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Archives: Could there be a new Currency War?

Originally published in May 2011
Simon Nguyen

Recent developments indicate a new round of currency war could be on the horizon. The most significant development has been the European Central Bank’s surprise decision to leave interest rates unchanged for at least two more months. Economists had expected the ECB to assertively raise rates in an effort to put the brake on Europe’s accelerating inflation. This unexpected maneuver will keep the euro from strengthening further against the dollar.

The ECB’s decision is seen as a direct response to the Federal Reserve’s weak-currency policy. The U.S. central bank has managed to maintain an anemic dollar by keeping interest rates very low. Additionally, Japan may intervene in the market to bring down the inexplicably strong yen. All of these measures are deliberate efforts by individual central banks to keep their currencies weak in an attempt to boost exports and domestic employment.

The world’s economic powers are seemingly engaging in a currency game of wait and see. None of these players will let market forces take hold unless the others will do likewise. If central banks around the world continue to pursue the current monetary policy, the end result will be widespread inflation and possibly a global recession. The biggest losers in a possible currency war will be developing countries, whose economies will face even more inflationary pressure on top of what they are presently facing.

The good news is that the world’s central banks are not oblivious of the grave threat of inflation. The operators of key central banks understand well that beggar-thy-neighbor policies such as currency devaluations are more detrimental than beneficial. Even China, which has been the biggest currency manipulator, has allowed for a small but measurable appreciation of the yuan to combat the country’s ballooning inflation. Moreover, both the European Central Bank and the Federal Reserve have indicated that future tightening of monetary policy is likely.

Historically, currency wars have had disastrous consequences. In fact, out-of-control currency devaluations were among the factors that triggered the Great Depression in the 1930s. As today’s governments are more sophisticated in their handling of the market, any new currency war won’t have remotely the same impact as past currency wars. Yet, it is still important that central banks around the world resist domestic political pressures and do what is best for the long-term health of the global economy.

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