A Currency Race to the Bottom

Policymakers are trying to boost their economies by bashing their tender

By Stephen Gandel Monday, Jan. 17, 2011
    • Illustration by Peter Arkle for TIME

    Earlier this year, the Swiss franc became a hot investment, up nearly 12% in six months. So how did the Swiss respond to the market's vote of confidence? Not well. Officials said the franc's appreciation was not welcome.

    Switzerland is not alone. From Brazil to Vietnam, policymakers are doing their best to force their tender to drop. The Fed's $600 billion plan to buy bonds, which some have equated with printing money, is likely to hurt the dollar. China continues to unofficially peg its currency to the dollar, which may lower the value of the renminbi as much as 20%. A plan to allow losses on the bonds of the European Union's weaker members will further damage the euro.

    At a time when the global economy is struggling, policymakers are using exchange rates to produce growth. A weaker currency boosts exports. But some economists fear the race to the bottom will do more harm than good. It could cause massive global inflation, slowing the rise in wealth of the past few decades in China and other developing nations. Lower consumption in those countries would in turn hurt demand in the U.S. and Europe. "Everyone thinks their country can avoid or get out of recession on the back of another country's growth," says Joseph Mason, a professor of finance at Louisiana State University. "But in a global crisis, there is no one left to beg from."

    Central bankers can target either inflation or the value of their currency — not both. To drive down the value of money, bankers lower interest rates. But lower rates typically lead to higher economic growth, an influx of foreign capital and, potentially, inflation. The biggest sufferers may be workers in poor countries. Barry Eichengreen, a professor of economics and political science at the University of California, Berkeley, worries that if developing nations continue on their current course, we are likely to see wage disputes and riots. "Workers get angry when wages don't keep up with prices," says Eichengreen.

    Rising prices may lead developing nations to boost interest rates to tame growth. Indeed, China has already begun raising rates. As other nations make the same move, money will flow out of the dollar and the euro in search of higher rates elsewhere. "The general consensus is that the euro will continue to fall in 2011, and by midyear the dollar should follow," says Ken Jakubzak, who runs a currency hedge fund in Lake of the Hills, Ill.

    Short-term, American and European companies will benefit, as will their shares. Stocks of developing-market companies may suffer. The one silver lining is that the currency shuffle could help rebalance the global economy if it forces emerging nations away from exports and toward policies that increase domestic consumption. But it's not clear how long that could take. And if growth doesn't reappear in poor nations in 2012 or 2013, the U.S. could suffer as well. As John Hathaway of the Tocqueville Gold Fund says, "Historically, currency wars have not ended well."