invest in silver

The "Currency War" and Why It Makes Gold Shine Brighter

May 16, 2012, 5:49 PM

The yellow metal, money for more than three millennia, has a close relationship to other forms of money. Some argue that it isn't gold that has risen in value in the last decade, as much that fiat currencies have lost value against gold. Ever since gold began its spectacular rise a decade ago, the U.S. dollar has lost over 80% of its purchasing power. The other currencies have not fared much better. The euro and the Japanese yen have lost over 70%. Gold is the only form of money that governments cannot create out of thin air, which is why the supply of fiat currencies is expanding exponentially faster than gold supplies, which increase by about only 3% per year.

We like to pay close attention to currencies and to the multi-front currency war because of the effect on gold.

Conventional wisdom has it that there are three safe haven currencies—the Swiss Franc, the Japanese Yen and the U.S. dollar. But perceptions are changing. The US dollar is no longer the default shelter. Instead, the Swiss franc and the Japanese yen have been the hideaways in a financial storm along with history’s longest used currency—gold. But both the Swiss and Japanese governments are desperately trying to curtail their currencies appreciation and to curb the inflow of investments by selling their currencies into the market and creating an oversupply that will lower prices. They have both cut interest rates to zero. A strong currency makes it difficult to export your country’s goods.

It’s easy to understand why investors have perceived the Swiss franc as a safe haven. Switzerland boasts a strong economy not plagued by high national debt and budget deficits. With its conservative Swiss banking monetary policy, it has not resorted to money printing schemes with names like “quantitative easing.” The Swiss franc reached milestone parity with the dollar in 2011 and since then has appreciated by an additional 20%.

In the “currency war,” neutrality does not pay as Switzerland discovered.

In September 2011 the Swiss franc plunged dramatically versus the euro and other major rivals after the Swiss National Bank took the extraordinary step of setting a floor for the euro/Swiss franc exchange rate at 1.20 francs and vowed to buy “unlimited quantities” of euros to defend it.

This is not the first time the Swiss central bank has resorted to such a strategy to contain the franc. It used a similar strategy in the late 1970s to weaken the currency against the Deutschmark mark. The central bank’s new target commits it to buying euros and selling francs any time the euro falls below 1.20 francs. That amounts to setting a floor for the euro or a ceiling for the franc.

Needless to say, such moves give gold a boost.

A currency war has been waging between the U.S. and China and a trade war between the two most important economies in the world is certainly a cause for worry. For much of the past two years China has been under pressure from the US to allow the yuan to appreciate. For its part, China has accused the U.S. of lowering the value of the dollar by printing so much of it. There are those that suggest that both China and the US are “winning” the currency war by holding down their currencies while pushing up the value of the Euro, Yen and currencies of some emerging economies.

How did it all begin?

It was on September 27 last year that Brazilian Finance Minister Guido Mantega announced that the world is in the midst of an international currency war as nations race to devalue their currencies in hopes of exporting their way out of trouble. The problem began earlier as a logical consequence of the financial meltdown of 2008. We started off with international savings imbalance that led to excessively low interest rates. With such low interest rates people were tempted to buy homes, especially when the banks offered great subprime deals to people that normally would not qualify. All this home buying created the real estate bubble where it seemed that prices would keep going up forever.

Then in 2008 the subprime implosion prompted government rescue packages and the 24/7 running the money printing presses. The resulting explosion of sovereign debt put governments in the bind between two evils. Run a budget austerity program with sever cutbacks on public expenditure and risk deflation, or print more money and cause inflation via the devaluation of the currency.

There are only three ways to reduce public debt.

  • Budget austerity that, in theory, is supposed to enable the government to eventually run a surplus and pay down the debt.
  • Monetization where the government takes advantage of the unique right of the central bank to print money. The government then can borrow this fiat money freshly printed by its own central bank to finance public spending. The danger here is the specter of inflation.
  • Default is where a government swamped by debt repudiates or reschedules its debt. There has been much talk that it's only a question of time when Greece will have to go this route.

We live in a different world now. If until 2007 exchange rates developed in a conventional economic environment in which high yield currencies appreciated, since 2008 the game has changed. Now it's a race to devalue the currency.

For a widespread currency war to take place several significant world economies must wish to devalue their currencies at the same time. This can take place in times when the world is suffering through a recession, as it is now.

Just like gold, US dollars have value only to the extent that they are strictly limited in supply. Imagine that one could, through alchemy, produce gold in unlimited quantities. The price would plunge immediately. The same will be true in the long run for fiat currencies. You can't flood the market with a supply of more and more dollars without the value of those dollars declining (monetarists would argue and discuss the impact of the population growth rate, but that is a different matter).

This is not the first time that the dollar has been devaluated through manipulation. Franklin D. Roosevelt did it in 1933-34. Here is what Ben Bernanke, a good student of economic history, said in remarks he made before the National Economists Club in 2002.

Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.

With interest rates hovering near the zero level central banks have only one tool in their box to combat slowing growth. Yes, currency creation, which inevitably will lead to inflation. Printing money is such an attractive solution for governments because it spurs growth by exports since goods are now cheaper for countries whose currencies are stronger. Inflation is imported and the debt burden is reduced.

China and Japan have bet massively on exports to drive growth and to help achieve that goal they weaken their currency. It is estimated that the Chinese yuan is about 40% undervalued against the dollar. Although the currency has been allowed to rise 7 percent against the dollar since June of 2010, in late August the rise slowed to a virtual halt. China is returning to its old strategy to support its exports amid a faltering global economy.

A best-selling book right now in China is titled “Currency Wars” with more than 2 million copies sold. The book pushes towards an isolationist financial policy.

The bottom line is that as these currency wars develop and the world's economic situation does not improve, capital will flow into safe havens. The Swiss franc is too expensive and in a currency war it becomes difficult to position oneself correctly in the forex market. The central banks of both Switzerland and Japan can take action to lower the value of their currencies. But gold is not controlled by any central bank. Unlike fiat currencies it can’t be printed at will. Gold’s scarcity is dictated by nature rather than by politicians. The dollar has a debt burden alongside it that gold does not. So, with Japan massively intervening in the currency market and the Swiss curbing the safe-haven status of the Swiss franc, the only safe haven currency that remains standing is gold (that is, except silver and platinum).

Shula Kopf
Sunshine Profits' Contributing Author

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