The Real Targets Of Currency Wars

Xi Jinping, likely to be China’s next president, visits President Obama in the White House this week. This visit ensures that the ongoing currency war between the United States and China will be on the list of things that Obama and Xi discuss along with the looming war with Iran, the North Korean succession and other geopolitical issues.

Currency wars arise when a country steals growth from trading partners by cheapening its currency to promote exports. The new currency war began in 2010 when President Obama declared in his State of the Union address that it was the policy of the United States to double exports in five years. Since the U.S. would not become twice as productive in five years, the implication was the U.S. would severely cheapen its currency to achieve this goal.

The Federal Reserve set about trying to cheapen the dollar through policies such as quantitative easing – the printing of money – and zero interest rates. The idea was to make the U.S. dollar unattractive to foreign investors and import inflation from abroad through higher import prices. The prospect of inflation would encourage Americans to borrow and spend and ultimately get the U.S. economy growing. Inflation was being encouraged for the first time in forty years because it was the key to reducing the real value of America’s debt.

This U.S. policy of devaluation and inflation would hurt not only foreign investors but also U.S. savers who held bank accounts, insurance policies, retirement plans, annuities and other fixed-income investments. All savers and investors, both U.S. and foreign, would be deprived of the value of their savings through U.S. dollar devaluation in order to benefit banks, hedge funds, speculators and other leveraged investors.

Yet the currency war with China is really a red herring. China may generate an enormous dollar volume of exports to the United States but it is far from the greatest source of value added. Indeed, it is the policy of the United States to devalue against all trading partners not just China.

The reason for this has to do with the complex nature of supply chains in a globalized world. The U.S. imports the popular iPhone from China and the full cost of the iPhone contributes to the U.S. trade deficit with China. However, important components of the iPhone are sourced from all over the world. The iPhone flash memory and touch screens come from Japan. Camera modules and GPS receivers come from Germany. Powerful processors come from South Korea. In all, China adds only 3.6% to the overall value of the iPhone.

By contrast, Japan adds 34%, Germany adds 17% and South Korea adds 13%, respectively. A U.S. devaluation against the Chinese yuan of 50% alone will only affect the price of an imported iPhone by 1.8%, a trivial amount. In order to import inflation from abroad, the U.S. must devalue against the euro, the Japanese yen, the South Korean won and the currencies of all trading partners in the global supply chain.

Because of this, the importance of countries such as South Korea and Taiwan as trading partners to the United States goes well beyond their bilateral trade relationships. For example, South Korean value added is embedded in the U.S. trading relationships with China, Vietnam, Indonesia and other countries engaged in assembly of components. A country such as South Korea is even more of a target for U.S. efforts at devaluation than China itself. If the U.S. is successful in devaluing the dollar against the South Korean won, the result for South Korea will be lost exports, lost tourism and lower earnings for South Korean based global corporations that earn profits abroad.

Countries such as South Korea, Taiwan and Brazil are often the biggest losers in a currency war because their exports suffer from devaluation of major currencies such as the dollar but they lack the status of a reserve currency and the ability to defend their valuations by redirecting capital flows in their favor. These countries are the silent victims of currency wars. They are important enough to suffer revaluation but not powerful enough to change the outcome. In the end, these countries may have to resort to capital controls similar to those imposed recently by Switzerland to prevent a super-strong local currency from further damaging their economies.

This scenario – one country trying to devalue its currency and inviting retaliation from other countries – is at the heart of all currency wars. The result can either be a deflationary contraction of world trade as seen in the 1930’s or an inflationary destruction of wealth as seen in the 1970s. An even worse outcome – hyperinflation followed by a crash and deflation – cannot be ruled out.

Citizens everywhere should realize that competitive devaluations are not a path to prosperity – they are a path to ruin. The currency wars have not run their course, they have only just begun. Yet it is not too late for policymakers to change the outcome for the better. All that is required is a grasp of the dynamics and a determination to grow economies through education, technology, investment and improved health rather than the beggar-thy-neighbor currency policies of the past.