Opening shot fired in currency war?

China's unexpected devaluation of its currency lead to a decline in world wide stocks, global commodity prices, and and increase in US bond prices.  This could be the opening salvo in a long and expensive currency war:

One reason is that it raises fears of a more intense and destabilising currency war — the trend for countries to use a weaker exchange rate rather than supply-side efficiencies — to bolster exports. ... 

Tuesday’s PBoC move followed the release of weak trade data over the weekend that showed exports tumbled 8.3 per cent in July from a year earlier.

Shots fired in currency war against US

With so-called "quantitative easing" (funny video), the Fed is increasing the supply of longer term loans, which will bring down US interest rates.  This, in turn, encourages foreign borrowers to borrow in US currency, trade their dollars for, e.g., Brazilian real, and then invest in Brazil.

The increased demand causes the Brazilian real to appreciate relative to the dollar which makes Brazilian exports more expensive.  This leads to reduced demand for domestic labor in Brazil.  If wages cannot fall, then you get domestic unemployment.

Predictably, foreign governments are trying to stop this from happening:

China, Brazil and Germany on Thursday criticised the Fed’s action a day earlier, and a string of east Asian central banks said they were preparing measures to defend their economies against large capital inflows.

Guido Mantega, the Brazilian finance minister who was the first to warn of a “currency war”, said: “Everybody wants the US economy to recover, but it does no good at all to just throw dollars from a helicopter.”

Currency wars as a prisoners' dilemma

As the European Central Bank prints more money, and lowers its interest rates, demand for the euro in the foreign exchange market falls because capital leaves the country to find better return abroad.  This weakens the euro which makes its exports less expensive, and stimulates employment in the domestic economies of the Eurozone.  

Of course, this also weakens export driven economies like those in Asia (and in the US), which could lead to a "currency war" where rival central banks print money and reduce interest rates to keep their own currencies low.  

South Korea ... currency fell 0.5% against the dollar and 0.7% versus the euro on the news. 

Thailand’s decision to cut rates Wednesday also helps its exporters, who have been complaining recently about the baht currency’s relative strength. 

No matter what the rhetoric is from central bankers, many of them are hoping that rate cuts help lower the value of their currencies versus those of their neighbors. 

“They’re thinking of it in the context of currency wars,” said David Mann, chief economist in Asia at Standard Chartered Bank.

As the MBAOracle.com says:  

Use game theory to figure out where self interest is taking you; if you don’t like where that is, change the rules of the game.

How can a country increase exports?

Countries with strong currencies, face reduced demand for their exports:

“I would not want to be in machine tools in Germany at the moment,” said Adam Posen, president of the Peterson Institute for International Economics and a former Bank of England official. “I would not want to be in ship building in South Korea.”

The feeble recovery is tempting countries to weaken their currencies (by printing money):

European Central Bank President Mario Draghi has praised the euro’s decline, an indication to investors that a weaker currency is a key ECB policy objective. Bank of Japan governor Haruhiko Kuroda made similar remarks about the yen’s value. South Korea and China have come under fire for keeping their currencies lower than levels many economists say would reflect fair market values.

But this works only if you are the only country doing it.  If rivals also weaken their currencies, the net effect is zero, a type of prisoners' dilemma.

Top finance officials trying to talk down the value of their exchange rates have resurrected warnings of a global currency war. Such tit-for-tat devaluations tend to create short-term growth at other countries’ expense.

When will the bubble burst?

David Stockman, Reagan's former budget director, who resigned in protest over what he calls the "state wreck" of capitalism by Republicans and Democrats alike, offers this prediction,

If and when the Fed — which now promises to get unemployment below 6.5 percent as long as inflation doesn’t exceed 2.5 percent — even hints at shrinking its balance sheet, it will elicit a tidal wave of sell orders, because even a modest drop in bond prices would destroy the arbitrageurs’ profits. Notwithstanding Mr. Bernanke’s assurances about eventually, gradually making a smooth exit, the Fed is domiciled in a monetary prison of its own making.  ... 

...there are trillions of dollars of assets, from Shanghai skyscrapers to Fortune 1000 stocks to the latest housing market “recovery,” artificially propped up by the Fed’s interest-rate repression. The United States is broke — fiscally, morally, intellectually — and the Fed has incited a global currency war (Japan just signed up, the Brazilians and Chinese are angry, and the German-dominated euro zone is crumbling) that will soon overwhelm it. When the latest bubble pops, there will be nothing to stop the collapse. If this sounds like advice to get out of the markets and hide out in cash, it is.

What to expect as countries try to get out of debt

Niall Ferguson, Historian of the Apocalypse, is worried about public debt levels in the Japan, the US and Europe. He tells us what usually happens as governments try to dig out from under World War size debt burdens.

Here is what usually does NOT happen:

• Slash expenditure on entitlements
• Reduce marginal tax rates to stimulate growth
• Raise taxes on consumption to reduce deficit
• Grow way out without defaulting or depreciating the currency

and what usually DOES happen:

• Oblige central bank and commercial banks to hold govt. debt
• Restrict overseas investmnet by firms and citizens
• Defaul on commitments to politically weak groups and foreign creditors
• Condemn bond investors to negative real interest rates

What the Middle East can learn from Ireland

In past posts, we have blogged about how economic prosperity raises the opportunity cost of fighting (End war by raising the opportunity cost of fighting; World Index of Economic Freedom). Steve Forbes has something similar to say about the Middle East:

...we should be firmly advocating genuine changes that will bring about prosperity. One would be a Hong Kong-like flat tax. Another would be currency boards, such as Estonia's, or a variation of one, such as Latvia's, which have stabilized the once inflation-prone currencies of those two countries. ... It's no surprise that most Mideast countries (as well as African ones) are economic laggards. One happy exception is Egypt, which seems to be making real progress in instituting pro-growth policies. A vibrant middle class, long term, is the key to genuine and lasting peace.