The US will win the currency war - Martin Wolf

We have had much to say about the currency war from the first sniff of ignition and we truly believe this is a destabilising dynamic to the global economy and global co-operation to get this current economic malaise moved toward resolution.

Writing in the FT today Martin Wolf (http://www.ft.com/cms/s/0/fe45eeb2-d644-11df-81f0-00144feabdc0.html?ftcamp=rss)  deals with the current spat which centres on the USD and the Yuan and he suggests, and we agree that at the end of the day the United States will win.

"Aggressive monetary policy by reserve-issuing advanced countries, particularly the US, is an element in both processes. The cries of pain now heard around the world, as markets push currencies up against the dollar, partly reflect the uneven impact of US policy. Still more, they reflect the stubborn unwillingness to accept the needed changes, with each capital recipient trying to deflect the unwanted adjustment elsewhere.

To put it crudely, the US wants to inflate the rest of the world, while the latter is trying to deflate the US. The US must win, since it has infinite ammunition: there is no limit to the dollars the Federal Reserve can create. What needs to be discussed is the terms of the world’s surrender: the needed changes in nominal exchange rates and domestic policies around the world."

Wolf goes on to Quote Bill Dudley of the New York Fed and the discussion about the potential for deflation. We think deflation is more likely than not in the US over the years to come and indeed have been looking at the Japanese experience that Wolf looks at. This has massive implications for asset markets not least of which the current dichotomy between equity and bond valuations.

One o fht reasons we think that the US believes it needs to push its currency down is that there is a real chance, we think, that with the current fractured financial system that QE will work in the US. The transmission mechanism between Fed purschase and economic activity is fractured on a number of levels not least of which are:

1. The Banks aren't so keen to play their role in the process by on lending and
2. The demand for credit and desire to be entrepenuerial is not likely to be enough to put the funds to their real productive use even if the Fed can get it in productive hands
3. Renewed housing weakness and
4. The overhang of unemployed and underemployed almost guarantee that consumer demand will remain depressed for some time yet

But the economic outcomes get worse for everyone if the US slides into deflation so it will and must win this war. So the Fed is going to put pressure on the rest of the world.

Wolf ends on this note saying:

"Prof Blanchard is clearly right: the adjustments ahead are going to be very difficult; and they have also hardly begun. Instead of co-operation on adjustment of exchange rates and the external account, the US is seeking to impose its will, via the printing press. The US is going to win this war, one way or the other: it will either inflate the rest of the world or force their nominal exchange rates up against the dollar. Unfortunately, the impact will also be higgledy piggledy, with the less protected economies (such as Brazil or South Africa) forced to adjust and others, protected by exchange controls (such as China), able to manage the adjustment better.

It would be far better for everybody to seek a co-operative outcome. Maybe the leaders of the group of 20 will even be able to use their “mutual assessment process” to achieve just that. Their November summit in Seoul is the opportunity. Of the need there can be no doubt. Of the will, the doubts are many. In the worst of the crisis, leaders hung together. Now, the Fed is about to hang them all separately."

What choice does the US have if the Chinese won't play ball. We don't like this outcome but the Administration and the Fed have to try something. But, as Wolf says a co-operative outcome would be prepared becase as we have said before we fear the currency battle is the "Smoot Hawley" of 2010.