How a financial crisis morphs into a currency war

In a synchronized global economic downturn, the temptation for policy makers is to view economic growth as a zero-sum game and to take policies that, while favourable to domestic constituents, end up ‘stealing’ growth from elsewhere. The thinking goes: "If I can’t get the economy to grow quickly, I’ll have to depend on exports to do the heavy lifting until things stabilise." But what’s good for the goose is good for the gander and once we head down the path of today’s neologisms of quantitative easing, fiscal austerity, and competitive currency devaluations, the die is cast; there will be no domestic growth except that which comes at the expense of others.

This time last year, I wrote a piece called The recession is over but the depression has just begun the basic premise of which was that the initial downside shock of the financial crisis would fade due to unprecedented policy stimulus, but that political constraints would eventually lead to a second more severe dip and depression.  While I wrote the piece in declarative sentences, my hope really has been to see indications that policy makers were avoiding ‘escalation’. Unfortunately, policy makers, trapped in the zero-sum game mind-set, are indeed escalating. And chances are they will escalate further.

Here’s how we got here. In a future post, I will focus on where I believe we could be headed.

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Unbalanced global economy

Leading up to the credit crisis, the global economy was dominated by a number of countries with large external imbalances, some on the surplus side like China, Japan and Germany and others on the deficit side like the United States, the UK, and Spain.  When the credit bubble popped after the US sub-prime trigger, aggregate demand in bubble economies cratered, causing the imbalances to shrink dramatically. The result was a huge shortfall in demand in both the countries with large external deficits and in those countries with surpluses as their economies had become inter-dependent. For example, external surplus Germany and Japan suffered steeper falls in GDP peak to trough than did the US or the UK. The economies in the external-deficit Baltics cratered when capital flows from Scandinavia reversed. Even China suffered a huge downswing in GDP on a rolling quarter-to-quarter basis that was masked by their year-on-year reporting standard.

As a result, policy makers around the world went on a massive policy stimulus campaign in order to avoid another Great Depression. We saw massive fiscal stimulus in China, Germany, Japan, the UK, the US and everywhere in between. Short-term interest rates plummeted to 1% or below everywhere in the US, Western Europe and Japan. A number of countries ‘provided liquidity’ into the crippled financial sector by lending to banks for next to nothing or buying assets off of those financial institutions in return for cold hard cash freshly printed by government.

Competitive Currency Devaluation starts

Massive liquidity is supposed to stimulate the economy but it is also a weapon of choice for bringing the currency down and exporting one’s way out of malaise. David Rosenberg recently wrote a piece on the competitive currency devaluations, demonstrating that we have witnessed a Rolling Bear Market in Various Currencies Since 2007 with each country doing whatever it can to depreciate its currency’s value against the others.

Interest rate reductions are one way. This helped precipitate a huge fall in the Australian and New Zealand dollars that started in the period leading up to the Lehman crisis despite high inflation. Quantitative easing is another  way. QE is just a  more elegant way of saying ‘printing money’. The US started this process after the Lehman bankruptcy, causing Treasury yields to go below zero briefly in 2008. Soon the Japanese and the British were at it. By March 2009, the Swiss decided to go QE as well.

Uneven Recovery

The result of the policy stimulus was a stabilization of the global economy. Corporate debt and stock prices soared. Nevertheless, all is not well. Unemployment in the euro zone and in the US is 10%. House prices are still falling in Ireland and Spain and have likely resumed a downward path in the US and the UK. Commercial Property is still on a downward path. Mind you, some economies are doing better than others. The German economy has done particularly well with unemployment at the lowest level since 1992 and growth at the highest since 1987. But this was exactly the problem leading up to the crisis – external imbalances; Germany first suffered disproportionately as the economy went down but is now benefitting in equal measure as the economy has stabilized due its export orientation. Domestic demand growth remains weak.

Competitive Currency Devaluation continues post-Dubai

If everyone was seeing the improvements that Germany or China is seeing, all would be well. But this is not the case.  All of this started to come to a head in November 2009 when the Dubai crisis turned into a sovereign debt crisis.  Dubai brought home that governments were creating a massive risk transfer from specific private sector agents to the public sector in order to stave off the crisis in 2008 and 2009.  Ireland has been one of the worst of the lot, with this year’s public sector deficit set to hit 32% of GDP due to the bailout of the Irish banking system.

At the time Dubai started us on this path last year, I wrote:

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the Dubai World events underline the unpredictability of exogenous shocks. All of these potential crisis situations — dollar carry trade unwind, debt crisis in the Baltics, oil price spike, an unexpected surge in interest rates, war in the Middle East — are still there lurking in the background. We don’t see coverage in the press on them everyday, but they are still there

I have been optimistic about the near-term prospects for the global economy in large part due to the myriad pro-cyclical effects of recovery. Longer-term, however, there are some serious obstacles to a sustainable recovery.  This is not a garden-variety recession and recovery. It is a recession within a longer-term depression.  And while we are in a technical recovery, I believe much of the fundamental problems which triggered this downturn are still there, lurking. The debt troubles at Dubai World bring this point home.

