Review & Outlook

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Competitive Currency Devaluation Continues Apace

29 January, 2015 by Matthew O'Brien, Ph.D. in Commentary

One of the first things that you learn about economic growth, if you learn anything at all, is that growth is not a zero-sum game.  That is, when a company like Apple increases its earnings by 40% or so, as it did last quarter, it didn’t simply “take” those earnings from its competitors, who thereby earned less.  When a company develops or improves some product or service, it doesn’t necessarily just take a bigger slice of the economic pie, but helps to increase size of the whole pie.

Not so with central banking and the “loose” monetary policy that is all the rage among today’s central bankers, however.  Since the financial crises, the world’s central banks have successively devalued their currencies and artificially suppressed interest rates, ostensibly in order to “stimulate” economic growth in their home countries.   If the policy works, and it’s not evident that it does, it works as a zero-sum game, benefiting certain sectors of the domestic economy at the expense of others, and benefiting in the aggregate the domestic economy  at the expense of foreign ones.

The domestic winners include users of debt like leveraged buyout-firms, business development companies, and speculative fracking companies, for example, all of which rely upon the existence of cheap debt in order to function.  Losers include unsophisticated Mom and Pop savers who typically rely upon the interest income from certificates of deposit, which has disappeared since the financial crisis and the ensuing years of “easy money” from the Federal Reserve.  Easy money basically functions to transfer wealth from the losers to the winners.  Internationally, the winners are the exporters whose products become more competitive against the exporters from other countries, and the losers are those exporting countries whose currencies remain strong.

euro bank

The European Central Bank’s decision to begin a €60 billion bond-buying program can’t really be aimed at inducing more borrowing among eurozone companies, because borrowing rates are already close to rock-bottom.  Apart from easing the debt burden of eurozone sovereigns (which is almost always an unstated goal of modern central banking), their real rationale has to be the devaluation of the euro against other currencies.   Currency devaluation has diminishing returns, however, because it induces a “race to the bottom” among central banks as each country’s bank tries to devalue its currency to stay in competition with others.  This is why the ECB’s policy, which itself can be understood as a competitive response to the past devaluing quantitative easing programs in Japan, the US, Switzerland and the UK, has been met with a growing round of devaluations from other central banks.  The Wall Street Journal reports that the Danish central bank has cut its deposit rates for the third time in two weeks; now its deposit rate has been lowered to minus 0.5% from minus 0.35%.  Singapore’s central bank also recently announced lower rates.  Watch the Federal Reserve’s upcoming discussions to see whether fretting about the “strength of the dollar” becomes part of the rationale for delaying yet again the normalization of interest rates.

Where does it end?  Unfortunately, there’s little reason to think it will end with renewed prosperity.  Rather, it will probably end up distorting the market pricing mechanism, lead to the mis-allocation of capital and risk, and destroy wealth — particularly the wealth of prudent savers and people who aren’t rich or sophisticated enough to deploy complicated financial strategies to avoid it.