Currency Wars Continue

President Trump shocked markets yesterday when he announced tariffs on the remaining $300 billion of Chinese goods that aren’t presently subject to tariffs. The stock market turned sharply lower, which continued into today. I should mention that gold was up over $20 today, as investors look for a safe haven. The trade war is back, although it never went away.

There’s been a lot of talk about Wednesday’s rate cut. But you should ignore the official statements and much of the mainstream media, which is mostly a distraction. The rate cut had almost nothing to do with “stimulus” or what have you. It was all about currency wars, which are related to trade wars. They cannot easily be separated.

The European Central Bank will likely launch additional easing when it meets again in September, to weaken the euro. And the Fed was trying to get out ahead of that so the dollar didn’t gain strength. A weaker dollar would certainly make Trump happy.

Trump has declared a currency war on the rest of the world. He resents China and Europe cheapening the yuan and the euro against the dollar in order to help their exports and hurt ours.

He’s said it’s time for the U.S. to cheapen the dollar also. And on one level. Trump has a point. If you put a 25% tariff on many Chinese exports to the U.S. (as Trump has done) or a 25% tariff on German cars exported to the U.S., it can be a powerful way to reduce the U.S. trade deficit and generate revenue for the U.S. Treasury.

There’s only one problem with Trump’s currency war plan. There’s nothing new about it. As soon as one country devalues, its trading partners devalue in retaliation and nothing is gained. This tactic does not work because trade partners retaliate by reducing the value of their own currencies.

A trading partner can undo the effect of the tariff just by cheapening its own currency. Let’s say a Chinese-made cellphone costs $500 in the U.S. If you slap a 25% tariff on the imported phone, the immediate effect is to raise the price by $125.

Regardless of cost shifting or supply changes, a simple solution to tariffs is to devalue your currency by 20% against the dollar. Local currency costs do not change, but the cellphone now costs $400 when the local currency price is converted to U.S. dollars.

A 25% tariff on $400 results in a total cost of $500 — exactly the same as before the tariffs were imposed. Tariff costs have been converted into lower production costs through currency manipulation.

This competitive devaluation can go back and forth for years.

Currency wars are a way to steal growth from trading partners by reducing the cost of exports. Currency war is an economic policy countries use to fight deflation and encourage inflation by cheapening the currency and creating inflation in the form of higher import prices.

They typically happen when there’s not enough growth in the world to go around for all the debt obligations. In other words, when growth is too low relative to debt burdens. And that’s the world we live in today.

Think of a bunch of starving people fighting over a few crumbs. That’s what happens when there’s too much debt in the world and not enough growth. That’s what a currency war is. It’s going on now. It will continue to go on. It has enormous explanatory power.

It’s an age-old economic policy, used most famously in the late 1920s and 1930s in what became known as ‘beggar thy neighbor.’ Countries were stealing growth from each other by debasing their currencies, trying to import inflation and improve their trade balances by causing cheaper exports to foreign buyers and more expensive imports for domestic buyers. That combination was seen to bolster growth.

In a currency war, it’s not that you want to destroy the other currencies, it’s that you want to cheapen your own currency; that actually means you’re strengthening the other currencies. You want to import inflation through higher import prices.

The immediate impact of a cheaper dollar is to increase our costs — importing inflation — which is exactly what the Fed wants. The effect, of course, is it promotes exports. In the case of the United States, something like Boeing aircraft, which are big ticket items, are competing with AirBus in France or Embraer in Brazil or Bombardier in Canada (I’m using Boeing as an example. Put aside Boeing’s current problems for now).

There are only a few aircraft manufacturers around the world. Boeing competes with them. And so a cheaper dollar, in theory, helps Boeing sell more planes. But from the U.S. point of view, that could be jobs and growth in the U.S. So a cheaper dollar is perceived to be a benefit.

Now, a lot of those benefits are illusory. But it’s very, very appealing to politicians because he or she can stand up and take credit for the jobs. But the reality is, it doesn’t promote jobs. It just promotes inflation.

You’re actually better off with a strong currency because that attracts capital from overseas. People want to invest in the strong currency area, and it’s that investment and those capital inflows that actually creates the jobs. So as usual, the politicians and the central bankers have it completely wrong.

Currency wars are like real wars in more ways than one. They can last longer than the combatants expect, and produce unexpected victories and losses. Real wars do not involve all fighting, all the time. There are quiet periods, punctuated by major battles, followed by new quiet periods as the armies rest and regroup. So the world is not always in a currency war.

But when it is, they can last for a very long time. They can last for five, 10 or 15 years, sometimes longer. The latest flare-up of the currency wars started in 2010, as described in my 2011 book Currency Wars. And so it’s really not a surprise that here we are in 2019 talking about currency wars.

A lot of what you read or see on TV after some policy move by, say, Japan to weaken the yen, reporters will say: “Hey, there’s a currency war going on,” or “There’s a new currency war.”

I roll my eyes and think: “No, this is the same one, the same currency war; it’s just a new phase or new battle.”

Currency wars produce no winners, just continual devaluation until they are followed by trade wars. That’s exactly what has happened in the global economy over the past 10 years.

Currency wars and trade wars can exist side by side as they do today. Eventually, both financial tactics fail and the original problem of debt and growth persists.

Eventually, they may end up in shooting wars, as they did in 1939. We haven’t reached that point yet. But the risk is real, and may be growing.


Jim Rickards
for The Daily Reckoning

The Daily Reckoning