Currency Wars: The Making of the Next Global Crisis

by James Rickards

  The Atlantic Theater

  The Atlantic theater, the relationship between the dollar and the euro, is better understood as one of codependence rather than confrontation. This is because of the much larger scale and degree of interconnectedness between U.S. and European capital markets and banking systems compared to any other pair of financial relationships in the world. This interdependence was never on more vivid display than in the immediate aftermath of the bankruptcy of the Lehman Brothers investment bank in September 2008. Although the bankruptcy was filed in U.S. federal courts after a failed bailout attempt led by the U.S. Treasury, some of the largest financial victims and worst-affected parties were European hedge funds that had done over-the-counter swaps business or maintained clearing accounts at Lehman’s London affiliates. This transatlantic fiasco, heavily reported at the time, was amplified in December 2010 when the Fed, in response to disclosures required by the new Dodd-Frank Act, released extensive details of its emergency lending and bailout operations to Europe during the Panic of 2008.

  The euro-dollar exchange rate in early 2011 was almost exactly where it was in 2007. The euro was worth $1.30 in early January 2007 and traded right around $1.30 four years later, but this equivalence should not be mistaken for stability. In fact the euro-dollar relationship has been highly volatile, with the euro trading as high as $1.59 in July 2008 and as low as $1.10 in June 2010.

  The euro and dollar are best understood as two passengers on the same ship. At any given time, one passenger may be on a higher deck and the other on a lower one. They can change places at will and move higher or lower relative to each other, but at the end of the day they are on the same vessel moving at the same speed heading for the same destination. The day-to-day fluctuations reflect technical factors, short-term supply and demand requirements, fears of default or disintegration of the euro followed quickly by relief at the latest rescue or bailout package. Through it all, the euro-dollar pair travel on, never separated by more than the dimensions of the vessel on which they both sail.

  The United States nevertheless has its hands full on the currency war’s Atlantic front, not in trying to strengthen the euro excessively but rather in making sure it does not fall apart altogether. The euro itself is a kind of miracle of modern monetary creation, having been invented by the members of the European Union after thirty years of discussion and ten years of intensive technical study and planning. It was the capstone of a European project begun after World War II and intended to preserve the peace.

  Beginning at the end of the Renaissance in the mid-sixteenth century, Europe had been racked for over four hundred years by the battles waged during the Reformation, the Counter-Reformation, the Thirty Years’ War, the English Revolution, the wars of Louis XIV, the Seven Years’ War, the French Revolution, the Napoleonic Wars, the Franco-Prussian War, World War I, World War II, the Holocaust, the dropping of the Iron Curtain and the nuclear terror of the Cold War. By the late twentieth century, Europe was highly cynical about nationalist claims and the potential for military advantage. The old ethnic, national and religious divides were still there. What was needed was a unifying force—something that would tie economies so closely together that war would be unthinkable, if not impossible.

  Starting with the six-nation Coal and Steel Community in 1951, Europe progressed through various forms of free trade areas, common markets and monetary systems. The Maastricht Treaty of 1992, named after the city in the Netherlands where it was negotiated and signed, provided for the formation of a political entity, the European Union, and ultimately led to the creation of the euro in 1999. The euro was to be issued by the new European Central Bank. By 2011, the euro was used by seventeen member states.

  Yet from the start, analysts warned that a single currency backed by a single central bank was incompatible with the diverse fiscal policies of the member countries adopting the euro. Countries that had historically been profligate and had defaulted on debt or devalued their currencies, such as Greece or Spain, would be awkward partners in a union that included fiscally prudent countries like Germany.

  It took ten years for all the flaws in this grand scheme to be fully revealed, although they were there from the start. A toxic combination of venal government ministers, Wall Street hit-and-run derivatives scam artists and willfully blind European Union officials in Brussels allowed countries such as Greece to run deficits and borrow at levels far in excess of Maastricht Treaty limits while burying the true costs in out years and off-balance-sheet contracts. Meanwhile investors happily snapped up billions of euros in sovereign debt from the likes of Greece, Portugal, Spain, Ireland and other eurozone member states at interest rates only slightly higher than solid credits such as Germany. This was done on the basis of high ratings from incompetent ratings agencies, misleading financial statements from government ministries and wishful thinking by investors that a euro sovereign would never default.

  The path to the 2010 European sovereign debt crisis was partly the fruit of a new entente among banks, borrowers and bureaucrats. The banks would buy the European sovereign bonds and book the related profits secure in the belief that no sovereign would be allowed to fail. The sovereigns happily issued the bonds in order to finance nonsustainable spending that largely benefitted public unions. The interests of the bureaucrats in Brussels were perhaps most insidious of all. If the European sovereign debt crisis resolved itself, everyone would praise the success of the euro project. If some European sovereign debt failed, the bureaucrats’ solution would be more, not less, integration and more, not less, oversight from Brussels. By turning a blind eye to the recklessness, Brussels had constructed a no-lose situation. If the euro succeeded they won praise and if the euro came under stress they won power. The stress came soon enough.

  The European banks gorged not only on euro sovereign debt but also on debt issued by Fannie Mae and the full alphabet soup of fraudulent Wall Street structured products such as collateralized debt obligations, or CDOs. These debts were originated by inexperienced local bankers around the United States and repackaged in the billions of dollars by the likes of Lehman Brothers before they went bust. The European banks were the true weak links in the global financial system, weaker even than Citigroup, Goldman Sachs and the other bailed-out icons of American finance.

