Tuesday, July 24, 2012

The End of Growth Through Currency Wars

The End of Growth Through Currency Wars

by Dan Denning on 23 July 2012

Money Morning Australia

The Plaza accord was initially set up in 1985 and included five countries; the United States, West Germany, Japan, France and the United Kingdom.
What was it?

The US dollar was strong against all the major currencies towards the end of the seventies, giving American trading partners, like Japan, and Europe a competitive advantage when it came to their exports. This was becoming a political problem for the US. Car manufacturers lost market share and jobs to Japan.
What’s more, Europe and Japan were so addicted to export led growth that domestic consumption fell off a cliff. Economies in Europe, much like Japan, ran huge trade surpluses with the US but actually experienced economic contraction. 

The solution was now what’s known as the Plaza Accord of 1985, so called because it was negotiated in September at the Plaza Hotel in New York. Back then it was just the G-5. All five countries agreed to intervene in the currency markets to orchestrate a weaker US dollar.

The point of the whole exercise was to transfer growth from the US market to the rest of the world. The world has stopped growing. The monetary authorities agreed to engineer some growth by weakening the dollar (especially against the Yen and the Deutschmark) and encouraging consumption and investment in the rest of the world. It worked.It worked too well.

By 1987, the G-5 had expanded to the G-6 to include Canada. The G-6 gathered in Paris to sign the Louvre accord. This time their goal was to strengthen the dollar in the name of stability. Global growth had been rebooted, but the dollar’s slide had resulted in too much volatility in currency and financial markets

The Start of the Currency War

A currency war is fundamentally an attempt to improve economic competitiveness at the national level. The self-defeating aspect of a currency war is that you can only do so at the expense of your neighbours, whom you hope to make your customers. Your growth comes at their expense. They must consume in order for you to save.

This was fine back in 1985 with the Plaza accord. The US could effectively ‘lend’ growth to Japan and Europe. The US ran large current account deficits. But the key difference between then and now was that there was a strong currency (the US dollar) which could be weakened, and weak currencies which could be strengthened.

The US could let the dollar slide because the economy was booming. Jobs were plentiful. The government deficits were growing but not huge. Devaluation hurt, but only to the national pride, not in any noticeable way on a purchasing-power basis.

Today, there is no one currency against which all others can strengthen to everyone’s mutual benefit. Competitive devaluations have become a zero sum game, always costing one country jobs and exports. This is why Brazilian Finance Minister Guido Mantega said in 2010 that the world was in a new currency war. He knew that interest rates were being used by central banks as a weapon to deal with domestic debt problems and boost export competitiveness.

Effectively, everyone in the world is trying to boost their own economic growth by weakening their currency so they can sell their goods to other countries. This has led Europe, Japan, and the US all to the same place: zero real interest rates.

These countries have chosen to deal with deflating asset bubbles and low growth by lowering real interest rates. They’ve avoided a reckoning. But in so doing, they’ve zombified their economies, sucking out all the life of a dynamic market and injecting it with the formaldehyde of unproductive debt. They have also trod the path of currency devaluation down to its logical conclusion.

Protecting Your Investments in a Currency War

What I’m almost certain of is that this is just the beginning. If the currency war moves from interest rates and monetary and fiscal policy to cyber weapons, price manipulation and an attack on the financial architecture of the modern world, then a threat exists that is neither fully understood nor appreciated. So what can and should you about this emerging threat?

How do you create non-financial wealth and personal security?
Short of opting out of the current system and dropping off ‘the grid’ — a radical option that most of us are not in the position to choose and probably wouldn’t choose anyway — what can you realistically do to hedge against major losses in the share market as a result of deleveraging and major disruptions to the economy as a result of the evolving currency war of all against all?

Well, I think the answer lies in thinking about what wealth really is. I don’t mean to get philosophical. But really, it doesn’t hurt to think about why we bother to invest and protect and grow our wealth. Is it for the love of the game? Is it because we enjoy the challenge?

It may be for those reasons. But fundamentally, wealth creation and preservation is about having the freedom to live the life you’ve imagined for yourself, a life of purpose and creation and value, whatever value means to you. Financial wealth helps us achieve those ends. But it is not an end in itself. Building non-financial wealth means taking steps to improve your quality of life and personal security. For me, that means appraising the financial system with honest and sceptical eyes.It then means reducing the amount of my wealth at risk in financial markets and converting it into tangible assets that have utility.

For some people it may mean living a simpler financial life with less risk and fewer day-to-day decisions (peace of mind). This is probably a demographic trend we’ll see anyway. As the baby boomers approach retirement age, I expect those that are able to will begin liquidating their retirement portfolios and living off their accumulated savings.

Dan Denning
Editor, Australian Wealth Gamepla


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