Currency War III: How Will It Play Out?

James Rickards

US Federal Reserve Chairman Ben Bernanke may not yet be among them, but a growing number of people seem to acknowledge that the world is engaged in a “currency war,” a term famously used in 2010 by Brazilian Finance Minister Guido Mantega to describe the competitive devaluations being orchestrated by developed nations in their attempts to spark economic growth.

“The world economic system is not always in a currency war, but when it is, it can go on a long time,” warned James Rickards, senior managing director at Tangent Capital Partners, who spoke at the Sixth Annual European Investment Conference in London. “They don’t have a logical resolution but go back and forth until there is an extreme intervention, likely a collapse or a shooting war.”

Rickards, author of Currency Wars: The Making of the Next Global Crisis, explained that the first Currency War occurred following World War I, spanning 1921 to 1936, and was “resolved” in the conflagration of World War II. Currency War II occurred from 1967 to 1987 and was ultimately resolved through the Plaza and Louvre Accords.

What we’re now experiencing, Rickards asserts, is Currency War III — and how it is ultimately resolved will likely have enormous consequences for the international economic system and the world itself.

According to Rickards, Currency Wars I and II involved currency competition between the world’s developed nations. Currency War III consists of the coordinated and simultaneous devaluation of the four major global currencies — the US dollar, the Japanese yen, the euro, and the UK pound sterling — at the expense of developing nations, which must print currencies to maintain exchange rates, in effect importing inflation from developed nations.

Rickards says Currency War III is a desperate attempt by the major central banks to pull the world economy out of a structural depression. Fed Chairman Bernanke’s gamble, he says, is that simultaneous devaluation would bring liquidity benefits without introducing the destructive, competitive, cross-rate changes that wreaked havoc during the Great Depression of the 1930s.

Rickards explained that the monetary theory behind what central banks are doing is offered in a paper by Princeton University economist Lars Svensson, whose research suggests that at zero interest rates, policymakers can seek further monetary easing by cheapening the currency.

Thus far, policymakers have engineered a sort of equilibrium between the deflationary forces of global deleveraging and the inflationary forces of money printing. Rickards likened it to the stability he felt standing on the grassy strip that is the San Andreas Fault. But policymakers are hoping to stimulate inflationary forces to “bend the velocity curve” and arrest the steady plunge in the velocity of money. (This concept was more fully explained by Rickards in a previous appearance at a CFA Institute Conference.)

“Expect helicopter money soon,” he said, predicting that as the next US election draws near, both political parties will begin backing tax cuts as a way to deliver cash directly into the hands of American consumers. “But that will fail too,” he said.

The problem? The Fed is using an “equilibrium model” of the world economy in modeling its assumptions, when the economy has actually taken on the characteristics of a complex system. He demonstrated the concept with computer-generated graphics that showed the ever-growing interconnectedness of the economy’s five largest sectors.

“In 2003, there [were] linkages, but the sectors were distinct,” he explained. “Then they converge over time and become a big blob sucked into finance. A grad student in complexity theory would look at the graphic from 2008 and say the system is on the verge of collapse.”

How does Rickards expect Currency War III to play out?

“We should expect a collapse in the near future,” he warned. But that doesn’t mean the end of the world. “The international monetary system has collapsed three times in the last 100 years” and required a restructuring of the system. We should expect another collapse, he said, and identified four potential outcomes:

  1. a system of multiple reserve currencies
  2. adoption of some form of gold standard
  3. a system of “Special Drawing Rights (SDR)” issued by the International Monetary Fund
  4. societal collapse

Of these, Rickards thinks the SDR strategy will likely come into play in the next financial crisis, which he expects will dwarf the financial crisis of 2008. This collapse, he contended, “will be bigger than the Fed. They look like a bad hedge fund today, and there are limits to what they can do. The only clean balance sheet is the IMF, and they will print trillions of SDRs to create a phase transition from dollar standard to SDR.”

Rickards believes smart investors are preparing for the upheavals that would inevitably accompany such a monetary restructuring. He cited China’s recent gold acquisitions and Warren Buffett buying railroads as examples of big investors moving into real assets, which retain economic value during currency transitions.

How will governments respond to the civil unrest that Rickards believes will accompany the restructuring?

“Expect a harsh response. Neo-fascism is a word I would use to describe it,” he said.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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