Currency War

For the past few years the US and other nations have accused China of currency manipulation. What they are talking about is China buying US government debt (aka buying dollars) to prop up the value of the dollar and keep their currencies deflated. How does this work? When governments' buy US debt they do it in dollars. Since only the US government may print dollars, these governments must buy dollars with their own currency. This decreases the supply of dollars in global circulation and increases the amount of their currency in circulation. When demand increases and supply decreases, costs go up. In this case it is the cost of buying that currency, i.e. the exchange rate. Conversely, the value of the country's own currency (the currency used to buy dollars) decreases.

Why is this a problem? When a country devalues its own currency it makes its products relatively less expensive in foreign markets because it now costs fewer dollars to reach the purchase price in the foreign currency. This makes the foreign goods more attractive to the consumers in those countries. It instantly makes these foreign goods and services more competitive. Unfortunately, this also means that the citizens purchasing power of US made goods decreases, since their earnings are in the now devalued currency. So a currency manipulator lowers the purchasing power of its own citizens, but promotes local business and employment over foreign ones. Devaluing currency leads to inflation as foreign goods' values go up and local industries see they can raise prices without losing competitiveness with their foreign rivals. This is why economists refer to inflation as a hidden tax. Governments' intentionally lowering the purchasing power of their own citizens to promote local business and job growth is very similar to taxing citizens and giving that money to local businesses. The only difference is that in the case of currency manipulation you get the added benefit of hurting foreign competitors.

Sounds like a great way to promote local industry then doesn't it? That is why countries like China find it so attractive. Unfortunately, there is one drawback, it is exceedingly obvious when a country starts playing with its monetary supply to manipulate its exchange rates. The end result is that other countries will take retaliatory measures. This leads to a currency value war. Before international markets for currencies it was more common to accomplish these tasks by taxing foreign goods, so called tariffs. However, since the Great Depression tariffs are deeply unpopular among economists because of their role in worsening the Great Depression. The damage that was sparked by the Smoot Hawley Tariff Act of 1930, which caused our trading partners to pass retaliatory tariffs, crippled international trade. This is also why "free trade" deals have become so popular. We know the damage a trade war can do.

The problem is, with the global economy stagnating, it is becoming exceedingly popular for countries to manipulate their currencies to gain an advantage over their trading partners. This is leading to retaliatory measures. Example: China manipulates its currency, we print a ton of money swamping world markets with dollars. Second Example: Japan, a country with a relatively stable and strong currency has seen the value of their money increase, incentivising international investors to buy their currency, creating a self reinforcing spiral where the value of the currency keeps going up. This then causes deflation in Japan and leads to its economic stagnation (not the only reason for Japan's two decades of economic stagnation). Japan has now pledged to devalue their currency in response to regain their competitive edge.

Some Opinion pieces have recently asked if a global currency war is on the horizon. I would argue we have been in the midst of one since the beginning of the great recession of 2007 and 2008. This is likely also a factor in why the global economy is stagnating. Like Smoot Hawley in 1930, modern currency manipulation is harming international trade and competitiveness. It is too easy for a government to print money to pay its bills instead of cutting its budgets and harming its entitlements in economic downturns. That it acts as an invisible tax on its citizens doesn't bother politicians because the average citizen doesn't realize it. Because they don't have to pay their governments anything, they don't know they have any reason to complain. Meanwhile the damage to the international economy continues unabated.