Friday, October 15, 2010

Are We on the Verge of a Currency War?

The news in today's Financial Times was stark and to the point: the U.S. dollar tumbled yesterday against nearly all the world's major currencies. The precipitous drop was such that warnings have been sounded that continued dollar weakness could destabilize the global economy and also trigger a currency war - where many other nations enact their own currency devaluations to support their own exports.

As we know from basic economics, when a currency is devalued or systematically debased (as the Fed has been doing with its continued low interest rates, and "quantitative easing"- see earlier blog on this) then the cost of its exports decreases relative to those of other trade partners. In particular, this is one way of establishing an improved balance of payments accounting and to reduce a burgeoning trade deficit.

But is this the right thing to do? Look at the dollar index(graph) , which tracks a swatch of global currencies and the dollar's average value in relation to them. It will be seen the dollar's value is now at about 76 cents. This debasement of the nation's currency, in the eyes of many of us, is a symbol for the debasement of the country. We are now, to put it bluntly, on the verge of becoming a third world nation operating as a first world pretender. Never mind all the military machines arrayed around the world - Rome was also the power of its age before misplaced taxation was allowed to bleed it try and military overstretch finished its empire. But hey, we're a "nation under God", so what's to worry?

Well, plenty!

Because if the nations with yen, or euros, or the pound sterling also decide on their own formal policy of currency devaluation, we end up right back at 'square one'. One senior European policy maker quoted in The Financial Times, asserted that a further round of quantitative easing by the Federal Reserve would be "irresponsible" if it made U.S. exports more competitive at the expense of its trade rivals.

Why is the dollar value falling? Because it's prefiguring the word of the Fed's next decision at its next meeting, to do $500 billion worth of quantitative easing. And not only is the dollar falling, but the price of commodities is increasing: Gold is now $1,371 per troy ounce, silver is $2, 449 and corn has risen to $5.71 per bushel. The last is especially frightening given the world is now at the doorstep of an emerging food crisis, as reported in the FT of Oct. 13. This food crisis has been incepted by wheat failures in Russia(from climatic engendered droughts), as well as other drought-induced corn crop failures in the U.S. Recall here that world-wide rioting erupted in 2008 when commodities price rises made it nearly impossible for billions to get enough to eat.

Russia's finance minister Alexei Kudrin isn't fooled by any of what he sees, noting the U.S. is clearly trying to solve its "structural problems" by using monetary policy.

I believe he's spot on.

What Bernanke and his clique of fellow Fed bankers gaming the system need to realize is they need to deal with the core structural problems of the country, and not merely treat symptoms with more cheap cash infusions.

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