The world’s major trading blocs are descending into a potentially lethal battle over currency rates. The Americans are arguing with the Chinese over the value of the yuan. The Japanese are frantically trying to lower the yen. Emerging nations, such as Brazil, are introducing capital controls to try to stem the appreciation of their currencies. The annual meeting of the International Monetary Fund (IMF) in Washington last week was dominated by talk of a new global agreement on currencies. No doubt the next meeting of the G20 finance ministers will be as well – although it is unlikely that any deal will result.
The focus for now is on the likes of the yen, the dollar and the yuan. Yet the real victim of turbulence on the foreign exchange markets may well turn out to be the euro. Any kind of war always exposes structural weakness. The currency with the greatest structural weaknesses right now is the euro. A full-scale currency battle may well finish it off.
We’ll get to that in a minute. But why all the talk of currency wars now? One of the major underlying causes of the credit crunch was the vast trade surpluses run up by China and the deficits run by the US (and, to a lesser extent, Britain and Spain). Huge amounts of money had to be recycled through the banking system: the financial markets became bloated and unstable as a result. Nothing that has happened in the last two years has done anything to fix those imbalances. Worse, governments have reached the limits of their ability to spend their way out of recession. They can’t push their deficits any higher – the sovereign debt crisis has slammed that door shut. The only option left is to depreciate their currencies and boost demand that way.
But countries can’t, of course, depreciate their currencies all at the same time. Instead, they are racing to devalue first. If that doesn’t work, they will have to try to negotiate and bully their currencies lower instead. Agreements on exchange rates are hard to strike, and even harder to make stick. The last of any significance was 1985’s Plaza Accord, which depreciated the dollar versus the yen and the deutschmark. While it was successful for a period, it didn’t last very long.
A deal like that is unlikely now. Most major currencies will just muddle through instead. The dollar may fall in value, particularly if the Federal Reserve embarks on another round of quantitative easing (QE). The Chinese may allow a very gradual rise in the yuan, so long as they can stop it from leading to a steep rise in unemployment. The Japanese may get the soaring yen under control, and the Swiss the franc. The pound has already been substantially devalued, and it’s likely to be a while before the Bank of England has to worry about the strength of sterling.
The fact is, the real weak point may well turn out to be the euro. Here’s why. QE has become a form of devaluation by the back door. The currency markets hate it. As they see it, if there is suddenly a lot more of a currency conjured out of nowhere, that means it is worth less. They promptly start selling. Its impact on the overall economy is debatable, to say the least, but there is no doubt it drives the currency down a lot more effectively than intervening in the markets directly.
But there is nothing in the rule book that permits the European Central Bank (ECB) to print money. And it still has too much of the old Bundesbank imprinted on its DNA to regard minting bank notes out of nothing with anything other than horror. It can fret and wail about the strength of the euro, but the one weapon that might help it stem the currency’s rise is not available to it.
Worse still, it’s impossible to gain consensus on where the euro should go. Germany is running big trade surpluses. Its export industries are booming, partly because of the euro’s weakness last year, and partly because the Germans are really good at making products that the high-growth emerging economies want to buy. It wants a stronger currency, not a weaker one. But the peripheral eurozone economies – Greece, Ireland, Italy and Spain – need precisely the reverse. They were getting crucified when the euro was trading at less than $1.20 earlier this year. It will be even harder for them now that it’s up to $1.40. Those countries desperately need to try to export their way out of trouble. But you can’t do that when your industrial base has taken a hammering, and your currency keeps appreciating.
The net result? Paralysis. We can expect to hear a lot of talk over the next few months about how the euro is too high. But as Mark Twain once said about the weather, ‘Everyone keeps talking about it, but no one ever does anything about it’. The same will be true of the euro. As global exchange rates get reshuffled, it won’t have a voice – because no one will be able to agree where it should be going. As every other major currency competes to devalue, the euro will inevitably go up – just by staying out of the game.
That will test the euro to destruction. The last six months have revealed how dangerously fragile the single currency is. A currency war between the major economic blocs will cruelly expose how dysfunctional the euro has become – and might even turn out to be the catalyst that sparks its dismemberment.