Let Us Not Be Dragged Into a Currency War

One of the highlights of last year's trading was our decision to short the Japanese yen. It was a great example of trading on political intrigue, as opposed to using technical or fundamental analysis. I'd like to congratulate all of the Real Money Pro subscribers who profited from that trade.

There are implications and side effects to Japan's new policies, and their reverberations are now being felt here in the U.S. On Thursday the Big Three automakers, represented by the American Automotive Policy Council, asked the Obama Administration to retaliate against Japan for pursuing a weak yen policy -- to "make it clear to Japan that such policies are unacceptable and will be met by reciprocal measures," as AAPC president Matt Blunt put it.

It is true that, with the ascendance of new Prime Minister Shinzō Abe, the yen is now weaker than it has been since 2010. However, the currency is currently stronger than it was from 1996 through 2009. When viewed in those terms, Blunt's argument loses steam.

In fact, for most of those years -- from 1996 through 2007 -- the dollar-yen exchange rate was comfortably above 100, and at one point it climbed above 147. I'm sure that, at that time, U.S. automakers would have given anything for a rate near 90 -- the basis of their current complaint.

Blunt went on to accuse Japan of pursuing a "Beggar Thy Neighbor" policy, a term that harkens back to the currency wars of the 1930s. Here's a brief look at what occurred at that time: After World War I, the U.S. and Great Britain returned to the gold standard, as had been the case prior to the war. In 1926, France did the same -- but it devalued its currency first, which gave the country a competitive edge in international trade.  

Five years later, with the world economy now in shambles, Great Britain dropped the gold standard and devalued the pound. Two years after that, the U.S. followed suit.  The U.S. and Britain then engaged in a series of retaliatory devaluations, with each trying to gain the upper hand via a lower currency. All the while, countries like France and Switzerland, still linked to gold, saw their currencies skyrocket in comparison.

Of course, in 2013, none of these countries are on the gold standard; the way to fight a currency war today is through central-bank easing. There has been plenty of that, both in the U.S. and in Japan.

Currencies move in relation to one another -- so, when one currency is weakening, by default another one is strengthening. One could make the argument that dollar-yen cross never should have been as strong as it was, and that strength was partly due to the Federal Reserve's easing policies.

I doubt the dollar-yen currency pair would have ever reached the sub-80 level if not for the first and second rounds of quantitative easing, and for the natural disasters that occurred in Japan in 2011. The strong yen was partly driven by the Fed's policies and nature's wrath. So Japan could certainly make the argument that its actions are reciprocal -- a reaction to the Fed.

The currency wars of the 1930s finally ended when the participants realized that it was lose-lose proposition for all involved. The constant valuation swings created uncertainty in exchange rates, which in turn had a chilling effect on international trade. The world economy was already a mess, and the currency war prolonged and exacerbated that weakness. Let's not make the same mistake again.

At the time of publication, Ponsi had no positions in the securities mentioned.