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Fuel of a Currency War, Part 4

Fuel of a Currency War, Part 4

Article Summary: In an effort to prevent another Financial Collapse, the world’s largest Central Bank has taken on massive intervention efforts in an effort to stimulate their economies. This environment has been dubbed ‘The Global Currency War.’ In this article, we examine the best and worst case scenarios in regards to potential outcomes; and we finish by examining the ‘most probable’ scenario.

In our previous 3 articles, we got more in-depth behind the current hot topic of the financial media: The Currency War.

In the first article, we looked at the impetus behind such a policy, and how a strong currency can create considerable discourse for an economy.

In our second article, we looked at why and how economies would want to weaken their own currency, and what the after-affects may be.

In our third article, we looked at the key player in The Currency War: The United States, and the policies that have been utilized by The Federal Reserve since 2007.

In this article, we look at how this all might play out.

Best Case Scenario

The best possible outcome from a Global Currency War is that each economy is able to reach their objectives without causing too much disharmony to their trade partners.

The eventual result would be a normalized global economy in which interest rates increase, and Central Bankers have the ability to steward the economy with their favorite tool of them all: rate adjustments.

In this ‘best case’ scenario, the additional weight added to Central Banks balance sheets would not cause the types of problems that it could go if the situation turned worse.

So, the best case scenario for The Currency War is a return to a normal environment. This is what the global economy is fighting for right now.

Quite a few things would need to take place to allow for this to happen. Global growth would need to be the spark to initiate this movement. That would necessitate the participation of consumers in The United States and Europe. While consumer behavior in The United States may be sufficient to stave off an economic collapse, it’s not likely enough to propel the entire global economy past problems that have plagued the world for 5 years.

European consumers could be the tipping point to allow for the global growth engine to kick into full gear; and likely participation would be needed in economies not named Germany (such as France, Italy, and Spain).

Growth in these economies can drive additional industrial production in the East; as China and Japan begin to feel the impact of surging demand by churning out more and more products at a faster rate. But to build those products, they would need raw materials, and this demand for raw materials can drive growth in emerging markets such as Brazil, Mexico, and India. The growth story would be complete as the global economy ticks higher, driven by demand of consumers. Rates normalize, and Central Bankers gain back their favorite tool for making adjustments to an economy: Interest rate adjustments.

What is needed to attain the best-case scenario?

Frankly, Europe has to find a ‘fix,’ and it would likely need to be something more thorough than a simple pledge to purchase bonds in the open market. Keeping short-term rates low, while necessary for the economy to continue to exist, doesn’t do anything to fix the structural problems within the economy; it does nothing to reorganize the government so that the citizens of the state aren’t dependent on the state for safety and well-being.

Outside of a fix in the economic conundrum that has become Europe, few situations would allow for this favorable scenario to play out. The United States would need to put up amazing growth numbers, or emerging markets in Africa and Asia would need to grow considerably faster to offset the waning demand from the world’s largest economy (The European Union).

Without a recovery in Europe, brought upon by structural changes that can allow for future recessions without full-scale meltdown, the world is unlikely to see our ‘best-case’ scenario.

Worst Case Scenario

The reason that more aggressive monetary policies weren’t used earlier (such as the recent Bank of Japan stance or the ‘QE-finity’ program in The United States), is because of the potential risks of such actions.

Growth, for most intents and purposes, is a good thing. When prices increase, or inflate, Central bankers will generally try to offset those higher prices by increasing interest rates. But if a Central bank cannot increase interest rates fast enough and prices continue running higher - a problem far worse than a bear market or correction is introduced into the equation: uncontrollable and perhaps eventually ‘hyper’ inflation.

And while it may initially sound like hyperinflation is a better option than a bear market, keep in mind that once hyperinflation enters an economy its destructive effects can be catastrophic; potentially even spelling death for that monetary system.

These are the cases where it might cost $300 for a gallon of milk, or $25 for a pack of gum.

This is an environment in which prices are so out of control that mayhem ensues within the economy. Panic takes over. Capital leaves the country at a breakneck pace as investors grow increasingly more worried about the purchasing power that they are constantly losing to increased prices. Real assets, like Gold or Real Estate, skyrocket in value because the currency used to buy them is worth so much less today than it was yesterday.

We discussed such an environment in the article The Consequences of Currency Devaluation, in which we examine the economy of Zimbabwe; a nation so overtaken by inflation that it led to the eventual abandonment of their own currency. In Zimbabwe, they currently use US Dollars to transact business because the hyperinflation that ravaged their economy destroyed their currency system.

And while this may sound like a far-out type of scenario, it could be a lot closer than we think. While it may be easy to point fingers at Zimbabwe and criticize a litany of details that may or may not have seen a different outcome; but the fact of the matter is that if you drive over a cliff, it’s probably too late to do anything about it once the car is airborne. That’s what happened when hyperinflation started in Zimbabwe.

But for capital to flow out of a country, as it did in Zimbabwe, it has to flow in somewhere, right? So it would be unlikely to see coordinated hyperinflation in the largest economies in the world simply because of deductive logic: If all of that capital is coming out of Europe, or Japan – it has to go somewhere for safety of value.

If rampant or uncontrollable inflation set foot in any of the three above economies, we’d likely see investors choosing the other two simply for lack of options. So structural difficulties in the non-affected nations would likely become an in issue with such a strong inflow of capital, similar to what was happening in Switzerland in 2010 before the Swiss National Bank pegged their currency to the value of the Euro.

Most probable scenario

If there is one thing that we should expect from politicians it is to ‘kick the can down the road’ to avoid tackling the hard issues and exposing themselves politically. Given that Europe is a collection of independent economies trying to act as one, without any type of unification or charter to denote the relationship, continued uncertainty is likely as the requirement for the best case scenario above remains out of reach.

This can continue until more harsh realities set in throughout Europe, although these realities can manifest themselves in other economies first. China is exposed with their ‘shadow’ banking system that is largely off-the-books and unaccounted for; Japan continues to expose themselves even more with a debt-to-GDP ratio over 220 and continuing to add stimulus with each passing Bank of Japan meeting.

The most probable scenario is for a continuation of volatility as the world struggles to de-leverage, a fight that has been undertaken since the initial throes of the financial collapse in 2008.

Unification, and further – growth in Europe could allow for a full recovery of the global economy. Without it, risk continues to dominate the environment as the benefits of globalization have become the shackles of economic disparity.

--- Written by James Stanley

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.