The Currency Wars

The Currency Wars are in full swing. Of course we might ask just what is a currency war.  For that one must understand what a currency is and how it interacts with other currencies.  So a quick review.  We normally associate currency with money yet that can be a misnomer.  Money represents a unit of exchange, a unit of value and acts as the third party to any transaction.  If I have apples to sell and you have bread then perhaps you will take some of my apples in exchange for some of you bread.  But what if you want oranges and I have none to trade?  We have a problem.  I would need to find someone with oranges to trade who would accept my apples for their oranges so that I could trade my newly acquired oranges for bread.  If we agree on a medium of exchange such as some quantity precious metal then we have found an exchange medium.  Currency may be either backed by some standard such as precious metals or it is a fiat issued currency.  We say fiat because the government that issues that currency has stated its value and will accept it for payment of taxes.  There may be an official government rate or value of this fiat currency.  On the other hand, the world markets will place their own value upon such currency.  If too many other countries hold your currency there may be less demand for your currency and thus its international value is lower than the official value in the home country.  This is related to the perceived purchasing power of the fiat currency in another country.  On the other hand a country can always “peg” its currency to the value of another country’s currency.  China did that for a great many years and thus kept the price of its exports low in relation to the US Dollar.  But a currency that is “Pegged” often makes imports more expensive relative to export.  Again, China was concentrating of its manufacturing economy to the exclusion of its consumers.

Now a word about current accounts.  Every country that has its own currency (Equitador uses the US Dollar) and wants to buy and sell in the international place must have a current account.  You see, your money isn’t any good in those other countries unless they value it very highly.  Say I want to buy wine from France and France is still using the French Franc.  The merchant can’t spend the Country of Bill currency to pay his utility bill.  He needs French Francs.  That is the only money the utility company will accept.  So he wants to be paid in French Francs.  Ah, so now you need to “buy” French Francs with your currency?  Who will sell you French Francs for the Country of Bill Pesos?  Foreign exchange traders match those who need particular currencies with those who have excess amounts of those currencies.  So maybe Argentina was to buy my new crop of tacos.  They have no Bill Pesos, but the do have French Francs left over from a previous sale to a French importer.  Well, there you go, we have a match.  I can accept payment in French Francs from Argentina and send them to France in payment for the French Wine I want.  When a country opts for a fiat currency it often allows the value of its currency to “float” against other fiat currencies.  A currency that changes very little in value is indicative of a stable government and economy.

Finally, there is usually a world “reserve” currency.  Ever since most of the world’s currencies abandoned the gold standard the one currency that many international contracts specify financial settlement use the US Dollar.  Since 1972 OPEC has quoted crude oil prices in terms of dollars and only recently has that begun to change.  That means that foreign exchange markets had to rely of a very large supply of US Dollars so the world could conduct business.  It also gave the US Dollar an added strength it never really possessed.  Being a reserve currency tended towards a type of inflation for the US where our exports were not quite as attractive in terms of prices and our imports a little higher in price value than they should have been.  In the last ten years there has been an attempt to create an international reserve currency by creating a “basket” of currencies.  this basket would consist of Dollars, Euros, Pounds, Yen, and a few others.  The Chinese have worked very hard to have their currency, the yuan, added to that basket and are trying to supplant the US Dollar as the reserve currency of the world.  I doubt they they will succeed in the latter undertaking.

The international value of a currency is dependent on many factors.  The economic condition of that currency’s country may be suffering from recession or inflation.  The government may be indulging in too much deficit spending creating inflation by crowding the private sector’s spending with its own.  Or perhaps it starts to nationalize too many companies in too many industries that should have gone bankrupt, delaying job loss at the cost of high taxes.  Perhaps it imports too much from other countries and exports very little.  The actions of its central bank will affect that float such lowering or raising interest rates or indulging in pumping money into the banks and investment companies by quantitative easing.  Then there is the devaluation or revaluation of its currency.  One does that by declaring an official exchange rate against other currencies.  Japan is one of the few countries to allow the valuation of its currency to increase.  The official value was 300 to 1 against the dollar whereas the real value was closer to parity, or one to one.  We have seen the official rates for Argentina and Venezuela fall where in the former case much of that was due to government bond default combined with excessive imports while in the latter the attempt was aimed at stability in a government gone mad.  The black market set the real values.

