Currency Wars

"If you can keep your head when all about you are losing theirs, it's just possible that you haven't grasped the situation." - Jean Kerr

Just in case you haven't grasped the situation, currency wars are in full force.  They have been raging for years but now things are starting to come to a head.  So while there is no blood being shed those who are supposedly allied during war are happy to fight one another on the currency front.  So what is a currency war and how does this affect anything?

Let's start with an example.  Country A has a strong economy with a budget surplus (the government spends less than it takes in through taxes), a healthy banking system, low interest rates and a stable currency.  This safety attracts investment from abroad and with this investment asset prices start to rise.  At first the rise is manageable but then speculators show up and prices start to accelerate.  The central bank now has a choice to make - let the rising prices (inflation) continue or fight them by raising interest rates.  Most central bankers try to contain inflation so they increase interest rates.  The direct impact of this is to strengthen the currency making their exports less attractive to outsiders while imports decrease in local prices.  This weakens the economy and the government slumps to a budget deficit and starts to print money to pay their bills.

Once debt reaches a high level the government has another dilemma - how does it pay down the debt while not capsizing the ship it is trying to salvage?  The normal solution is to let the value of the country's currency drop which expands exports, curbs imports and stimulates GDP growth through the resulting inflation pressures making the debt burden (whose value remains fixed) drop of as a percentage of the country's GDP.  Voila, debt as a percent of GDP falls to a manageable level restoring the country's credit rating and the cycle starts again. 

As an aside, this is why Greece cannot get themselves out of hot water as they are tied to the Euro and cannot depreciate their currency to help with growth.  Furthermore the problems at Spain, Protugal, Italy and Ireland will continue down the same path unless the Euro drops significantly in value.  The beneficiary to their problems is Germany which has seen its position strengthen due in large part to the Mark (their original currency) weakening (in relative terms) when it was converted to Euros as it was now tied to these weaker economies.

As can be seen in the European example above the problem to this is that while one country is the beneficiary of currency depreciation others fall victim to its weakness.  Their economies feel the negative effect of a strengthening currency and try to put a stop to their country's currency appreciation.  Now what if everyone around the globe has massive debt burdens and they all try to weaken their currency at the same time?  This is the situation that we are in today and the result is all out currency war.  Everyone is trying to depreciate their currency and someone has to lose.  At present the loser is the United States whose currency has been the direct beneficiary of global weakness and this is starting to show up in the United States' anemic GDP growth rate.

Today payrolls were once again weak and once again JP Morgan and the other investment bankers lowered their expected growth rate for the US to 2.0% from 3.0%.  I stated earlier this year that I believed that we would grow by 1.5% but even that is looking optimistic at present.  The problem is that while a stronger currency is not in and of itself a problem but it needs to be based on strong economic fundamentals.  If it is not (as is the current situation in the United States) it will result in slower growth, an increase in the country's debt burden and eventually to an inability to pay (this is the Greek situation).  While the UNited States is a long way from this state of affairs, to think that the market will expand from here is to not have grasped the situation.