Is the World on the Brink of a Currency War?


The latest hot topic among economic talking heads is the coming currency war. According to conventional wisdom, there’s a risk that major countries will – simultaneously – try to revive their sluggish economies by pushing down the value of their currencies. That strategy could backfire, according to this line of thought, stifling international trade, tipping economies back into recession, and possibly causing Depression-style hyperinflation to boot. Get ready to sell apples on the nearest street corner and buy your morning coffee with a wheelbarrow full of paper money. It all sounds very unpleasant.

But the dogs of war are unlikely to slip their leash. In a classic currency war, a country prints money, holds interest rates down, or intervenes in foreign exchange markets in order to depress the value of its own currency. That makes the country’s exports cheaper and more attractive for foreign buyers. In theory, this can enable an economy to grow faster than would be possible on the basis of domestic demand alone. Only trouble is, if every country pursues a similar strategy, they all devalue their currencies at the same time and no country gains an advantage over its trading partners.

It may look as though that’s what’s happening now, since many of the largest economies are following policies that could depress the value of their currencies. But they’re doing so for fundamentally different reasons – to address domestic economic problems rather than to boost exports. And while this creates some real risks, they aren’t the ones that the term “currency war” implies.

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Currency wars – and trade wars generally – have their origins in a 17th and 18th century economic theory known as mercantilism. The idea was that a country’s wealth comes from selling more than it buys. A colonial empire could achieve this positive balance of trade by acquiring cheap raw materials from its colonies and then ensuring that it exported more finished goods than it imported. This was usually accomplished with tariffs that made imports very expensive.

Such an approach couldn’t work in the modern world. Countries don’t get cheap raw materials from colonies anymore. They have to buy them – especially oil – on the open market. So while currency devaluation makes exports cheaper for foreign buyers, it also makes essential imports more expensive. For Europe in particular, which imports so much of its energy, devaluation isn’t necessarily a plus.

Countries with economies that are not fully developed may still depress their currencies to promote exports because they don’t have sufficient domestic demand to sustain their growth. That occurs to some degree in Latin America, for instance. But among the largest economies, only China is still at a stage where it can benefit significantly by holding its currency down to gain a trade advantage.

Japan has pushed its currency down 17% since September, reversing the yen’s appreciation over the previous three years. And the U.S., as well as many European countries, advocate policies that appear to be aimed at devaluing their currencies, but they’re not doing it chiefly to foment a trade war. The Federal Reserve’s quantitative easing – buying bonds to swell the money supply – is aimed principally at stimulating domestic demand. European advocates of a cheaper euro currency, meanwhile, are hoping to make national debt easier to finance, not trying to pump up exports. In fact, the continent’s greatest exporter, Germany, is the country least amenable to currency devaluation.

The actual point of current policies is to lower the real cost of money – that is, the effective interest rate that borrowers pay after inflation is taken into account – in order to spur consumer spending and business investment. That reduction can be achieved by pushing down interest rates and by allowing inflation. So rather than seeing what’s going on today as the beginning of a global trade war, we should think about it as a side effect of economic stimulus. And in theory, as economies recover, the policies could be reversed before chronic inflation becomes entrenched. But as I said, there are risks to all this – and in practice, inflation can easily get out of hand.

There isn’t a lot individuals can do to protect themselves against such a possibility. People about to retire should favor benefit options with the best cost-of-living increases. Real estate can be a smart buy now that prices are down so much, especially buying a home if it’s financially competitive with renting. Among financial investments, it makes sense to avoid long-term bonds because their payouts are fixed. Utilities and other high-yield stocks are preferable because they raise their dividends over time. And raw materials producers can be a defensive choice, especially some of the international oil stocks with yields of 3% or more.

So forget all the talk of a currency war. What’s going on has nothing to do with trade and everything to do with debt and growth and inflation. If the global economy is in danger of reliving the past, it will not be a repeat of the 1930s. Rather, it will be a repeat of the 1970s, when the Federal Reserve expanded the money supply to offset the economic slowdown caused by the oil crisis – and ended up encouraging double-digit inflation.

Current easy money policies may well create some inflation, although perhaps not as much as 40 years ago. But in any event, revived growth with some inflation is preferable to stable prices accompanied by depression. The problems of the 1970s can all be overcome – except perhaps the hairstyles.


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