A "Currency war" sounds about as intimidating as a gang of puppies with bandanas and tear drop tattoos...what's the BFD?

I know! I promised! Way back in the black n white film era of mid August 2010, I wrote an intro post saying that this blog would be able to give you some sort of response to some dweeb saying “the fed is sacrificing the dollar like a virgin in Tecnochtitlan” other than your usual response of “NEEERRRRRRDDDDDDDDD.” So let’s start from the top, the first question I got on this was “uhhh….bro….what the shit is Tech…notch….tit….land?” it was the capital city of the Aztec civilization, founded in 1325, and they did not take too kindly to virgins there. So now from the top that’s a little…less…at the top…than that top, currencies: what they are, how their value changes, why different interest groups want to control their values, and how they are effing up the current international economic situation.


At their most basic level, currencies are what you use to buy shit in a different country. You’re chillin in Canada and you wanna buy some knock off Big Wrrrreeague Chew from South Korea, but they don’t want your stupid Canadian monopoly money they want to be paid in South Korean Won (most of you were probably expecting a China joke there, and trust me I had it all written and everything, but China’s currency policy is super important and all messed up so its got its whole own section later….engrish included). So you click in your monacle, iron your tuxedo t-shirt and roll down to your local financial institution to hook up some damn Won! At the same time you are doing this, another gender neutral person across town is looking at investing some money super low risk and notices that government bonds in South Korea will pay it 3% per year instead of 0.75% in Canada and says “screw this noise, I’m gonna give the South Korean government my cashish instead” and travels to their financial institution to hook up some Won as well. In both of these situations you are getting rid of or “selling” Canadian Dollars and “buying” South Korean Won. So what happens when everyone is selling something and buying something else? The price of the desired object rises (ISBA: currency “appreciates” when it goes up in value).

Currencies can kinda be thought of as similar to anything else in that it’s “price” is controlled by supply and demand. Think back to economics 101…thiiiiiiiiiink…...look past the girl with the playboy bunny trampstamp you can just see through her chair, forget about the guy with the….sexy thing that…some guys have…or whatever, and remember this diagram:

Dude.……..your economics teacher was pretty fucked up….. I guess we can work with this though?

So if demand (downward sloping boner) goes up while supply (upward sloping boner) remains the same, price goes up and that makes it more expensive relative to other currencies. Demand decreases while supply remains constant, price goes down. Supply goes up without an increase in demand, the price of the currency goes down and vice versa.

So we touched above on a few of the things that can happen to drive demand and therefore increase currency values, but for those who can only learn things in list form here’s a summary:

• If a company has attractive products to sell internationally (oil and other natural resources, knock off big league chew, etc), it will generally export more than it imports (ISBA: countries that do this are said to be running a “trade surplus” or a “trade deficit” if they import more than they export). Say this is South Korea, more people from other countries will buy the Won than people in South Korea selling the Won, and it will become more expensive.
• If a country has a more attractive interest rate for investors in the government bond market, they will flock to get that currency to be able to invest in that country’s bonds. This also applies if there is just a better investment climate in certain countries (ie. “Everything sucks here, but there are some gnarly companies to invest in/acquire in South Korea let’s get some Won and go to town”)
• The relationship between interest rates is actually super exact in theory. If a country’s interest rate is 2% higher than another, its currency SHOULD appreciate 2% against that other country over a year. This is called the (ISBA) International Fisher Effect. If you can use this one accurately in conversation you have my blessing to chug and spike whatever you are drinking, yell “spring break Panama City 2004”, and promptly exit the room for you have hit the high water mark of your night, financial conversationally speaking.
• This final major factor driving currency values higher is a less logical one and more of an emotional response: the flight to safety. This essentially happens when you have terror poos, stop caring about return, and hunker down with whatever you think won’t totally collapse. This is one of the things keeping the US dollar afloat these days.

But for every currency appreciation, there needs to be a loser right? If someone is buying one currency they are selling another. So what factors drive down currencies?

• Well what causes the SUPPLY of money to INCREASE?? Eh? EH? See? All these articles hang together in the grand scheme of things! For those of you looking at me cockeyed, monetary policies like decreasing interest rates and quantitative easing cause a large increase in the supply of money (see stimulus article for deets), which in turn will drive the value of a currency down.
• An offshoot of these monetary policies that expand the supply of money (ISBA: “expansionary monetary policies”) is inflation. There is a complicated explanation for why this erodes a currencies value but if you just think about it from a sensical perspective, if one Canadian dollar buys less in Canada…. why would someone else pay the same amount as they did before to acquire that one Canadian dollar? The only thing to remember here is that currencies are relative though, so if Canada has 5% inflation and the other country also has 5% inflation…. then the currencies won’t change against one another.
• A country running a trade deficit will also de-value the currency (as discussed above).

So now that we understand sorta how currency works, let’s see how you can fuck with em! The two biggest cases I’d like to look at are China and the US. Just to give you a heads up, we are delving somewhat into opinion in some places here instead of staying strictly fact based as I try to do.

