On Tuesday the market soared on the grounds that global efforts to engage in another round of monetary ease and devalue currencies would boost economies around the world. We think that the market’s initial reaction is a wrong-footed move that will soon be reversed upon further reflection. What we are actually facing is an all-out global currency war and old-fashioned "beggar-thy-neighbor" policies where every nation tries to devalue its currency to create more exports in order to boost its economy at the expense of every other nation.
It is obvious, however, that it is impossible for all currencies to decline in relation to each other. The failure then leads to other desperate measures to increase protectionist barriers such as higher tariffs, quotas and various restrictions on international capital flows. The result is a collapse of world trade leading to depression and the dreaded deflation that nations are trying to avoid in the first place.
As such, the recent actions of Japan, the anticipated start of QE2 by the U.S. and general global currency devaluation moves are something to be feared rather than celebrated. We know because we’ve been there before and know how it all ends. (See the Great Depression, competitive devaluations and Smoot-Hawley tariffs.)
The currency wars started slowly, but have recently been stepped up. Don’t be fooled into thinking that this is merely further monetary easing. The world has already undergone the most massive round of easing in history and we are facing a liquidity trap where further easing will have minimal effect. The real goal of various nations is to devalue. The Fed has indicated its intention to institute QE2, and, in anticipation, Japan has announced its own quantitative easing program to protect any additional rise in the Yen. The U.S. has stepped up its pressure on China to let the Yuan rise by a significant amount. The House has passed legislation allowing economic sanctions on China and other countries that are manipulating their currencies to gain trade advantages. China is vigorously resisting the pressure out of fear that a substantially higher Yuan would slash exports, leading to domestic unemployment and social unrest that would threaten the regime.
Other nations that have engaged in various forms of quantitative easing are Brazil, South Korea, Taiwan, Peru, Argentina and Switzerland. The Brazilian Real has already appreciated 25% against the dollar this year, and the Brazilian Finance Minister has stated his willingness to buy unlimited amounts of Dollars. In just a small sign of what’s to come, Brazil has also implemented a 2% tax on financial transactions to slow down the amount of "hot" money coming into the country. Meanwhile the ECB is one of the few areas trying to actually withdraw its post-crisis support of the banking system, and also has no plans to reduce its 1% refinancing rate any further. However, the Euro has increased 17% against the Dollar and 7% against an average of its major trading partners. This could impact EU growth rates in the period ahead and also put even more pressure on the already fragile economies of their peripheral nations such as Greece, Portugal, Ireland and Spain.
The IMF and World Bank are meeting this weekend, and these issues are obviously on the agenda. Leaders of both organizations have warned that a currency war could destabilize global financial markets. World Bank President Robert Zoellick stated that tensions over currencies could undermine investor confidence at a time when the world needs the private sector to boost growth. We doubt, though, that anything of real significance will come out of the meeting other than a general statement of good intentions. What we fear is that every nation will be bound so much by its own domestic political considerations that compromise will prove to be too difficult. What we hope is that we are not on the same path that led to the Great Depression.