Competitive Devaluation

The issue I fear most from an economic, political and geo-political standpoint is the huge debt overhang of the largest developed economies of the world: U.S., Europe, U.K. and Japan.

Solving this nightmare is not just an issue for the developed world, either, because it also greatly impacts the developing world (especially Brazil, Russia, China and India).

In order for the developed economies to pay off their debt, they must either grow their way out of debt or print money to inflate away the debt they owe. 

Growth would be the best and most honorable way to solve the problem, but growth in developed economies is inhibited by high debt loads (which lead to slower growth) and huge social programs (Medicare, Medicaid, Social Security and their equivalents in the other developed economies).

I’m sorry to admit it, but democracies have never successfully voted away social programs, and I don’t think they will this time, either.

That leaves inflation.

But, inflation is a nasty solution to debt problems. 

From an economic standpoint inflation is tough to put back in the bottle once you let it out.  If you think the Federal Reserve or any other central bank has a dial they can turn to 3%, 5%, or any other specific level of inflation, I’m sorry to let you know that smurfs aren’t real, either.

Inflation crimps a whole economy as everyone–from employees to employers, from government bureaucrats to private companies–becomes bogged down in trying to figure out wages, salaries, costs, prices, tax rates, etc.  No high inflation economy runs smoothly and efficiently.

The political and geo-political stage started to ripple this week as the U.S. Congress is trying to pressure China into revaluing their currency and Brazil’s Finance Minister remarked that an “international currency war” is taking place as governments manipulate their currencies to improve their export effectiveness.  Japan recently announced they will be active in currency markets to prevent the price of the yen from rising too much and becoming uncompetitive in global markets.  These trends will result in the beggar thy neighbor problem I highlighted in a previous blog.

This competitive devaluation process is a race to the bottom and has an ugly history.  In the past it’s led to world war and economic collapse.  I wish I could say these were idle fears, but they are not.

The U.S. economy currently has low inflation, and that looks set to last until the private market works down its bad debt problem (which I think will happen over the next 3 – 5 years).  Some believe the U.S. economy will experience the low inflation, deflation and low interest rates of Japan over the last 20 years.  In that environment, cash and bonds will do very well.

Never say never, but I doubt we’ll experience what Japan did.  In that case, inflation is the more likely threat, and that’s not a good scenario for owning a lot of bonds or cash.

The competitive devaluation that’s occurring does not need to continue, so my fears may be unjustified.  Even if they are justified, the end-game is unlikely to play out soon, but over the next decade.  Hope is not a strategy, so I’m hoping for the best while preparing for the worst.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Competitive Devaluation

Beggar thy neighbor

I was surprised this week to read several reports that Europe announced improving production and business confidence, particularly out of Germany.  Several European companies announced better than expected earnings, too. 

After all, weren’t financial commentators the world over (including yours truly) prattling on a couple of months ago that Europe was coming apart at the seams?

And then I remembered the phrase “beggar thy neighbor.”  It refers to the political policy of devaluing one’s currency and/or erecting trade barriers to boost one country’s economy at the expense of other economies. 

It’s called beggar thy neighbor because it only works as long as your neighboring countries don’t react (hence the begging).  If they erect their own trade barriers or devalue their currency, then the game is up and everyone ends up worse off.  Like most boondoggles, it only seems to work as long as you focus on the surface and not the aggregate.

Because I have a sarcastic sense of humor, I couldn’t help but be amused by all the Germans who were coldly saying, a few short months ago, that the Club Med countries should be dumped from the euro currency and even the European Union.  Now that the Club Meds have caused the euro to drop, Germany seems to be making out like a bandit. 

The main reason is that Germany is mostly an export economy (like China and Japan).  In fact, China overtook Germany only last year as the world’s largest exporter.  Germany’s economy would grind to a halt if it weren’t selling to others.  Not surprisingly, the euro dropping benefited them most.

But, it won’t last too long.  Even now, U.S., Japanese and Chinese politicians are most likely forming policies that will lead to our own devalued currencies or new trade barriers that will eliminate the euro advantage.  The effort will succeed in kicking Europe–particularly German–in the shins, but it won’t make anyone better off.

In the long run, people adjust to currency changes.  Over time, a burger in Asia, Europe and America will cost about the same in real value.  Buyers and sellers adjust the prices they are willing to pay and receive until things are back to the way they were.  Currency depreciations don’t work for long, and trade barriers just reduce everyone’s standard of living. 

Beggar thy neighbor doesn’t work, unless of course your goal is to get elected in the short run.  It may be the only thing less productive than re-arranging deck chairs on the Titanic.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Beggar thy neighbor