What exactly is a currency war, anyway?

Currency volatility is certainly a problem, but no one’s quite sure if we’ll know when it becomes a full-blown war.

Tensions are escalating among some of the world’s biggest economies as finance ministers find incentives to devalue their currencies. But are we in a currency war, or merely a currency spat?

Treasury Secretary Tim Geithner says unequivocally it is not a war. He told Charlie Rose last week there is “no risk” of the current strife escalating to a currency war. But Brazilian Finance Minister Guido Mantega disagrees — last month he publicly said an “international currency war” has broken out.

When pressed for an explanation of what exactly a currency war is, a Treasury Department spokesperson emailed this response: “I don’t think we’re best suited to define the term for you. As I understand it, the Brazilian Finance Minister coined the term so you may want to go straight to the source.”

And there you have the real answer: No one really knows exactly when this kind of global economic tension actually becomes war. Even Geithner, who adamantly says there’s no risk of a war, apparently isn’t in a position to define it.

Whatever name we assign to the state of the world’s currency problems, Mantega’s alarm isn’t entirely unfounded. For one, Japan last month sold an estimated $20 billion of yen. This marks the first time in six years officials have intervened in the foreign exchange markets, although for now at least, they’re expected to refrain from intervening further. South Korea has also held down the won by intervening occasionally over the past year. And countries ranging from Singapore to Colombia have warned about the strength of their currencies.

And China’s relatively weak renminbi has long been a sore spot. Bad domestic conditions in the U.S. and other parts of the world have made world leaders especially touchy to the perception that they are somehow being screwed by currency manipulation.

There is good reason for countries to intervene in their currency valuations: A lower exchange rate generally makes selling goods and services abroad cheaper – a competitive edge that’s grown increasingly attractive as world leaders look to recover from a global recession marked by tighter credit markets, and for some, unnervingly high levels of debt and unemployment that have contributed to plunges in domestic demand.

Central bankers around the globe are trying to give their economies an extra jolt, such as slashing interest rates and even taking the unusual route of essentially printing vast amounts of cash, which U.S. Federal Reserve Chairman Ben Bernanke last week focused on as an option to boost the economy.

Whatever the intentions, all these actions end up weakening currencies. More important, such “beggar-thy-neighbor” interest rate policies tend to encourage a domino effect: The fall of one currency leads to the irritating rise of another, and so on.

And what could transpire is competitive devaluation similar to that of the 1930s, the last time there was an official currency war. Back then, collapse in confidence in the international gold standard sent the British pound on a downward spiral and caused huge exchange rate volatility throughout the world.

Risk of a trade war

The currency war led to trade wars, which worsened the Great Depression as tensions contributed to rising tariffs and considerable drops in international trade. Mark Thoma, economist at the University of Oregon, says today’s state of affairs signals that a trade war isn’t too far away, especially if the Fed next month decides to buy Treasury securities with newly created dollars. Another round of quantitative easing could send several currencies on a worrisome downward path.

So policies intended to give the economy a boost might actually hurt growth in the long run. Competitive devaluation could lead to a fall in world trade, as well as foreign investments. And expansion of the global money supply could create a bubble in commodities.

The U.S. is being cautious, as China is one of its main trading partners. Even South Korea, host of the upcoming G20 meeting next month, has reportedly been hesitant from highlighting the currency issue on the gathering’s agenda, according to the Financial Times.

Perhaps the deeper problem has more to do with political imbalances than anything currency related. It’s no secret that emerging economies generally survived the global recession better than industrialized nations. This has shifted economic influences away from star economies including the U.S., Europe and Japan.

And amidst the economic recovery, it’s really an economic race to the top.

See also:

Is the dollar toast?

China sill stockpiling foreign currency

Dollar war heats up

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