The world is presently engaged in a potentially lethal round of competitive devaluations. The G7 countries are resisting joining the rush to competitive devaluation, but they are hanging on only by the skin of their teeth. The European Monetary Union (EMU) depends on the G7’s ability to hang on, with one G7 member, Japan, the “victim” with a rising currency.
Unless the U.S. can rescue its banking system — and then rein in the massive money creation that was necessary to save the banking system — it will develop runaway inflation and a dollar devaluation to end all devaluations. It is possible that instead of being too big to fail, some U.S. banks are too big and laden with toxic paper to save. The U.S. could get runaway inflation and a crippled banking system at the same time.
Incoming Treasury Secretary Timothy Geithner stated strongly that he believes a strong dollar is in the U.S.’s best interest — the mantra of former Treasury Secretary Robert Rubin from the Clinton Administration. During the first 100 days of the Obama Administration, we have no reason to believe the U.S. will abandon the strong dollar “policy.” But later it may have no choice. And how far away is “later”? It’s probably not beyond the current calendar year.
Competitive devaluation is an economic strategy that has been around for centuries. If your trade deficit is getting so big that foreign banks will no longer issue letters of credit to your importers, devalue. A cheaper currency immediately reduces imports and promotes exports. Inflation too high? Devalue. Foreign buyers of your debt immediately get a better real (after-inflation) rate of return. Competitive devaluations are also called “beggar-thy-neighbor” policies because they give an instant lift to an economy and suction capital and trade out of other countries.
A series of competitive devaluations slashes trust in governments. The “need” for devaluation is almost always a rise in domestic inflation, for which the correct remedy is tighter money. Devaluations are inflationary because the price of imported goods, including intermediate goods used in domestic production, are now higher. Governments know both of these things; if they deliberately engage in competitive devaluation anyway, market players see governments as not acting in the best interests of the public and the economy.
The beneficiary is always gold. As Hoover told Roosevelt, “We have gold because we cannot trust governments.” We can link the recent large leap in gold from $681 in October to nearly $1,000 in late January directly to a statement from a Swiss National Bank official who said (in late January) the bank was considering an intervention in the Swiss franc/Euro exchange rate to drive the Swiss franc down.
Former U.S. Federal Reserve chairman Paul Volcker, now an economic advisor to President Obama, says no country ever devalued its way to prosperity. Devaluation is a finger in the dike. It may temporarily halt import money outflow and the outflow of capital seeking a better real return, but it worsens already-high inflation with additional inflation in a vicious cycle.
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