Headlines using the term "currency war" have multiplied of late and, in the process, may have raised fears about asset bubbles and generalized inflation. Reinforcing such concerns are the links drawn between this so-called war, the Federal Reserve's quantitative easing and the rising price of gasoline.
For many inclined to worry about the long-term implications, the situation is all too reminiscent of the run-up to the great inflation of the 1970s. But before bracing for similar horrible events, it is crucial to note the differences between then and now, differences big enough to render a bubble-prone, inflation-plagued outlook neither an immediate concern nor inevitable.
The picture today does indeed bear a resemblance to that period. That inflationary decade did begin with a currency war. On Aug. 15, 1971, President Richard Nixon suddenly took the dollar off its long-standing gold peg. He was determined to drive down the currency's foreign exchange value in order to enhance this country's export prospects.
The action shattered the Bretton Woods system of fixed exchange rates that had prevailed since the end of World War II. Within six months, the dollar lost about 15% relative to the German mark and the Japanese yen, a shock after years of complete stability. As each nation scrambled to enhance its export advantage by pushing down the value of its currency, a generalized depreciation of purchasing power set off an inflationary trend.
This course then received considerable additional momentum when the Federal Reserve, freed from the discipline of the gold peg, pursued an extremely easy monetary policy and when in 1973 the oil exporting nations, after imposing a brief embargo, pushed up crude oil prices 70%.
Actually, Nixon's action was not really the first shot in the currency war. It was rather a counterstroke to what could be described as a long-standing slow-motion offensive against the United States. This earlier aspect of the war was an unavoidable result of the rigidity built into the Bretton Woods system. The fixed exchange rates, adopted right after World War II, had set the dollar's value high, to take account of the tremendous relative strength of the U.S. economy, and set the values of the mark and yen low, to take account of the remarkable weakness of those war-ravaged economies.
But with each step toward recovery, the economies of Germany and Japan became more efficient and competitive, making their weaker exchange rates less appropriate and increasingly advantageous. The more the United States felt the effects of this competition, the more Washington pressed Germany and Japan to revalue the mark and the yen upward. But these countries so enjoyed the export edge offered by their underpriced currencies that they refused. Nixon's move in August 1971 reflected his and Washington's huge frustration.
Whatever American frustrations, rationalizations, or motivations, the effect was ultimately wildly inflationary. Competitive currency depreciations prompted a price bubble in real assets and commodities, as investors shifted away from purely financial assets to preserve the purchasing power of their wealth.
In all likelihood, it was the decline in the dollar's value that prompted oil exporters to push up prices. Oil, after all, was priced in dollars then, as it is now, and the dollar's depreciation hit directly at exporters' global purchasing power. Of course, the rising price of fuel then imparted still greater momentum to global inflation and blew up the bubble in real asset prices still more. The Fed's aggressively stimulative monetary policy added to the mix, as it accelerated the growth in the money supply; the broad M2 category expanded at an annual rate of almost 10% in the five years after Nixon's move.
The whole linked picturethe falling dollar, the rise in the price of critical commodities, and the flood of liquidityaccelerated the pace of inflation in the United States and globally. In an effort to stem that tide, Nixon imposed wage-price controls, but they had little effect.
Even before the oil price jump, inflationary pressure had become evident. From 1971 to 1973, consumer prices rose at a 6.1% annual rate, more than a third faster than during the previous five years. The jump no doubt would have been more pronounced had not the wage-price controls been in place. The oil price increases in 1973 added to that pressure, while the aggressively easy monetary policy drove matters to extremes. From 1974 to 1977, M2 surged at close to a 12% annual rate. Consumer price inflation kept accelerating even before a second round of oil price rises in the late 1970s rocked markets and the economy and set the stage for an even more feverish inflation in the early 1980s.
If some of today's patterns resemble this historic record, a lot is different. From the American point of view, the causality between currency and monetary policy is the reverse of what is was in the 1970s. Nixon's move on the currency allowed a more expansive monetary policy to follow. This time, monetary ease has preceded the relative dollar weakness. Bank reserves have surged 17.4% a year since quantitative easing began in 2008. It is doubtful that this liquidity explosion was aimed at dollar manipulation, but according to America's trade competitors, the policy nonetheless has held down the dollar's foreign exchange value, disadvantaging their exports, and, from their point of view, it looks like the first shot in a currency war.
This change in the order of things may do little to relieve investor concerns, but there are other, more substantive, differences as well. One critical contrast is the slack in both the U.S. and the world economy. In the years after Nixon took the dollar off its gold peg and the Fed began to accelerate money growth, there was no slack to speak of. The unemployment rate in the United States hovered near 5% and was sometimes lower. Today, the figure hovers closer to 8% and would be higher had not so many given up the search for work and left the labor force. Nor were Europe and Japan in recession back in the early 1970s, as they are today. On the contrary, both were growing rapidly, with low rates of unemployment and high rates of capacity utilization.
With so much relative economic slack, the world can expect much less immediate pressure on wages or prices than in the 1970s. What is more, the monetary ease this time has hit the economy less suddenly. Because banks, still wounded by the events of 2007 to 2008, are reluctant to extend credit, much of the expansive Fed policy has yet to flow generally through the system. That difference is apparent in the behavior of the broad money supply, which despite the explosion in Fed-provided reserves has expanded at a relatively modest 8% to 9% yearly rate.
To be sure, these differences do little to alter the underlying inflationary risk implicit in the so-called currency war and the extreme monetary ease adopted by the Fed and now other central banks. They do, however, promise to delay any effect. It would in fact take until 2015 at the earliest to bring inflation out of this environment, even if the currency war were to go on and the Fed were to make no effort to moderate the pressure. Meanwhile, this delay buys time for the authorities to implement remedies.
The Group of Seven major developed economies have taken a stand against competitive currency devaluations. Also, Fed Chairman Ben Bernanke has indicated a willingness to pull back from extreme easing when the time is right, perhaps before the huge growth in liquidity even finds its way fully into the economy's money supply. The Fed's Open Market Committee is already discussing such a change.
But even if the Fed were to fail, the inflationary effects would still wait so long that investors would have ample time to adjust their portfolios. In the meantime, especially since there is still a good chance of a policy remedy, such anti-inflationary portfolio twists are, at the very least, premature.
- Man Fund-of-Hedge-Funds Unit Expects Best Return Since 2009
- Active Traders Want More Action
- Predicting the Future of Reform
Milton Ezrati is senior columnist and market strategist for Lord Abbett & Co.
and an affiliate of the Center for the Study of Human Capital and Economic Growth
at the State University of New York at Buffalo. His new book, Thirty Tomorrows, linking
globalization to aging demographics, is forthcoming from Thomas Dunne Books of St. Martin's Press.