“Until now the international monetary system got through the crisis without competitive devaluations, and I hope very much it stays that way.” – Jens Weidmann, Bundesbank President
The global financial crisis in 2008 was a game changer on many levels. One of which was, and continues to be, the gross reality that developed economies can no longer borrow their way to prosperity. The easy credit markets of the 1980’s, 1990’s, and early 2000’s juiced economic growth and employment. The tight credit markets we have today are having the opposite effect leading to subpar growth and stubbornly high levels of unemployment. Potential solutions to this problem vary widely depending on who you ask, but the collective answer of various central banks around the world has been to export unemployment to other countries.
How does a country export unemployment one might ask? By devaluing a currency against other trading partners to make one’s goods and services more affordable to the global marketplace. Affordability increases demand which leads to more commerce requiring more workers (higher employment) to increase the supply of whatever good or service is in demand. Countries that are not devaluing become less competitive in the global market, which reduces demand for their goods and services leading to cost cutting and higher levels of unemployment. These types of strategies where one country tries to remedy their economic problems at the expense of another country (or countries) are collectively known as beggar-thy-neighbor policies in economics.
The problem with this seemingly simple solution lies in the fact that no country wants to import the problems of its trading partners. If one country sees a major trading partner trying to devalue their currency, they will respond in kind by devaluing their own currency to stay competitive. The exception to this rule is when the devaluing country is relatively small and the trading partner can absorb the negative effect of the move due to their strong economic position. Unfortunately, this is not the case today as countries are all clamoring to boost economic growth through whatever extraordinary measures they deem necessary.
Before the late part of the 19th century, exporting unemployment through currency devaluation wasn’t really in an option since commerce was primarily localized and global trade was fairly nonexistent. When global trade started to pick up, economic powerhouses like the United States, Great Britain, and France agreed to a gold standard which tied the value of their respective currencies to the price of gold. Then the Depression hit in 1929 and countries slowly began abandoning the gold standard. At the time, currency devaluation was a radically new concept since the common philosophy at the time was that a strong and stable currency created global confidence in an economy, which would lead to more economic growth. As the embedded video explains, Britain was the first to take their currency off of the gold standard deciding to “sacrifice international status for domestic recovery.”
This act had ripple effects throughout the world which eventually led to a loss in competitiveness for the US. In response, FDR took the US off of the gold standard and devalued the Dollar to make the US more competitive with Britain and other European trading partners. The “currency war” ended in 1936 with the Tripartite Agreement which was an informal accord between the United States, Great Britain, and France to refrain from competitive depreciation of their currencies. In the end, currency devaluation hurt global trade due to the increase in exchange rate volatility and did little to spur economic growth for any country.
Today, talks of currency wars are surfacing again. In the past week officials in Russia and Germany have warned of impending currency wars as alluded to in the opening quote. Today, the Bank of Japan decided to adopt an economic policy heavily pushed by newly elected Prime Minister Shinzo Abe of a 2% inflation target with unlimited asset purchases (e.g. quantitative easing) to weaken the Yen. The market has been anticipating this move ever since Abe’s rise to power starting back in October of last year. Consequently, the Yen has weakened roughly 20% against the Euro and 15% against the Dollar over that time.
If history is any guide, this trend will be temporary in nature as other countries with a vested interest in staying competitive with Japanese exporters respond in kind. This is why competitive devaluation rarely works unless it is a coordinated effort by both or multiple trading partners. Perhaps the only clear winner in the race to the bottom in currencies will be hard assets like gold, commodities, and real estate which can’t be printed ad infinitum. This is one of the reasons we maintain an overweight to these and related assets in our client portfolios.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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