If the financial press is to be believed, the world is on the verge of a currency war. Central bankers have pulled out their bazookas in a desperate, take-no-prisoners effort to weaken their currencies.
* The Fed is preparing for another round of quantitative easing. If this results in a weaker dollar that boosts US exports, then no one on the FOMC will complain.
* The Bank of Japan, disconcerted by the conjuncture of a strong currency and weak economy, has already intervened in the foreign exchange market to push down the yen.
* The ECB has extended the term of its special bank credit facilities and will ramp up its government bond purchases if Europe’s sovereign debt crisis worsens. * China continues to limit the appreciation of the renminbi
. * Brazil and India, having seen their currencies rise to painful levels, may feel compelled to take countermeasures.
The repercussions could be devastating. Congress, seeing the US denied the benefits of a more competitive currency, is threatening China with a putative tariff. China has already fired a warning shot across America’s bow by slapping a tariff on US poultry exports. This dangerous dynamic, if allowed to spiral out of control, could bring down the global trading system.
Is the danger real?
Is the situation really so worrisome? Yes and no. Yes, sharp currency swings create tensions and have unintended consequences. But there is no need for sharp swings in the exchange rates between the dollar, euro and yen. The US, Japan and Europe all have weak economies. They all would benefit from a round of quantitative easing. If their central banks ease simultaneously, there is no reason for investors to favour one of their currencies over the others.
The problem is that the Fed, BOJ and ECB have not indicated when they will move and what kind of easing they will undertake.
* If the Fed moves but the ECB hesitates, the dollar will fall against the euro.
* If the ECB, seeing the European economy weaken, then follows, the initial currency swing will be reversed, wrong-footing investors who chose to ride the trend.
These are precisely the circumstances in which currency volatility demoralizes financial markets and fans trade tensions.