The US dollar has fallen out of bed this week. The break of important support at 80.00 on the USD index has sparked comment from notables in all corners of the globe concerning competitive currency devaluation.  On Monday, Brazilian finance minister Guido Mantega spoke out with the observation “We are in the midst of an international currency war”.  The comment reflects considerable pain felt by Brazilian exporters as the local currency has appreciated some 30% against the dollar in the past 12mths. With a fresh appetite for risk, investors chasing commodity exposure and higher yields have piled into currencies like the Brazilian real and our local Aussie dollar.

Currency intervention by central banks will become more frequent as strong currencies create problems for exporters competing in a global market where consumer demand is extremely weak. Competitive devaluations will continue through 2011, probably resulting in full blown trade wars and a possible move toward protectionism. Already this year, we’ve seen large scale buying of Euros by the Swiss National Bank in order to weaken to Swiss franc during the Greece saga. Japan bought approx $20billion in a feeble attempt to weaken the yen only two weeks ago. World War III will be fought in the currency markets with printing presses and fresh fiat. Einstein predicted it wouldn’t end well:

“I do not know how the Third World War will be fought, but I can tell you what they will use in the Fourth - rocks!" - Albert Einstein

Gold and silver bullion have struck fresh new highs amongst all this devaluation madness. Precious metals sit safely on the sidelines while every fiat currency participates in the final race to the bottom. Ben Davies of Hinde Capital gave a brilliant wrap up on this topic over at the King World News blog:

The World Monetary Earthquake, The Dash From Cash

September 28 (King World News) - Tinker, Tailor, Soldier, Sailor, Rich Man, Poor Man, Beggar Man........Thief

Globally GDP has been anaemic since the crisis first arose in 2007.  The inevitable conclusion of most countries today is that the best way to extricate themselves from the current mess is to shift effective demand away from imports onto domestically produced goods.   The preferred method is competitive currency devaluations.

Unfortunately this is not possible for all, and leads to friction as countries effectively steal other nations output to bolster their own.   Plato and Aristotle referred to this as 'overgrazing', the ‘tragedy of the commons’.  Nothing changes.   This always leads to heightened tensions and conditions of capital controls and other protectionist behaviour such as punitive tariffs and quotas on imports often prevail.   Friedman's flat world aside - it is already happening.

To maintain the last decade of prosperity (illusion) countries are systematically hell bent on exporting themselves to economic health.   This is a zero sum game.  Not all countries can export at the same time by definition that the global balance of payments will not then balance.   For one winner there is a loser.   The implication on import prices is dramatic.   Inflation is imported or exported depending on your view point around the world.   Let's rephrase 'inflation' - global citizens will experience a rise in the value of goods due to creation of more money used to devalue their currency.

The pursuit of mercantilist traditions may help alleviate the collapse in output for some, and the ensuing rise in goods prices may help government reduce the value of their debts; but at what costs? Increased international tensions and let's not forget the internal social unrest that is accompanied by citizens whose wages have not kept abreast of these rising prices.

As the traditional English folk tune rhymes Tinker, Tailor, Soldier, Sailor, Rich Man, Poor Man, Beggar Man........Thief.   Rich or poor, you beg from your neighbour there is no two ways about it in the world of current accounts - you are a thief.

It is politically more savoury to expropriate the output from another country, unfortunately this will be at the loss of the majority.

Within a single week 25 nations have deliberately slashed the values of their currencies.   Nothing quite comparable with this has ever happened before in the history of the world.   This world monetary earthquake will carry many lessons.

Henry Hazlitt 1948 wrote this in a book "From Bretton Woods to World Inflation", which predicted the inevitable collapse of this fixed exchange rate mechanism.   It was a compilation of his editorials from both his time at the New York Times and Newsweek, which ridiculed the prevailing economic Keynesian thinking to great effect.   A brilliant journalist, economists and liberal philosopher, this man intuitively understood the pernicious nature of the Bretton Woods fixed exchange rate arranged in 1944.

Murmurings of such 'beggar-thy-neighbour' currency devaluations have once again sprung up amongst the financial literati and rightly so. Better late than never. The truth be told is that we have been living in a highly unstable world even more so than under BW I.   The dollar pegs, primarily the Asian renminbi dollar semi-fixed exchange rate, what most refer to as Bretton Woods II, have (arguably) been responsible for the financial friction we observe today.

The RMB and US dollar are constantly colliding into each other. The clashing of these two tectonic currency plates has just begun to accelerate at an alarming rate.   Ironically the move to greater currency flexibility on the part of the RMB against the dollar stands ready to produce the almighty mother of seismic monetary events - the collapse of the fiat currency system.   The implications for government bonds, equities and real assets are profound.   Are we being overly sensational? We don't think so.

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