On Understanding Currency Wars

4 minute read

Imagine if you will the following scenario: Nigel lives in the Land of People with Below Average Dental Hygiene (LOPWBADH). Bob lives in a neighboring country, the Land of Guns and Large Border Fences (LOGALBF). Both Nigel and Bob own dairies. Nigel makes exceptionally good clotted cream in his dairy while Bob makes organic grass fed butter in his. Both men sell their products domestically as well as internationally. In Nigel’s country, the method of monetary exchange is the crumpet. He sells one pound of clotted cream for one crumpet. In Bob’s country, it’s the waffle and he sells a pound of butter for one waffle. One of the most interesting things about each man’s country is that there are a strictly defined number of crumpets and waffles respectively. In fact, there are only 10 crumpets in all of Nigel’s country and 10 waffles in all of Bob’s (yes, this greatly restricts the number of anything that gets sold in the country but bear with me).

The beneficent governments of the two lands have a set exchange rate for crumpets and waffles of one to one. When someone travels from either land to the other, they can exchange their respective pastry currency easily. Exports of all goods are stable. Both countries are strong. But one day, the winds of change come to Bob’s LOGALBF and the local economy takes a turn for the worse. A recession happens. A few people lose their jobs. And suddenly, Bob isn’t selling as much organic butter as he once was. Bob has a friend, Carl, in the government who sits on the Committee For Using Waffles As Currency and Bob hatches a plan. He knows that his fellow LOGALBFers will not be able to buy much fancy organic butter because they are struggling to get by. However, he knows that there is still demand for fancy butter in the LOPWBADH and that demand could increase if only they could buy more of his butter somehow. Bob goes to Carl and explains that if there were only a few more waffles around, he could sell more butter to people in Nigel’s country. If the supply of waffles doubled to 20, people with 1 crumpet could buy twice as much butter as they could before. Carl, being a good protective friend, agrees and whips up 10 more waffles. Butter exports to LOPWBADH go up and everyone is happy.

Well, not everyone. Nigel won’t be very happy because his clotted cream is now a lot more expensive to people in Bob’s country after the waffle increase. This is because waffles are now worth half as much and people in LOGALBF won’t buy as much clotted cream because it costs more. If Nigel has a friend that controls the quantity of crumpets, he might try to get more crumpets created to level out the playing field again. This in turn might cause LOGALBF to create more waffles and everyone ends up in a pastry/currency war in a race to the bottom.

This fanciful story leaves out a bunch of details in order to show what can happen when countries start devaluing their currencies in an effort to jump start their economies. The result is a currency war where every country tries to devalue their currency to increase exports. This essentially steals growth from neighboring countries whose currencies are stronger. The most recent currency war in history happened in the 60s and 70s culminating in the Nixon Shock when President Nixon effectively took the dollar off the gold standard in an attempt to jump start the American economy.

Like most political moves, the drive to devalue a national currency is always the expedient decision but rarely the best long term solution. There is a floor to how much devaluation can occur before a break down in confidence in the currency starts to happen. When Germany went off the gold standard at the beginning of WWI to make it easier to pay for the costs of the war, the result was a hyperinflation 8 years later that resulted in an entirely new currency being created.

Lots of smart people think we’re in a currency war now. Even though the dollar has strengthened of late, the long term goals of the Fed are aimed at a cheaper dollar with their QE and QE2 and other fancy new tricks at increasing liquidity. The problem is, none of those tricks have made much of a difference except to the rich who own stock (see the last chart on that page). We are stumbling towards another crash because none of the problems that brought us the last two have been fixed. We still have massive banks playing with taxpayer money and zero down side risk (because we’ll just bail them out again). The more we debase our currency, the longer we kick the can down the road but eventually, there is a wall at the end where we can’t kick it any farther. Until we have an economy focused on the middle class again, something we haven’t had in 20 years, we’ll continue to stumble along from crash to bubble to crash.