NEW YORK (TheStreet) -- Fears of a "currency war," in which countries devalue their currencies to gain a trade advantage, dominated headlines last week ahead of the weekend meetings in South Korea of the finance ministers from the 20 leading economies that make up the Group of 20 (G-20).Last week, U.S. Treasury Secretary Tim Geithner, who also attended the meeting, publically commented that the U.S. desires a further depreciation of the dollar against the Chinese currency. But he also noted that "the major currencies...are roughly in alignment now" -- a suggestion that he sees no need for the dollar to fall further against the euro and yen. However, U.S. Treasury Secretaries are notorious for stating an interest in a strong dollar while accommodating a slide. The dollar has fallen 13% against the major currencies since June. Last week the dollar rose slightly for the first time in six weeks. Brazil's finance minister warned of "an international currency war" and called for "some kind of currency agreement." India's prime minister has expressed similar concerns and the governor of the Bank of England has warned of protectionism unless "the need to act in the collective interest" is recognized. While any major announcements would come from the November meeting of G-20 leaders in Seoul, it is unlikely that there will be any globally coordinated move on exchange rates. Despite these calls for action, the "currency war" is unlikely to end anytime soon. It is primarily the result of the bifurcation of world economic growth. Many developed countries see further stimulative monetary policy, which lowers interest rates and pumps more currency into the system, as a necessary response to subpar growth. In the United States, a weaker dollar is a beneficial side-effect of the policy that can help boost inflation since a weaker dollar has less purchasing power as the Federal Reserve seeks to avoid the demand destroying effects posed by the threat of deflation, or falling prices. However, these policies create challenges for the emerging market countries where growth is currently strong, but increasingly pressured by a rising currency that threatens to reduce the global competitiveness of their exports and create a bubble in their economies as the world's capital increasingly pours into their borders.
There are three primary potential consequences of the ongoing currency war.1. A global currency agreement. We stated above that a globally coordinated move on exchange rates is unlikely. The framework suggested by some finance ministers for such an agreement would follow that of the Plaza Accord of 1985, when France, Germany, Japan and the UK governments agreed to intervene to devalue the U.S. dollar against the yen and the German deutsche mark. This devaluation was planned, done in an orderly, pre-announced manner and did not lead to a financial crisis or a currency war. Back then, the move was in response to a dramatic rise in the value of the dollar in response to restrictive monetary policy by the Federal Reserve as they hiked rates into the double-digits to curb rampant inflation. That situation is the complete opposite of today making the unique circumstances that led to the success of a global currency agreement such as the Plaza Accord extremely unlikely in the prevailing environment. However, emerging market countries have recently been allocated a larger percentage of voting rights and a bigger role at the International Monetary Fund when it comes to managing the global economy. 2. More monetary stimulus around the world. This seems to be the most likely outcome. In recent weeks, a number of countries have already started taking steps toward more stimulus as they follow the lead of the United States. Both the Bank of Japan and Bank of England have moved toward additional "quantitative easing," so-called because it increases the quantity of money in an effort to lower the value of the currency and boost growth. Nearly all of the world's major central banks are contemplating similar actions. Even the Bank of Canada, the first of the major central banks to begin to withdraw stimulus with rate hikes that began this past summer, is likely to put a halt to their actions. However, there are likely to be some exceptions among emerging markets where more than 20 central banks are raising rates to prevent a further rise in domestic inflation (inflation is running in the mid-to-high single-digits in countries such as Brazil, Russia and India). For these countries, a rising local currency is another way to slow inflation as it keeps a lid on the prices of imported goods.3. Emerging markets try to close the doors. The pressure on some emerging market countries to follow suit to reduce the strength of their currencies may lead to longer-term risks of bubbles becoming inflated due to the excessive stimulus from domestic actions in addition to inflows from abroad. This is prompting some emerging market countries to impose controls on the cross border flow of capital to weaken their currencies.