Currency Wars

December 18, 2011

Currency WarsWhen the economy of a country faces economic stress, that country’s central bank usually tries to take steps to recover by adjusting or boosting inputs to GDP.  GDP is based on:

– Consumer consumption
– Investments in housing and business
– Government spending
– Net exports (Exports minus Imports)

When the country reaches a level where there is high unemployment and excessive debt, it leads to a situation where consumer consumption is weak and no one is investing in housing or business because they are uncertain about the future.  Government spending can sometimes overcome this, but it comes with higher taxes or borrowing costs which become politically unpopular.

Therefore, as a last-ditch effort to boost GDP, a country will embark on currency debasement in order to increase its net exports. The currency is devalued by inflating the money supply.  The local citizens suffer because their own money buys less goods as things become more expensive at home.

However, as a country’s currency becomes weak in relation to its trading partners’ currencies, it makes its products and services cheaper for foreigners, and thus more attractive to buyers in other countries. As foreigners buy more, the affect is a rising GDP.

But this is only a temporary situation.  Other countries begin to experience problems because their imports are rising relative to their exports.  This hits their own GDP and now they have to take similar steps – debasing their currency to remain competitive.

Rickards explains that there have been two major global currency wars already – one from 1921 to 1936 and the other from 1967 to 1987 and that we are now in the third global currency war.  This war has three main participants – the U.S., China and Europe – although many countries around the world are severely affected by the currency games being played out and make their own contributions to the overall picture as well.

Rickards also gives four possible outcomes of this currency war:

  • Multiple reserve currencies. Instead of the U.S. dollar being the preferred reserve currency of the world, countries would hold several denominations from currencies around the globe. But imagine having to deal with the policies of several central banking activities – it’s bad enough dealing with those of the Fed.
  • SDRs. Special Drawing Rights have been the instrument of the IMF. SDRs are backed by a basket of different currencies from different countries around the world. However, the SDR’s value floats – that is, it is adjusted according to global exchange rates.  Furthermore, the IMF is able to print SDRs at will. Thus, there really is no difference between any other currency of the world, except it’s worse with the SDR – the IMF controls the SDR and the people controlling the IMF are appointed, not democratically elected.
  • A return to the gold standard. Here Rickards discusses some of the things to think about prior to a return to the gold standard, like what definition of the money supply (M0, M1, M2, etc.) to use as the base money supply on which to base on the gold supply?  Additionally what ratio should be used between paper and gold? And finally, what regulations should be in place for exceptions to be made in certain circumstances?
  • Chaos. If nothing is done to stem the current path towards currency debasement, a catestrophic collapse could devistate the world as we know it.

There’s also an interesting chapter explaining how currency and capital markets have become so complex that they are quickly approaching a breaking point. Current risk models used by most firms are inadequate to account for the existing risk and thus most are unaware of the true problems underlying the system and thus are unprepared for the inevitable catastrophe.

Here’s an interview with James Rickards where his book is discussed:

And here’s an audio interview discussing the book, whether or not America needs the Fed and whether or not a gold standard is a possible answer to today’s economic issues.

 

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