Currency Wars: Real Threat or Mass Illusion?

So what’s really going on in the global FX market? Are we really witnessing a fierce currency war unfolding before our eyes, or are we merely caught in the crossfire of political agendas? Taking into account the generalized strengthening of the US dollar against most currencies, one wonders why this super power, at a time of “true” conflict, has chosen to stay radio silent. Why would the US just stand back and endure one attack after another from its very own “soldier” while its trade balance bleeds out? Is this war real, or simply a simulation?

It’s true that the global economy landscape has been sending out red alerts for quite some time. The plummeting of the emerging market currencies, euro’s frantic freefall, the Japanese yen dive, and the recent devaluation of the Chinese yuan, all support the sentiment of a currency war. However, the very idea of war requires rapid strategic moves in order to gain ground against your opponent. It requires strikes and counter-strikes with a strong, and at times, even detrimental impact. But can such competitive currency devaluation tactics truly be considered as the heaviest artillery nations have in their armory? The answer is an emphatic no!

Devaluations Simply Don’t Work

Saying that currency devaluations are capable of improving the short term current account dynamics, is essentially negating the principle of a J-curve. This longstanding paradigm dictates that while currency devaluations could, potentially, yield positive results in the long run, the extremely low currency elasticity of demand in the short term, actually has the exact opposite effect on an economy. This means that even if a currency devaluates, its imports and exports will not vary in volume terms due to the inherently slow market response to this change. In essence, until the markets acclimate to the new reality, countries with devalued currencies have nothing to gain. Instead, they have much more to lose, as their import volumes will be priced higher while their respective exports will be priced lower; they end up selling the same for less, and buying the same for more.

To add to the problem, such abrupt currency devaluations not only fail to offer short-term reliefs, but also create an unstable financial environment with unpredictable ripple effects to their economy. This equation, therefore, constitutes the very definition of a nightmare for governments and policy makers. So, while countries believe that they are implementing a “your pain is my gain” strategy, in reality, they just suffer the consequences from this self-inflicted pain and self-mutilation. Why then rage currency wars to begin with?

The Masterminds of Currency Wars

The answer to this question might require a complex analysis, but the motive behind such tactics is quite simple – deficit countries demanding from surplus nations to pay their share. In an attempt to jumpstart business cycles, deficit countries apply pressure on surplus economies, forcing them into expansionary fiscal policies in order to take advantage of their very high income elasticity of demand. In practice, deficit countries invent ways to drive up the spending of surplus nations and thus have them cover their end of the bill when it comes to restoring global imbalances. What better way to do so than to wage a currency war?

Under such light, currency wars should not really be regarded as wars at all. Instead they should be viewed for what they are, powerful and vocal communication tools to publicly apply pressure on surplus nations. They are carefully constructed, high impact narratives feeding the propaganda machine operated by deficit countries. They are meant to strong-arm surplus players to “surrender” within their markets and increase their fiscal spending. Perhaps this assessment perfectly explains why the US giant has kept quiet in a currency war that it definitely waged, and keeps on fueling, but knows better than to partake in it. Maybe the next time we come across such “militant” narratives explaining the threats of currency wars, we should perhaps treat them as mere mass illusions, as simple simulations, for that’s all they are.