Currency Wars

1. Currency wars are cyclical and driven by domestic economic distress

A currency war, fought by one country through competitive devaluations of its currency against others, is one of the most destructive and feared outcomes in international economics.

Historical context: Currency wars have occurred in three major cycles over the past century. Currency War I (1921-1936) emerged from the ashes of World War I, with countries like Germany using hyperinflation to cope with war debts. Currency War II (1967-1987) was triggered by U.S. spending on the Vietnam War and social programs, leading to the collapse of the Bretton Woods system. Currency War III (2010-present) arose from the 2008 financial crisis and subsequent economic struggles.

Key characteristics:

• Competitive devaluations to boost exports and economic growth
• Beggar-thy-neighbor policies that harm trading partners
• Driven by domestic economic issues such as high unemployment, slow growth, and excessive debt
• Often lead to inflation, financial instability, and economic disruption

Consequences: Currency wars can result in trade tensions, economic retaliation, and a race to the bottom that ultimately harms all participants. They expose the fragility of the global monetary system and the interconnectedness of national economies.

2. The gold standard's abandonment led to increased monetary instability

Gold is not a commodity. Gold is not an investment. Gold is money par excellence.

Historical shift: The abandonment of the gold standard, particularly the U.S. decision to end dollar-gold convertibility in 1971, marked a significant turning point in monetary history. This shift allowed for greater monetary flexibility but also removed a key anchor of stability from the global financial system.

Consequences of fiat currency:

• Increased volatility in currency markets
• Greater potential for inflation and currency debasement
• Expanded powers for central banks to manipulate money supply
• Loss of a natural constraint on government spending and debt accumulation

Debate continues: While many economists argue that the gold standard was too rigid and deflationary, others contend that a return to some form of gold-backed currency could provide needed discipline and stability to the global monetary system.

3. Central banks often misuse economic theories to justify currency manipulation

Fundamentally, monetarism is insufficient as a policy tool not because it gets the variables wrong but because the variables are too hard to control.

Theoretical justifications: Central banks often rely on economic theories such as Keynesianism and monetarism to justify their policies. However, these theories are often misapplied or oversimplified in practice.

Problematic assumptions:

• The Keynesian multiplier effect is often overstated
• Monetarist models fail to account for the unpredictability of money velocity
• Efficient market hypothesis ignores irrational behavior and market imperfections

Real-world consequences: These misapplications can lead to policies that exacerbate economic problems rather than solve them. For example, quantitative easing programs may lead to asset bubbles and increased wealth inequality rather than broad-based economic growth.

4. Complexity in financial systems increases the risk of catastrophic collapse

Complex systems begin with individual components called autonomous agents, which make decisions and produce results in the system.

Complexity theory: Financial markets exhibit characteristics of complex systems, including interconnectedness, feedback loops, and emergent properties. This complexity makes them prone to sudden, catastrophic failures.

Key aspects of financial complexity:

• Derivatives and leveraged financial instruments
• Globalized, interconnected markets
• High-frequency trading and algorithmic decision-making
• Opaque and convoluted financial products

Implications: The increasing complexity of the financial system makes it more vulnerable to cascading failures and "black swan" events. This suggests that simplification and compartmentalization of financial systems could increase overall stability and resilience.

5. The U.S. dollar's dominance as a reserve currency is under threat

The dollar, for all its faults and weaknesses, is the pivot of the entire global system of currencies, stocks, bonds, derivatives and investments of all kinds.

Current status: The U.S. dollar remains the world's dominant reserve currency, but its position is increasingly challenged by other currencies and potential alternatives.

Threats to dollar dominance:

• Excessive U.S. debt and monetary expansion
• Rise of alternative reserve currencies (euro, yuan)
• Development of digital currencies and cryptocurrencies
• Proposals for new global reserve assets (e.g., IMF's Special Drawing Rights)

Potential consequences: A decline in the dollar's reserve status could lead to higher borrowing costs for the U.S., reduced global economic influence, and increased instability in international financial markets.

6. Behavioral economics and complexity theory offer new insights into financial markets

Behavioral economics possesses powerful tools and can offer superb insights despite occasional misuse.

New paradigms: Traditional economic models often fail to account for real-world behavior and system dynamics. Behavioral economics and complexity theory provide alternative frameworks for understanding financial markets.

Key insights:

• Markets are not always efficient or rational
• Cognitive biases significantly influence economic decision-making
• Financial systems exhibit emergent properties and nonlinear behavior
• Risk is not normally distributed; "black swan" events are more common than traditional models suggest

Implications for policy: These new perspectives suggest that policymakers should focus more on system resilience and robustness rather than trying to fine-tune the economy through traditional monetary and fiscal tools.

7. A return to a modified gold standard could provide monetary stability

A flexible gold standard should be adopted to reduce uncertainty about inflation, interest rates and exchange rates.

Proposal: The author suggests a return to a modified gold standard as a way to increase monetary stability and reduce economic uncertainty.

Key features of a modern gold standard:

• Partial backing of currency with gold reserves
• Flexibility to adjust gold-currency ratios in economic emergencies
• Transparent rules for monetary policy (e.g., Taylor Rule)
• International cooperation to maintain stability

Potential benefits:

• Reduced inflation and currency volatility
• Increased fiscal discipline for governments
• Greater certainty for long-term economic planning
• Natural constraint on excessive monetary expansion

8. The Pentagon is preparing for potential financial warfare scenarios

The threats envisioned in the Pentagon's 2009 financial war game are becoming more real by the day.

Military perspective: The U.S. Department of Defense is increasingly concerned about the potential for financial warfare and economic attacks on national security.

Potential threats:

• Coordinated selling of U.S. Treasury securities
• Cyberattacks on financial infrastructure
• Manipulation of commodity markets
• Use of alternative currencies to circumvent U.S. financial power

Implications: The intersection of finance and national security is becoming more pronounced, requiring greater cooperation between economic policymakers and defense planners.

9. Multiple outcomes are possible for the future of the global monetary system

The path of the dollar is unsustainable and therefore the dollar will not be sustained.

Possible scenarios:

1. Multiple reserve currencies coexisting
2. Adoption of a new global reserve currency (e.g., IMF's Special Drawing Rights)
3. Return to a gold-based monetary system
4. Chaotic collapse and potential reset of the global financial order

Factors influencing outcomes:

• Political will for international cooperation
• Technological developments in finance
• Geopolitical power shifts
• Severity of future economic crises

Preparation is key: Given the uncertainty surrounding the future of the global monetary system, countries and individuals should prepare for multiple scenarios and focus on building resilience against potential shocks.

Last updated: January 23, 2025