Global Currency War: How to Keep the "Race to the Bottom" From Stealing Our Future

[Editor's Note: Late last year, global investing expert Martin Hutchinson warned investors that Brazil's fortunes were eroding. In today's commentary and analysis, Hutchinson demonstrates how this once-vaunted "BRIC" economy could start us down the path toward dangerous "de-globalization."]

When Brazil Finance Minister Guido Mantega recently warned of a "currency war that is turning into a trade war," he wasn't far off the mark - at least as far as Latin America is concerned.

In that region - in the last two weeks alone - at least three countries have taken steps to prevent their currencies from appreciating against the U.S. dollar.

If you're a U.S. investor with no Brazilian holdings, you probably wouldn't think you'd have to worry a whole lot about what Brazil is doing to keep its currency - the real - from appreciating.

But on that point, you'd be wrong.

In fact, as Mantega warns, the fallout from a currency war could actually be quite severe - and global in reach. The games that governments are currently playing in currency markets could cause countries to set up trade barriers against imports. And that could bring about the end of the truly global economy - a "de-globalization" that would steal our current standard of living and thwart a return to prosperity.

Fortunately, there is a solution.

From Gamesmanship to De-Globalization

To some extent, Mantega's threats against the United States and China are the result of Brazil's eroding fortunes - and the latest round of global-economy gamesmanship.

For the last two years, Brazil's public expenditures have been skyrocketing - mostly through state-run companies and The Brazilian Development Bank (BNDS).

Since commodity prices have been soaring at the same time, the Brazilian inflation rate has been higher - and hotter - than authorities expected, even though the central bank has kept interest rates high. With massive foreign financing needed for the public-sector deficit, Brazil can't cut rates enough to enable its domestic private sector to grow at a healthy rate.

Hence, Mantega's rhetoric - and his attempts to tax banks' short positions on the Brazilian real - is merely an attempt to shift the blame and pain from where they should be placed: On Brazil's public sector.

Nevertheless, other commodity-exporting countries - with economies that are much less well balanced than that of gigantic Brazil - do have a problem. Cheap global money has created a commodities bubble, forcing prices up to unimagined levels and causing foreign currency to flood into their economies.

Sensibly run countries - such as Chile and Peru - understand that this is a purely temporary bonanza; at some point, global interest rates will rise to fight inflation and the flood of "hot money" into their economies will cease.

The smarter countries will attempt to fight any increases in their own currencies through the use of carefully designed intervention plans; earlier this month, for instance, Chile announced plans to buy $12 billion in the foreign-currency markets, and to follow that by issuing domestic currency bonds.

Land of the (Global Economy) Giants

China and India are at the other end of the spectrum.

Those two global-economic giants are each net importers of commodities and exporters of manufactured goods and services. And both countries are attempting to hold their currencies down artificially - albeit for different reasons.

China, worried that domestic wages are rising too fast, wants to avoid a rise in its currency - the renminbi (yuan) - in order to preserve its competitiveness.

India - like Brazil - runs an excessive budget deficit (in its case, on national and state budgets directly, rather than through state-owned companies). So it needs to hold down its own currency to maintain its balance of payments and to keep its government financing needs from "crowding out" its industrial sector (thereby keeping that part of the economy from accessing the capital markets at competitive rates).

Meanwhile, the European Union (EU) is seeking to prevent the euro from appreciating. That would affect the exports of such weaker Mediterranean countries as Spain and Italy which would be helped by a declining dollar. Japan, which normally copes well with a rising yen, is worried that a further rise will push its economy back into recession.

A Race With No Winners?

This gives us a pretty good picture of why this evolving currency war has been labeled as the "race to the bottom."

In short, pretty much every major economy is trying to weaken its currency against its competitors - albeit by a variety of methods. Some are holding interest rates artificially low. Others - as Brazil and China are increasingly attempting to do - are trying to drive down their currencies by putting direct blocks in the way of currency appreciation.

Let's be clear: Each protectionist "currency war" move blocks the free flow of finance around the world, and raises the temptation on competitors to raise barriers of its own.

If this persists, there will be two results - both of them bad.

First, this will cause inflation. With every country trying to depreciate its currency, interest rates will tend to remain at artificially low levels. Furthermore, thanks to several different forms of "quantitative easing," these countries will also tend to print more money than they should. This means that inflation, already surging in emerging markets like Brazil, India and China, will pretty soon become a major worldwide problem.

Second, each barrier erected against the free global flow of currencies will also serve as a barrier that impedes the free global flow of finance that is an essential ingredient of our tightly integrated, "globalized" world economy. And what's more - as the comments by Brazil's Mantega underscore - currency protectionism will inevitably be followed by trade protectionism, as countries find currency protectionism inadequate and impose tariff barriers, anti-dumping legislation and quotas to protect powerful domestic lobbies.

While globalization is no panacea, its impedance by this means will really torpedo our standard of living - just as it did in the 1930s. A system of tariff and non-tariff barriers and impedances to free exchange is inevitably far less economically efficient that one in which goods and investment can flow freely.

There is a solution: There has to be a total reversal of the fiscal and monetary policies that we're seeing worldwide right now. More specifically, we urgently need to see:

  • An end to the excessive supply of cheap money flowing around the world right now.
  • Higher interest rates and smaller budget deficits.
  • And a willingness by governments to absorb a smaller share of the world's financial resources, which will lessen - or (even better) bring an end to - the dangerous "crowding-out" effect.
  • And an additional willingness by governments to encourage an economically healthy "capital formation" via a positive return on savings.

In other words, we need an end to "Bernanke-ism" both here in the United States and worldwide.

The sooner this change is forced, the better. I'm not overreaching when I say that our future prosperity is at stake.

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