Prior to Nixon’s closing of the gold window in 1971, world currencies traded in value relative to the U.S. dollar, which was tethered to gold at $35 an ounce. Following the divorce, currencies began trading relative to the dollar, but the dollar in turn began trading relative to other currencies.
Economies that wanted to stimulate growth, like Japan in the 1980s or China in the 1990s, would intentionally peg the value of their currency well below fair value to make their goods and services cheap in the world marketplace. It worked. Today, in a fierce contest for growth, several nations have initiated similar devaluation policies. The fear mongering media has now labeled these conflicting policies, “The Currency War.”
The Race to the Bottom
The U.S. has pursued a weak dollar policy over recent years in an effort to offset the Chinese weak yuan policy. This has put upward pressure on the euro and the yen. The current Federal Reserve policy of printing $1 trillion annually in new money not only continues their devaluation policy, but augments it. Advantage America!
In response, Japan has now formally committed to a significant debasement strategy. The mere suggestion has decreased the yen by 15 percent over the last three months. Advantage Japan!
Europe, haunted by hyperinflation in Germany in 1923, has to date refused to enter the fray. However, Germany sells cars. Japan sells cars. Japan’s cars on currency movement alone have recently been discounted 25 percent against their German rivals. The Europeans may philosophically be monetary pacifists, but economic pressures to devalue are building. In a currency war, the central bank that prints the most wins.
Of course, the emerging market economies that have all benefited from export advantages due to their own cheap currencies are incensed. The thought that the developed nations would use their strategy against them is reprehensible! They, of course, will respond swiftly to preserve their advantage. India cut interest rates last week.
So far, the currency war has been an exchange of friendly fire. The more open and globalized the world economy becomes the better. The risk, if the battle gets acrimonious, is an increase in government retaliation through industry subsidies, tariffs and capital controls. These policies reverse global economic integration, and lead to an inefficient allocation of resources, lowering growth overall.
All countries in the battle need growth. Gaining more of a shrinking growth pie through a bitter currency war doesn’t really make economic sense. What will offset these tendencies is more communications and coordination between independent central bankers. Unfortunately, the last time this occurred meaningfully was at the Mount Washington Hotel after World War II when the U.S. dollar became the gold standard.
The impacts of the currency contest will influence markets, and since it is a zero sum game, there will be winners and there will be losers. Investor portfolios in 2013 need to be diversified among industries, geographies and currencies to mitigate potential damage.
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.