Economic Commentary: Skirmishes In A Currency War?

Rather, investors should worry about what various interventionist governments will do to try to boost GDP growth.  For example, look at all the wasted stimulus spending in Japan, China, the US and Europe over the last five years – it’s measured in trillions of dollars.  Except for an increase in Chinese infrastructure, much of which still lays idle, little has actually been achieved, and most of the money was misallocated to non-productive purposes.  Continued heroic efforts by government planners will ignore all these past failures and keep government spending elevated, with all of the money borrowed from the future.  This aspect of the problem is not yet fully discounted by the markets.

Currency War, or Just Re-Balancing?

Recently there has been much talk of the possible currency war we may have begun, with some observers suggesting that the mistakes of the 1930s could be repeated.[xii]  Countries in the 1930s attempted to boost trade, which had declined, by engaging in competitive devaluations, in effect making their products cheaper to consumers in other countries.  Unfortunately, we can’t all devalue our currencies at once, but still they tried back then, and as a result of this “beggar your neighbor” policy, trade completely collapsed. This made the Great Depression much more damaging than it otherwise would have been.  Other workers have compared the current situation to that of the Asian Financial Crisis of 1998, which was triggered by a rapidly rising US dollar.  This rising dollar trend caused liquidity in developing Asian countries to practically disappear (that is, hot money flows into Asia when the US dollar is declining, and flows back out again when the US dollar is rising).  Eventually the loss of liquidity took down the entire financial system in the region.[xiii]  A criticism of the Asian Crisis analogy might be that the US is printing money, which should tend to drive the dollar’s value down, not up, but that is an assumption that does not appear to be supported by the facts. 

Even though theory suggests that the dollar should have fallen under QE, that’s not really what has happened.  What we have actually observed is a rise in the dollar under the QE1 program, a subsequent decline in the dollar during the QE2 program, and another rise in the dollar under QE3 and QE4.[xiv]  In fact, the US dollar index (DXY) now stands at about 82, which is almost exactly what it was in August of 2007, when the Fed announced its first rate cut heading into the financial crisis.  One reason there has been no decline in the dollar in spite of $2.5 trillion of money printing is that other major countries were also printing money.  For example, the balance sheet of the U.K. has now reached about $608 billion, the Bank of Japan has about $1.73 trillion on its books, the US Federal Reserve has about $3.15 trillion on its books, and the ECB has about $3.60 trillion on its books.  Almost all this grand total of $9.09 trillion was added over just the five years since the financial crisis began.[xv]  Another explanation for the unexpected strength of the dollar may be that since core inflation rates have been benign, and inflation expectations are still low, there has been no driver for pushing the currency down.  Core inflation has in part been held in check by the fact that the assets purchased by the Fed are still on the Fed’s balance sheet, i.e., banks have not deployed the money out into the economy, thus keeping money supply subdued and preventing a major rise in core inflation.  Also working against inflation has been the high unemployment rate, which has kept real wages, which can be major drivers of inflation, in a downward trend.[xvi]      

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