Europe and the Currency Wars

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 31, 2015 2:22:00 PM

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currency warsAs I mentioned yesterday, I don’t believe that we’re in the middle of currency wars, but I do see countries taking action to boost their economic and job growth. The side effects include what may, from a certain perspective, look like a currency war.

How can we determine what we’re actually facing right now?

Case study: Europe past and present

Europe offers some great examples of how currency relationships can play out over time. Back in the interwar period, currency wars really were in effect, between Britain, France, Germany, and even the U.S. Driven by the gold standard, the zero-sum nature of currency movements forced countries onto a war footing. Currency wars do happen, but historically, they’ve occurred when an absolute like the gold standard is in place.

Once the gold standard collapsed, the game changed. In the postwar period, while the German currency, the deutsche mark, was famously strong, other countries—Spain, Italy, Greece—regularly devalued their currencies. These devaluations were explicitly intended to make the countries more competitive (and therefore fit the “currency war” definition), but the motivation was different, as were the consequences, in a fiat money world. Minus the absolute basis of the gold standard, the damage to other countries—Germany, for example—was minimal.

Currency devaluations were no longer considered an act of “war” but tools of economic management.

The European nations’ experience since the creation of the euro gives us another object lesson in how countries and currencies can interact. With the euro (which, just like gold, provides an absolute standard against which countries must act), the member nations are once again prevented from devaluing. The trouble that Greece and other Mediterranean countries are now having within the euro system demonstrates the value, in terms of economic flexibility, of a relative, fiat money-based framework.

Is the European experience relevant to today?

Looking at the world as a whole, we see that the major currencies—the dollar, the yen, the euro, the renmimbi, and even the pound—all have the flexibility to revalue without direct impact. Just as in the pre-euro Europe, currencies can adjust flexibly based on the economic needs of the individual countries. Economic adjustment doesn’t necessarily translate into currency wars.

The question, of course, is whether the European experience remains relevant to the situation we find ourselves in today. I would argue that it does.

When Spain and Italy, two of the largest European economies, systematically devalued their currencies, Germany, the largest and strongest economy in Europe, continued to grow. Germany has continued to succeed even as the euro grew stronger over the years. An appreciated currency was a consequence of economic success, and the depreciation of other currencies was a headwind, but not a systemic problem.

The parallel with today is obvious. The U.S. is the strongest developed economy and remains the major player in the world. Other, less economically robust areas are effectively depreciating their currencies, but this is actually a good thing. As we have seen in Europe, in a fiat currency system, the ability to depreciate a currency allows countries to maintain growth levels without making other hard choices.

The alternative to the kind of adjustments we’re now seeing is to put all of Europe, or Japan, where Greece is today. If Greece could devalue, it could reboot its economy as it had done many times before. Europe is effectively devaluing, on a global basis, to avoid going down the same road as Greece. Moreover, Europe (and Japan) are doing exactly what the Fed has done over the past several years. It worked here.

Let the healing begin

In context, the current currency volatility is actually evidence of a healing process. It is certainly unsettling, but the experience of Europe (both good and bad) shows us what the alternative would be. It also demonstrates that we’re not only not in a currency war, but actually in a very positive period of adjustment.

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