Currencies: The Winds of War

Suddenly, the headlines are full of talk about a "currency war." As with any war, there is much dispute about how it began and who is the aggressor. But the fact of the war is irrefutable. One way or another, intentionally or not, major trading countries are doing much to depress the values of their currencies. This is a war that no one can win. While all compete to devalue, no one can gain an advantage. If allowed to proceed, however, it is a war that all can lose. Currency devaluations, however pursued, will reduce the real value of money and, ultimately, produce price bubbles in commodities and other real assets, as well as a generalized inflation. At this juncture, still relatively early in the game, such an outcome is neither imminent nor inevitable. There is time to stop the competition. Even recognizing the risk, it is too soon to panic and too early to twist portfolios into an anti-inflationary posture.

Talk of war started with the policies announced by Japan's new prime minister, Shinzo Abe. He explicitly stated his intentions to depress the yen's foreign exchange value, demanding that the Bank of Japan (BoJ) pursue an aggressively easy monetary policy and allow more inflation than in the past. Pointedly, he demanded that the BoJ buy foreign securities, earmarking $128 billion for the purpose. Such a flow would flood exchange markets with yen and increase the demand for other currencies, reducing the yen's relative value in two ways. It is this last aspect of Abe's policy array that has led to the headlines. It becomes mighty close to outright currency manipulation of the sort China still practices and, it should be noted, Japan did for 40 years, from the end of the Second World War until the 1980s.1

But Japan's actions, dramatic and sudden as they are, hardly constitute the first shot in this war. They are, in fact, only the latest moves of what has been a lower-intensity conflict of long standing. More than a year before Japan's announcement, Switzerland began to intervene directly and aggressively in foreign exchange markets. Because the Swiss franc had risen in response to the eurozone's fiscal/financial crisis, the Swiss authorities, worried that the franc's surge would hamstring the country's export prospects, decided to intervene. More than just act at the margins, they announced a cap on the franc's value, promising to enforce it actively.2 Even before Switzerland's heavy-handed moves, Brazil had accused the United States of manipulating the dollar's value. According to Brazilian finance minister Guido Mantega, the U.S. Federal Reserve's quantitative easing has pumped more than enough liquidity into markets for domestic needs and must, as consequence, also aim "to depress the value of the dollar and boost U.S. exports."3 China and other emerging economics have made similar accusations. Beijing actually has two concerns: that the Fed's actions will dull China's trade edge and that the declining value of the dollar will cut the global purchasing power of Beijing's substantial holding of U.S. Treasury securities.

The Fed and Washington generally have denied the accusations coming out of Japan, Brazil, and other emerging economies. All claim that the quantitative easing aims only to protect damaged financial markets from additional strain and stimulate growth in a sluggish economic recovery. There is, they say, no currency agenda. Some at the Fed have so far dismissed Brazilian and Chinese claims, denying the existence of a currency war altogether. Atlanta Fed bank president Dennis Lockhart, for example, stated bluntly: "I don't believe we're in a currency war in any sense." He even welcomed Japan's recent policies as a way to achieve steady growth. But such haggling and denials are fundamentally beside the point. Whatever the Fed's motivations and however domestic its focus, the easy monetary policy does nonetheless flood U.S. and global markets with dollars and so cannot help but keep the currency's value lower than it otherwise might be.4

This drift, however much Washington denies it, presents an undeniable inflation risk and, as investors move to protect the purchasing power of their wealth, an invitation to price bubbles in commodities and other real assets. But real as these risks are, matters hardly require immediate defensive portfolio shifts. The world economy has so much slack that even if matters were to devolve into a no holds barred currency war, it would take years before real asset bubbles could blow up or the ultimate inflationary effect could emerge. Japan, for all its new bold policy, remains in recession for the time being. Europe's latest reports suggest that its recession is deepening. However much the European Central Bank (ECB) may follow the Fed's lead on easy monetary policy, the fiscal austerity in Europe promises to delay any recovery and keep it slow once it starts. China, though it seems to have missed the dreaded "hard" landing, is growing at a much slower pace than in the past, as is India and much of the rest of the emerging world. For an inflation to take hold, all these economies would have to reapproach their capacity limits, and at the rate they are going, 2015 looks like the earliest possible date and probably not even then.

What is more, there is reason to expect policymakers to reverse their course in time to forestall any major asset price bubbles or a general inflation problem. The Group of Seven (G-7) of the world's major developed economies has already criticized competitive currency devaluations, re-affirming its "longstanding commitment to market determined exchange rates." Although Japan finance minister Taro Aso took the G-7 comments as a sign that it understood and accepted his country's policy posture, G-7 officials quickly corrected him, saying that the group had effectively put Japan on warning. The Group of 20 (G-20) of the world's leading trading nations has also stood against the currency war, though less explicitly. Meanwhile, U.S. Fed chairman Ben Bernanke has indicated a willingness to modify his extremely easy monetary stance once the U.S. economy improves sufficiently, presumably before it gets close enough to its capacity to make more extreme inflationary pressures possible. The latest Federal Open Market Committee has already begun to consider such a retrenchment. Especially because the slack in the world economy gives these policymakers time to adjust, investors would seem to have the luxury of time before they have any need to twist their portfolios to deal with inflation, and if policymakers are true to their word, investors may never have to do so.

1 Milton Ezrati, "Japan: Another Season of "Downturn Abe"? January 21, 2013.

2 Richard Barley, "G-7 Lost in the Fog of a Currency War," The Wall Street Journal, February 12, 2013.

3 Nick Beams, "Currency War Warnings Follow U.S. Fed's 'Quantitative Easing,'" World Socialist, September 24, 2012.

4 "Fed's Lockharet: Not in a Currency War in Any Sense," Deutsche Borse Group, February 12, 2013; and "Fed Official Warns Against Slipping into Currency War," Reuters, January 11, 2013.

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