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Currency War by Jordan at Investing Blog

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It’s here. While the Federal Reserve looks to start a second round of quantitative easing, other central bankers are looking for ways to lower the value of their currency and increase exports. Of course, if everyone devalues their currency, no one wins.

Why Devalue Currency

Devaluing your currency is one of the best ways central bankers believe, to stimulate an economy in the short run. By reducing the value of a single unit of currency, things like regulation, minimum wages, and other laws are effectively revalued for foreign consumers. So, if the minimum wage in the United States is $7.25 and the dollar loses half its value over the next year, the effective minimum wage relative to today’s minimum wage is $3.675, or half of the present cost for foreign consumers.

Likewise, if it costs $100,000 in regulatory filing fees to start a factory, and the dollar is devalued by half, every foreigner with savings in foreign currency can afford to A) open up production within our borders and/or B) afford to buy our goods.

This all seems like a really good idea. Printing money costs us practically nothing, it helps inflate our GDP in the short run as more money swirls before prices rise to reflect the change in the money supply, and it helps to reduce our debts. But the problems, however, are two fold. First, it creates an unknown in the economy (inflation) and secondly, reducing the value of your currency does nothing if everyone else does it too.

An Example

Let’s assume that the United States, China, Europe, and Japan are the only countries in the world. The United States, seeking to increase its total exports while reducing imports decides to inflate its currency by a factor of two to chop its value in half. In response, China, Europe, and Japan all inflate their currency, hoping to bring back parity value between the world’s currencies and the United States.

So who wins? Well, since all the world currencies were devalued equally, no one wins. There is twice as much currency from each country and economic union so relatively they’re all equally valuable now as they were before.

But what happens in each local economy does matter. The United States, acting first and with a different central bank and monetary policy, forecasts high inflation going forward. Japan, suffering from nearly two decades of deflation, suggests that even rapid printing of Yen will do nothing, since few have incentive to borrow. China, with a previously weak currency is in the same situation as the United States and Europe, with a normally tight central bank fears extreme hyperinflation as low rates set in.

So, after the entirety of the world inflates its currency, no one benefits in increased exports (since all currencies are worth same relatively as they were before) but every business in every country, whether operating purely domestically or internationally now has to account for differing effects of inflation on different countries.

Japan may have little response to high inflation. China, with higher velocity of money, may experience inflation faster, and temporarily demand more. Europe, which sells luxury cars to China, revs up production to send cars to China to take advantage of high demand and low financing costs. Essentially, the whole of the world acts differently to respond to market volatility due solely to monetary policy, not economic growth. In the long run, the dust will settle, the currency will cool, and inflation will slowly dip, but not before billions of people alter their position to take advantage of short run benefit, many of whom will make long run investments to profit from a short-run phenomenon.

It is kind of like building houses (long run investment) to profit on low interest rates (short-run phenomenon). We saw how that worked out.

About Jordan

Jordan is the web master of www.investingblog.org, a site dedicated to skillful investing, news and recent trends. You can read the original article here.

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