The trade war with China is quickly morphing into a currency war. There is now serious talk of the U.S. intervening in the currency markets to strengthen the Chinese yuan and weaken the dollar. Even before Beijing allowed the yuan to drop below the key 7 yuan per dollar level, the Trump administration was already talking about additional currency-based tariffs that could be imposed if the yuan devalued further.
This is not a partisan issue in the United States that can be avoided by outlasting the Trump administration – both Donald Trump and Elizabeth Warren want the dollar to be weaker. Moreover, the dollar’s strength cannot be blamed only on the yuan’s devaluation; all other major currencies have been falling against the dollar (especially when accounting for the purchasing power parity of the currencies).
The yen has been falling ever since the start of Abeonomics in Japan. Sterling in the U.K. is weak – and continues to weaken more on Brexit concerns. On the European continent, the European Central Bank (ECB) is more than matching the Federal Reserve with rate cuts to keep Europe, where growth is extremely slow, stable.
The Rise of Free-Floating Currencies
In a world where growth appears to be slowing down, central banks are doing their best to weaken their own currencies because, despite what you might think, a strong currency is not a good thing for an economy – at least not in today’s world of free-floating currencies.
The relative value of currencies matters today in a way in did not before 1971. Before 1971, the currencies of the world operated under the Bretton Woods system of fixed exchange rates. Currencies were pegged to the dollar with, for example, a fixed amount of yen worth a fixed amount of dollars.
This system broke down in 1971 when Nixon ended the dollar’s convertibility to gold. Under the terms of the Bretton Woods agreement, the dollar was pegged to a fixed amount of gold and other nations pegged their currencies to the dollar. However, the United States printed so many dollars that countries like France lost confidence that the U.S. would be able to hold the peg to gold. These nations started to demand to have their dollars converted to gold by the United States. To prevent a run on Fort Knox, Nixon was forced to end gold/dollar convertibility and in response, countries broke their pegs to the dollar, allowing their currencies to float freely.
Free-Floating Currencies and Trade Imbalances
The era of free-floating currencies has enabled massive trade imbalances in the global economy. Mervyn King, former Governor of the Bank of England, described how today’s massive trade imbalances have divided the world:
The surpluses are concentrated in four countries - the euro area, China, Japan and Korea. Taken together, their combined current account surplus in 2016 was $886 billion, just over 3% of their GDP. The deficits were also concentrated in four countries – the United States, United Kingdom, Canada and Australia. Their combined deficits were $680 billion, just under 3% of their GDP. It is a striking example of the difference between the two “groups of four”: the Anglo-Saxon world, with its instinct of openness to trade and competitive financial markets, and Continental Europe and the Far East, with a more mercantilist outlook.
Under the current free-floating monetary system, imports and exports are no longer balanced between nations. Trade is no longer balanced by gold (which despite its faults did balance trade) or through the fixed exchange rates of the Bretton Woods system. Today a country can manipulate its currency lower and run trade surpluses for decades - leading to larger and larger trade deficits.
This is precisely what has happened to the United States over the last fifty years since the end of Bretton Woods. A massive trade deficit was created in the United States. And a tremendous amount of U.S. manufacturing jobs were outsourced with almost no counter-balancing increase in other sectors on the U.S. economy.
A Strong Dollar Has Been a Problem Before
In this world of free-floating currencies, an overly strong national currency can severely damage a nation’s export economy. Switzerland was probably the first example of this in the post-Bretton Woods era. In the turmoil that followed the end of Bretton Woods, money flowed into the Swiss Franc as a safe haven, throwing them into recession despite drastic attempts to prevent the Swiss Franc from strengthening.
In fact, a strong dollar has been a problem for the United States before. In 1985 the dollar was extremely strong. With the collapse of the Bretton Woods system fourteen years earlier, there was no longer an automatic mechanism to keep imports and exports between nations in balance - and suddenly currencies being under or overvalued relative to each other mattered a lot.
The United States began to see a widening trade deficit, as other nations, particularly Japan, devalued their currencies to indirectly boost exports and stimulate economic growth. (For more on the mechanics of this see: Why Did China Just Devalue the Yuan?
Unhappy with the situation, the United States negotiated an agreement with these nations to allow their currencies to strengthen against the dollar. The agreement was the Plaza Accord. However, such an agreement today seems unlikely – Chinese media has already highlighted that China will not to allow themselves to be forced to strengthen their currency like Japan was. Japan’s economy has arguably never recovered from the strengthening of yen in 1985. Soon after the Plaza Accord, Japan’s asset bubble popped and country fell into their “Lost Decade(s).” There is little hope for an international agreement on currency valuations this time.
Everyone Loses In Currency Wars
Ultimately there is likely to be no easy solution to the fight over currency valuations. With the global economy slowing down, nations will be desperate to boost their own economies. If the world does break down into currency wars and “beggar thy neighbor” currency devaluations, it won’t be the first time. But it didn’t work out so well for the world in the 1930s.
If Trump gets his way and the Federal Reserve makes moves to weaken the dollar, the most likely outcome is widespread competitive currency devaluation. A race to the bottom with every nation trying to boost exports by driving their own currency weaker. This is a formula for monetary instability, more tariffs, and a breakdown in global trade.
However, if the dollar remains relatively strong, it also presents major problems for the global economy. Since the Great Recession, much of the world – and particularly China – have borrowed a substantial amount in dollar-denominated debt. This means that while other nations may see an export boost from their own weaker currencies, the strength of the dollar could easily cause a major problem as companies struggle to service dollar-denominated debt with weakened currencies. This dollar-denominated debt could be even more of a drag on economies than the loss of exports from a stronger currency.
The inherent instability of the free-floating monetary system is becoming perhaps the problem for a world still struggling to find stability since the 2008 financial crisis. A problem surpassed only by the growing burden of national debts which means that The Next Recession (Whenever it Comes) Will Be About Sovereign Debt.
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About the Author Joshua Konstantinos Founder and Global Macro Strategist at Cassandra Capital LLC and author of Sleeping on A Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications, Joshua has been obsessively following global trends and collecting data for over a decade. His analysis takes into account not only the larger view of the rapidly changing global economy but also the longer demographic and geopolitical trends.