And indeed they have. Eventually, this led to the crisis in Greece, the solution to which was to ‘provide liquidity’ to those countries suffering most. The result, predictably, was another flashpoint in the race to the bottom on currencies. By this time, the friction had started to mount. As the U.S. economy started to roll over in the face of a still undervalued Chinese currency and a now plummeting Euro,  people started talking about a double dip recession in the US.

That’s when the talk of QE2 began.

This is the Federal Reserve Bank of St. Louis piece by James Bullard that everyone is talking about.

Here’s the money quote:

Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.

Translation: The helicopters are at the ready – very much in line with what I said I anticipate earlier today.

My view is that central banks and governments will always act to maintain the asset-based economic model of asset price growth and excess consumption. But they will be constrained during periods of growth, withdrawing stimulus at the behest of deficit and inflation hawks. When they do withdraw stimulus, the economy will lapse back into depression before they can act. At which point, they will respond aggressively.

Because of the deterioration in U.S. growth, stocks still got hammered in the U.S.; August was horrible. But, as the Bullard point of view gained traction, the probability of QE2 and a Bernanke put increased. The US dollar plunged and stocks came roaring back in September (in dollar terms).

The following two charts on U.S. August stock returns gives you a sense of this (hat tip Alberto Artero). In chart #1 you see the monster 71-year best for the S&P 500.


But if you take the same S&P rally in Euros, the chart looks like this:


Tensions are mounting

Friction is building within the EU, between China and the US, between China and Japan, between emerging markets like Brazil and the G7. At issue is the zero-sum mentality of competitive currency devaluation. This is a game that has been going on for some time but has only started to enter the main stream press.

The critical event bringing this onto front pages was the Brazilian finance minsters angry intervention last week.

The last post by Win Thin demonstrates that Emerging market countries that are doing the best in this difficult economic environment are feeling serious currency pressure. Brazil is looking for a way to deal with the volatility associated with hot money flows its strong economy has attracted. We are in the midst of what I call twenty-first century competitive currency devaluations.

Guido Mantega, the Brazilian finance minister is calling it "an international trade war" in which every nation attempts to gain the upper hand via some sort of currency depreciation to pick up some extra demand at everyone else’s expense. This is beggar thy neighbour pure and simple. And it causing countries like Brazil to institute capital controls.

The FT reports:

Mr Mantega, who has made increasingly aggressive comments recently about the need to control Brazil’s currency, said governments around the world were trying to weaken their currencies to promote competitiveness.

“We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness,” he said, according to Reuters.

The US dollar has fallen by about 25 per cent against the real since the beginning of last year, making the real the strongest performing currency in the world, according to Bloomberg.

In spite of Mr Mantega’s strong words, however, Brazil has so far held back from taking any action other than intervening in the local currency spot market.

How long will they continue to do so?

The answer is not long at all. In fact, as Win Thin , Brown Brother Harriman’s Head of Emerging Markets Strategy, reported earlier today, not only is Brazil responding with currency controls but so is South Korea.

No big surprise from Brazil’s decision to boost the IOF tax on fixed income foreign investment to 4% from 2% previously. This is a pretty strong statement from the authorities that 1.70 is the line in the sand, and if USD/BRL continues to grind lower below that level, we would expect further measures (IOF adjustments, FX intervention, possible lock-up period)…

And it’s not just Brazil in the news today. Bank of Korea said it will conduct audits of commercial bank FX derivative positions in conjunction with the Financial Supervisory Service. Audits will be conducted between Oct 19 and Nov 5 and are meant to ensure that banks are complying with measures announced June 13 requiring banks to reduce FX derivatives holdings over the next two years (after a 3 month grace period). Those measures were ostensibly taken to reduce KRW volatility but were widely interpreted by the markets as an attempt to limit currency strength.

South Korea and Brazil are two countries which have best weathered the financial crisis. What their moves tell us is that they are feeling the effects of beggar-thy-neighbour policies elsewhere and are prepared to act to thwart this threat to growth.


Policy makers are in a cul-de-sac. At first, it was shock and awe stimulus to prevent depression. For extra measure, we have added monetary stimulus, which has the side of effect of reducing currency’s value. In a world of rising global demand and economic strength, large countries can get away with this beggar thy neighbour response to domestic economic weakness. This is what Japan has done for nearly two decades, exporting their flood of money to create bubbles elsewhere in the global economy.

But in a world awash in excess capacity and suffering extreme shortfalls in demand, this strategy suffers from a fallacy of composition. Improving your external balance is a winning strategy if aggregate demand is weak and political resistance to deficit spending rises because of high public debt. However, everyone cannot improve its external balance simultaneously. Someone invariably gets stuck with the old maid.

Don’t expect any country to take this without a fight. Every political leader will fight to keep its country out of economic Depression. Every political leader will assuage domestic concerns that foreigners are getting the better of them. Currency controls are now a legitimate policy option everywhere as Willem Buiter predicted they would be. Expect more of this, especially from emerging market countries worried about the flood of money coming from the G7 as policy makers there try to improve competitiveness with beggar  thy neighbour policies. Eventually, this will escalate into tariffs. I will talk about what to expect as a result of tariffs in an upcoming post.

In the meantime, expect more money printing and more currency debasement. As an investor, this is a situation in which you have to be cautious about fixed income investments. On the other hand, equities do not necessarily suffer. But gold and other precious metals do very well.

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