Now we can start to understand currency wars.  If a currency is about perceived value, remember, we treat it as money, that medium of exchange in the marketplace, then a currency war is also about perceived value in the international marketplace. If my currency in the country of Bill is perceived as having less value that your country, the US, then my goods and services that I can sell to you will be perceived as costing less that the same ones you can provide.  If the machine tools I make are very similar performance and quality but cost less for me to make than the ones you make then I attract many of your companies to buy my machine tools.  Perhaps I have more local resources, a lower standard of living, and lower wages.  So my costs are less and give me an advantage even with the cost of shipping.  But suppose my country starts in with labor unions striking for higher wages, real estate developers building big box mansions to sell to American retirees, and investment bankers who flood my country with money.  Now my costs have risen and perhaps I can not longer compete in the international machine tool market.  Foreign capital pours into my country and pretty soon the value of my currency reflects that added value to my economy.  Now my currency becomes in parity with your dollar.  But my machine tool industry is facing ruin, what do I do.  I try to manipulate my currency to give me an edge in the marketplace.  So I peg my official rate to less than your rate.  As your rate floats, so does mine because I have pegged it to your rate.  China did this for many years and thus kept its trade advantage.  It did this by discouraging consumer goods production and discouraging wage increases.  There were other factors such as foreign capital controls, restrictive tariffs, government support, direct and indirect, of industries, and outright fraud.

On the other hand, if the country of Bill has been so foolishly run so that credit expansion has gone thoroughly unchecked, corruption rampant at every level of government and corporation, money from credit creation poured into projects of dubious value or future use, and bubbles generally allowed to run amuck, then my economy is out of control.  And further, if every one reporting the official economic statistics lies and either grossly understates or or states the figures, then I have no idea what to do.  I will lower interest rates to zero and below trying to get the economy moving again.  I will indulge in quantitative easing, maybe many times, trying to pump more money into the economy.  I will issue more government bonds to try and pay for it all (these bonds with higher yields would naturally attract foreign fools looking for a sure bet on a high yield investment).  I would prop up my stock market by buying stocks and halting trades.  and I would devalue my currency’s official exchange rate.  Now if I am a small country that devaluation would be done for me in the FX market.  If I am China, I have to do it myself.  If I am a small country my devaluation will hurt very few other countries since none would have more that a small stake in my currency.  If I am China, India, or Russia, my devaluation will have a worldwide effect, particularly if I have engages in trying to convince other countries to write their contract settlements in my currency.  To that point, as China continues to devalue its currency it has hurt many smaller countries such as Argentina, who holds about 34.7 billion denominated in the Chinese Yuan.  Argentina’s economy is already suffering from government mismanagement and the loss in foreign exchange value of its holding of Chinese Yuan by six percent and maybe more in the future may spark another round of their own currency’s devaluation.

What we are seeing world wide is a lot of volatility in the markets including foreign exchange.  There is a general world wide slowdown in trade between countries, although some countries are doing very well at the moment, thank you.  But India, Russia, Europe in general (ECB), the US, and a few others are, in trying to counteract that loss of trade and thus the drop in GDP, are turning to such things as the stupidity of Quantitative Easing and currency manipulation.  They are also enacting new tariffs.  Every one wants to keep his “comparative advantage” by hook or crook as we all race to the bottom.  China is imploding.  They thought that they could imitate Singapore.  Singapore is a dictatorship that opted to allow economic freedom while keeping political freedoms in check.  It has worked well for the past forty years as their citizens believed that making money was more important than free speech and other civil rights.  But the Chinese have never had a long history with free and open markets.  Emperors and warlords, tongs (criminal gangs), cabals, syndicates, and every other means of market control have been the norm in China.  Meanwhile the overlords who presided over this economic growth have been extremely ignorant of economic principles and even though they may have been guided by economists, often the advice was ignored or wrong.  We are watching Brazil, a medium sided economy, implode through both socialistic practices and great government corruption.  It too, is trying to play the currency war game in an effort to regain some sense of competitiveness.  Indeed, the currency wars encompass many large and small economies.  Japan, in response to the Chinese devaluations has just started my Quantitative Easing, its government debt going where no government has gone before and never should, most illogical, Captain.


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