China

• Everything described above? That all applies to floating rate currencies. Which are currencies whose value can change along with market forces. However, some countries elect to have a fixed (ISBA: “pegged”) currency, which uses the USD as a peg. China is one of these countries. If the USD rises then the Yuan (a.k.a. the Renmibi… I know! It sounds Italian, just go with it) rises and vice versa. The goal of this is to make international trade more consistent and predictable by having a relatively stable exchange rate. The way they do this is by the Chinese central bank saying “oh harrrroowwww market forces how you?” then proceeding to use their gigantic foreign exchange reserves to do the opposite of every effect of the market. Too many people buying Chinese goods or investing in China? Boom, buy some more USD and sell their own currency into the open market to increase supply and reduce the value again.
• It is the United States and much of the rest of the world’s opinion that the Yuan is significantly lower than it should be and this makes China’s exports super cheap internationally speaking. This makes sense if you think about it cause if the Yuan is held artificially low, then one dollar will buy more stuff in China than it will in say South Korea if the Won is correctly valued. Who are you gonna buy from then right?
• So sounds ok in theory right? The problem with pegs is that they are a bitch to maintain. If the for realsies value of your currency gets too far out of whack with the peg and you don’t have enough foreign currency to maintain the peg then your currency can revalue a shitload all at once and all kinds of hell breaks loose. This happened in Thailand in ‘97 and the Thai currency depreciated 30% almost instantly. It has also happened fairly recently in Russia (’97), Mexico (’95), and Argentina in 1999. (argentina debt crisis as well). China, though, has gigantic USD reserves and so has no trouble maintaining this peg, though they are under a buttload of international pressure to allow the Yuan to appreciate to even the playing field.
• Because China has such a gigantic amount of American currency (USD 2.45 Trillion as of March 2010), they have the power to eff with the value of the USD as well as their own currency…. needless to say this has important people in the States terrified.

The US

• The US is special because the value of its currency isn’t only derived from what happens in the US. It is the (ISBA) international reserve currency, which means basically that all governments hold it as their foreign exchange reserve and all of the commodities (gold, oil, corn, grain, etc) are priced in it. This means that there will ALWAYS be more of a demand for this currency than others, so a TON more of it can be created and sloshing around before the value of it is significantly deteriorated. Also, it has the benefit of being the currency that everyone flocks to when the proverbial poop hits the rapidly rotating device, further propping up its value in times of crisis.
• This being said, in my opinion the US Federal Reserve is doing its damn best to introduce the USD to its friend Throat Opener Charlie. US interest rates are at 0% and Quantitative Easing (see last post on stimulus) have taken the effective interest rate into negative territory (did your head just explode a teensy bit there? Yes essentially the US is paying banks to take money) and the USD, despite all its advantages is at a 15 year low against many major currencies.
• So what does a low US dollar do then? Well guess what stocks are valued in? USD. If Big League Chew Inc is trading at 5 bucks US when the USD is worth “1” (in reality it would be quoted against another currency like the Euro or the Yen or something but for illustration purposes), then Big League Chew Inc is gonna be trading at 10 bucks US if the USD is worth 0.5 no? So what distracts from a financial crises better than “S&P up 40% on the year!! Recovery in full swing!!” Take a look at this tasty little nug:

• Note: I would have loved to have made another wiener chart but alas sometimes real data works better. The blue line is the S&P 500, which essentially represents how the 500 biggest stocks on the New York Stock Exchange are doing (ISBA: the S&P 500, NASDAQ, and things like that are called “indices” or an “index”). The green line is an ETF that tracks the value of the USD. Notice that generally when the green line is going down the blue line is going up? Not a bad way to help it seem like everything is panda babies and rainbows eh? Again there are a TON of other factors that go into determining the price of an index like this, but this is a pretty strong correlation.
• A low USD also discourages Americans from buying foreign shit (cause it becomes super expensive) and encourages foreigners to buy American shit (cause it becomes super cheap).
• The bitch of a shitty USD though, is that because the returns are so crappy (0% interest rates don’t exactly make for a great return on American government bonds) and there is soooo much money sloshing around, a ton of money is flowing into emerging markets, where the returns will be much higher. Because people need to get the currency of those emerging markets to get these bonds, their currencies are flying upwards in value and guess what? No one wants their exports anymore cause now they are expensive and their fucked.
• The bottom line is that the Americans can keep printing currency as long as the USD is the international reserve currency. The USD will remain the international reserve currency for the foreseeable future because there is no alternative. It is in China’s interest that the value of the USD remain high, because they have so many in their reserve, however if the value of the USD is high, the value of the Yuan will rise due to the peg, which is not in China’s interest.

And so we come to the crux of this “currency war” that the main stream media is spazzing out about. The US, and a lot of the rest of the world, wants China to allow their currency to increase in value because Chinese exports and thus US imported goods like toasters, condoms, and politeness are artificially cheap and that is crowding out other emerging markets from exporting. China and other emerging markets want the Americans to raise interest rates and stop jooking their currency so that money doesn’t flood into these emerging markets and drive their values up, hindering their exports. The Bank of Japan has already stepped in to decrease the value of its currency and many other emerging market governments are talking shit about doing the same. It is a race to the bottom and no one will be the winner in the end.

I know there was a veritable ocean of information just assaulting your grill, but it was necessary. That’s the thing about macroeconomics, it’s impossible to write about one thing in isolation because everything is connected. I sit down to write a nice little article and then boom next thing you know I go into an economics blackout and wake up 3 days later in a pile of Google searches, covered in mustard with a 3000 word post and Bobby Banker saying "really dude? dicks made in paint for the supply and demand?". It’s a rough life. Seriously though, this is one of the biggest topics out there this currency war:

- U.S. is currency war's tomb maker: China economist | Reuters (October 14)

- IMF warns against currency war - Reuters (October 10)

- Dollar falls as 'currency war' concerns linger (October 11)

- BBC News - IMF chief's warning of currency war 'real threat' (October 7)

The best hope for sanity seems to be the upcoming G20 meeting in November, where ideally both sides can come to some sort of compromise that will allow for a narrowing of China and the US's trade imbalances (surplus and deficit). There is no easy answer, but countries acting alone to try and protect themselves and their exports is a surefire way for disaster, the only answer is cooperation.