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Currency Wars and How They Start

A Look at the Currency War Phenomena

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Currency wars are surprising phenomena to many people - one where countries compete to devalue their currencies relative to each other. While currency wars have been rare throughout history, there have been a couple in recent history, including the China's devaluation of the yuan versus the U.S. dollar and Japan's devaluation of the yen versus the euro.

The rationale behind a currency war is really quite simple. By devaluing one's currency, a country can make its exports cheaper than those produced by others, providing it with a clear advantage in international trade. Greater exports means employing more workers and therefore helping improve economic growth rates, at the eventual cost of inflation and unrest.

Currency devaluations themselves can be accomplished in several ways:

  • Direct Intervention - A country can sell its own currency in order to buy foreign currencies, resulting in a direct devaluation of its currency on a relative basis.
  • Interest Rates - A country can lower its interest rates and thereby create downward pressure on its currency, since it becomes cheaper to borrow against others.
  • Quantitative Easing - A country can use its own currency to buy its own sovereign debt - effectively foreign debt - and ultimately depreciate its currency.
  • Threats of Devaluation - A country can threaten to take any of the above actions and occasionally achieve the desired devaluation in the open market.

History of Currency Wars

The genesis of currency wars was arguable the 1930s, when several countries abandoned the gold standard in favor of their own currencies. During the Great Depression, many of these countries devalued their currencies in order to stimulate their economies. Trading partners quickly retaliated with their own devaluations and reduced overall trade levels.

Later in the 1980s, the International Monetary Fund (IMF) began promoting inflation as advantageous for countries suffering from high unemployment or slow growth rates, and particularly those with high public debts. Many subsequent crisis, including the Asian Financial Crisis, led to countries pursuing similar strategies to grow without taking on debt.

Recent Currency Wars

The most popular currency war in recent times has been the one between the United States and China over the yuan's valuation. While it's little secret that the yuan was artificially undervalued, the U.S. underwent its own program of arguable devaluation under the guise of quantitative easing - a set of programs that issued currency to purchase government bonds and other assets.

By holding down the value of their currencies, the U.S. and China were arguable benefiting from a higher yen, euro and other emerging market currencies over this period. And more recently, the Bank of Japan decided in early 2013 to launch an open-ended bond buying program that would likely devalue the yen and boost the euro and other currencies.

Key Takeaway Points

  • Currency wars are competitive devaluations that are launched in an effort to improve economic growth in participating countries.
  • There are many different ways for countries to devalue their currency, ranging from direct intervention to indirect quantitative easing.
  • The rationale behind a currency war is that lowering a currency's valuation will result in cheaper exports, which will improve employment.
  • While currency wars first came about in the 1930s, they have becoming popular today under different terminology, such as quantitative easing.

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