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Is A Currency War in the Cards?

September 16th, 2010

The recent moves by the Bank of Japan in driving down the value of the yen, on top of the continuing row over the value of the Chinese Renminbi or yuan, may be signs of a growing risk of a currency war by advanced and major emerging economies. With the risk of a double dip recession increasing, the transitory and increasingly marginalized economic recovery from the implosion of 2008 running out of steam after massive doses of public debt growth and the bond markets beginning to get restless over government deficits that are out of control, the supposedly unified G20 may be looking to their currencies as a last ditch attempt to reverse disastrous rates of unemployment.

It is ironic that devaluing one’s own currency is seen as being the best move on the grim economic horizon. However, with central bank interest rates of near zero percent having failed to unleash sustained economic growth, and debt-saturated fiscal policy proving as feeble as monetary policy, currency devaluation may be seen as the only viable option left for policymakers.

In theory, a cheapened currency makes a nation’s exports more competitive, while adding a premium on imports, leading to a better current account balance and growth in export-based manufacturing sectors. Devaluation is also a way of reducing the real value of the national debt. The problem with this approach is that it is not unilateral; other countries can play around with their currencies. Furthermore, trying to effectively restructure your debt on the sly through devaluation will undoubtedly choke off cheap sources of credit. If the recent currency moves are pointing towards increased currency manipulation by sovereigns, my belief is that this approach will prove every bit as ineffective as has been massive government deficits and zero interests rates offered by central banks.

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