Perils of Currency Wars

In the global economy, our fates are intertwined. And yet, a global currency war – a shortsighted race to the bottom in which countries try to make their exports more competitive, could destabilize the entire system and lead to runaway inflation.

This is why investors should be concerned about the global currency war. In the long term, it could be disastrous for more than just your portfolio.

With the sequestration showdown in Congress – automatic spending cuts due to start this coming Friday, March 1 – and other pressing domestic news, we hardly have time to think about Europe. Yet the continent is as troubled as ever, and it’s crying out for attention again.

Recently, global gross domestic product figures disappointed. For 2012’s fourth quarter, the eurozone economy shrank for a fourth consecutive period, leading to a 0.5% drop in GDP for the year. It was the first time the region’s economy shrank for four sequential quarters since 1995. Even stalwart Germany saw its economy shrink by 0.6%. Unlike most of Europe, Germany has avoided recession since the beginning of the debt crisis. The French economy also fared worse than expected, contracting by 0.3%. Greece, Portugal and Italy all declined as well.

To push out of the recession, many on the continent want a weaker euro, because a less valuable currency provides competitive advantages to exporters. The euro is up about 13% against the dollar since last summer, hurting Europe’s efforts at economic recovery, because its exports are relatively more expensive for customers in other countries.

However, the war for weakness is global. For more than a decade, U.S. has weakened the dollar to stay competitive. China and other countries followed suit.

Quantitative easing, through central banks’ purchase of bonds and printing of money, is the preferred method for weakening currency these days. The United States, of course, is in its third round of quantitative easing with no end date.

Now Japan is seeking to weaken its currency. Japan is in its 11th round of quantitative easing and its economy is still a mess. The newly elected government pledged to fight deflation, which persisted since the early 1990s, and make the yen more competitive in the world market. To achieve that end, the government might take the unprecedented step of removing the central bank’s independence.

The currency war was a hot topic at G-20 meeting this month. Ahead of the meeting in Moscow, the group of the world’s largest economies (including Japan) issued a statement condemning competitive devaluation and reiterating their “commitments to move more rapidly towards more market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals, and avoid persistent exchange rate misalignments.”

They did not specifically single out Japan as a currency manipulator, as some expected. As Zerohedge wrote, “the lack of a stern rebuke of Japan simply means the currency wars will now intensify, devolving into the same protectionism and trade wars as the first Great Depression.”

It’s a bit severe to predict another Great Depression and World War III; foreign exchange gyrations some 70 years ago helped produce such global cataclysms. But worldwide currency manipulation is bound to have some nasty side effects, such as higher inflation. Imported goods become more expensive when a currency weakens. Then the price of domestic goods increases, since a nation’s companies can raise prices and remain competitive.

When prices increase, consumers buy less, save less or carry more debt. Less purchasing by consumers reduces sales, which can lead to a recession or worse.

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Brenda P. Wenning is president of Wenning Investments LLC in Newton, Mass.  
 
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