose a broad range of trade restrictions on Chinese goods. But as this dispute escalates, there are other important developments in currency policy taking place around the globe with potentially highly destabilizing and economically destructive consequences.
It is a common delusion that major exchange rates, such as those between the dollar, the euro, the yen and the pound sterling, are free-floating. The cause of this may be that FX rates appear to move up or down on a regular basis in seemingly random fashion, or that mainstream economic textbooks generally make this claim. But it is not true. Japan demonstrated as much in September, when the Bank of Japan, under the instructions of the Ministry of Finance, sold yen into the foreign exchange market, pushing up the USD/JPY exchange rate from 83 to nearly 86, a 4% move, in a single day. According to Japanese authorities, the yen had become too strong to remain compatible with their economic objectives of maintaining positive economic growth and preventing deflation.
Policymakers elsewhere were quick to condemn Japan’s unilateral action. One prominent vocal critic was Jean-Claude Juncker, Prime Minister of Luxembourg and, more importantly, the Chairman of the “Eurogroup”: the council of euro-area finance ministers responsible for coordinating economic and policy. As such, in matters of currency policy, Mr Juncker’s role is comparable to that of the US Treasury Secretary or Japanese Minister of Finance.
A possible concern shared by Mr Juncker and his Eurogroup colleagues is that, should Japan continue to intervene to weaken the yen, then the euro-area will become less competitive in world export markets, in particular for the machinery and other capital goods in which there is intense competition between European and Japanese firms.
Indeed, at an exchange rate of 1.35 to the dollar, the euro is at a lofty level relative to history. Yet at 113 versus the yen, the euro is in fact quite weak. Prior to the financial crisis in 2008, the EUR/JPY exchange rate reached nearly 170. Thus over the past two years euro-area exports have become much more competitive relative to Japanese. So why should Mr. Juncker be complaining so loudly if Japan is now attempting to prevent further yen strength?
It could be that he is concerned more by what unilateral currency intervention represents in principle, rather than what it in fact achieves in practice. Consider: What if not only Japan but other countries facing weak growth and potentially deflation begin to intervene? Well, many countries are already doing so. China manages its exchange rate versus the dollar. So do all other Asian countries in varying degrees. Brazil buys dollars on a regular basis to keep their currency, the real, at a targeted level. Russia does the same with the ruble. The risk is that, by acting unilaterally, Japan has escalated what is already a “cold” currency war, greatly increasing the chances that it becomes “hot”, with countries not seeking merely to maintain a given exchange rate but to devalue faster and by more than others in a, “beggar thy neighbor” policy.
Currency wars might thus appear to be zero-sum. But this is true only up to a point. For if all countries intervene to weaken their currencies in equal measure, then no country succeeds in devaluing versus the others. As such, they might then resort to raising trade barriers or enacting currency controls which restrict the flow of capital across borders. These sorts of actions cause substantial economic damage however and are thus hugely counterproductive. The 1930s were characterized by, among other things, currency devaluation, capital controls and rising trade barriers such as the infamous “Smoot-Hawley” tariff.
While potentially growth negative for the global economy, currency and trade wars can, however, contribute to rising price inflation. Why? Well, the weapons of currency wars are the printing presses. The more you print, the more you can weaken your currency, or at a minimum prevent it from rising. He who prints most, devalues most and “wins”. But if all print in equal measure, exchange rates don’t move, but the global money supply soars. As such, currency wars don’t stimulate real economic growth–indeed they are much more likely to weaken it–they stimulate only nominal growth, that is, inflation. The net result is most likely to be a global “stagflation”.
The economically devastating effects of currency and trade wars can be seen in the chart above, which shows the dramatic contraction in world trade that took place in the early 1930s. Now it is easy to mix up cause and effect here. It is perfectly normal for trade to contract when growth contracts. But when trade barriers are raised they become the cause of contraction rather than the effect. The Smoot-Hawley tariff was enacted in June 1930 but had already passed the US House of Representatives in May 1929, well prior to the stock market crash in October that year. It is thus rightly considered a cause rather than effect of the Great Depression. Nor was it an isolated act. Among other countries, Canada, the largest US trading partner, retaliated by raising tariffs on US goods. Great Britain devalued the pound sterling in 1931. Japan did the same with the yen that year. In 1934, the US devalued the dollar. These were all major acts in a prolonged and devastating currency and trade war.
Some might argue based on the 1930s US experience that currency and trade wars should lead to deflationary depression rather than stagflation. But the US experienced deflation, visible in falling commodity and consumer prices, only as long as it kept the dollar fixed to gold at $20.67/oz. Following the 1934 dollar devaluation to $35/oz, the deflation was over. Commodity prices generally moved sideways rather than lower in the second half of the decade. Growth remained weak, to be sure, but that was not the result of deflation but, rather, structural economic weakness related to the unprecedented level of government micromanagement in the economy, with all manner of wage and price controls and, of course, counterproductive global trade barriers such as Smoot-Hawley.
As neither the world nor the US are on a gold (or silver, or other) standard, currency and trade wars are thus likely to translate directly into stagflationary pressures, with economic growth generally weaker and commodity prices generally higher. This is a horrible set of conditions for corporate profit growth, which is going to get squeezed between rising raw material costs on the one side and poor overall revenue growth on the other. The 1970s are instructive in this regard. The CRB broad commodity index trebled between 1971–when the US devalued and went off the gold standard–and 1981, whereas the S&P index rose by a mere 35%. The lesson for investors today, as the currency wars escalate, should be obvious.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]