  By 2010, European sovereign finance was a complex web composed of cross-holdings of debt. Of the $236 billion of Greek debt, $15 billion was owed to UK entities, $75 billion was owed to French entities and $45 billion was owed to German entities. Of the $867 billion of Irish debt, $60 billion was owed to French entities, $188 billion was owed to UK entities and $184 billion was owed to German entities. Of the $1.1 trillion of Spanish debt, $114 billion was owed to UK entities, $220 billion was owed to French entities and $238 billion was owed to German entities. The same pattern prevailed in Italy, Portugal and the other heavily indebted members of the euro system. The mother of all inter-European debts was the $511 billion that Italy owed to France.

  While this sovereign debt was owed to a variety of institutions, including pension funds and endowments, the vast majority was owed to other countries’ banks. This was the reason for the Fed’s secret bailout of Europe in 2008 and why the Fed fought so hard to keep the details confidential until some of it was forced into the open by the Dodd-Frank legislation of 2010. This was the reason Fannie Mae and Freddie Mac bondholders never took any losses when those companies were bailed out by the U.S. taxpayers in 2008. This was why the leading states, Germany and France, rallied quickly to prop up sovereign borrowers in the periphery such as Greece, Ireland and Portugal when the euro sovereign crisis reached a critical stage in 2010. The impetus behind all three bailouts was that the European banking system was insolvent. Subsidizing Greek pensioners and Irish banks was a small price to pay to avoid watching the whole rotten edifice collapse.

  However, in the European sovereign debt crisis, Europe was not alone. Both the United States and China supported the European bailouts for differe
nt but ultimately self-interested reasons. Europe is a massive export market for the United States. A strong euro keeps up the European appetite for U.S. machines, aircraft, pharmaceuticals, software, agricultural produce, education and the variety of goods and services the United States has to offer. A collapse of the euro would mean a collapse in trade between the two giants of global output. A collapse of a European sovereign could take down the European banks and the euro with it, as investors instantaneously developed a revulsion for all debt denominated in euros and fled from European banks. The consequences of a European sovereign debt default for U.S. exporters to Europe would be too great; here was an entire continent that was too big too fail. The U.S. bailouts, swap lines and support for issuers like Fannie Mae were all part of a multifaceted, multiyear effort to prop up the value of the euro.

  China also had an interest in propping up the euro, but its efforts came with a political agenda. Europe is a huge export market for China as well as the United States, and to that extent China’s interests are the same as the United States. But China’s banks are not nearly as entwined with Europe’s as are America’s, which gives China more degrees of freedom in terms of deciding how and when to help. The European sovereign debt crisis offered China the chance to diversify its reserves and investment portfolios away from dollars and toward euros, to acquire leading-edge technology systems that had been denied it by the United States and to develop platforms from which it could engage in large-scale technology transfer back to China.

  Germany welcomed the U.S. and Chinese support for the euro. As an export powerhouse, Germany might have been expected to favor a weak euro for the same reason that the United States favors a weak dollar and China favors a weak yuan: to gain an edge in the currency wars with a cheap currency that promotes exports. Germany, however, was not only an external exporter; it was an internal exporter within the European Union. For those eurozone exports, there was no currency consideration since both the exporter and the importer, for instance Germany and Spain, used the euro. If the euro were to collapse or members broke away from the euro and reverted to their old currencies at devalued levels, those markets might be lost.

  Conventional wisdom had it that Germany anguished over support for Greece and Ireland and the other weak links in the euro chain. In fact, Germany had no attractive alternatives. The costs of a euro collapse far outweighed the costs of regional bailouts. Germany actually benefitted from the European sovereign debt crisis. The continued existence of the euro gave Germany a dominant position inside Europe while a somewhat weaker euro internationally enabled it to gain market share in the rest of the world. The sweet spot for Germany was a euro that was weak enough to help exports to the United States and China but not so weak as to collapse. Germany was successful in finding that sweet spot during 2010 despite the sturm und drang surrounding the euro itself.

  With the self-interests of the United States, China and Germany all pointing in the same direction, there would be no doubt for now about the survival of the euro. That the banks were flush with rotten assets, that the periphery nations were running nonsustainable fiscal policies and that the people of Greece, Ireland, Portugal and Spain were facing austerity in order to keep the assembly lines moving in Seattle and Shanghai were all matters that could wait for another day. For now, the center held.

  The Eurasian Theater

  If the relationship between the euro and the dollar can be described as codependent, the relationship between the euro and the yuan is simply dependent. China is fast emerging as a potential savior of certain peripheral European economies such as Greece, Portugal and Spain based on Chinese willingness to buy some of their sovereign bonds in the midst of the European sovereign debt crisis. However, Chinese intentions toward Europe and the euro are based on self-interest and cold calculation.

  China has a vital interest in a strong euro. The European Union surpasses the United States as China’s largest trading partner. If European turmoil were to result in countries such as Greece or Ireland leaving the euro, those countries would return to their former currencies at greatly devalued rates relative to the yuan. This would badly hurt China’s exports to parts of Europe. China’s interest in supporting the euro is as great or greater than its interest in maintaining the yuan peg against the dollar.

  China’s motives in Europe include diversifying its reserve position to include more euros, winning respect or friendship among the European countries that it assists directly with bond purchases, and gaining a quid pro quo in connection with such purchases. This quid pro quo can take many forms, including direct foreign investment in sensitive infrastructure such as ports and power generation, access to sensitive European technology and the ability to purchase advanced weapons systems normally reserved for NATO allies and friends such as Israel. China’s interests in supporting the euro are not at all adverse to those of Germany, even though Germany and China compete fiercely for export business around the world.

  By buying sovereign bonds from peripheral European states, China helps Germany to bear the costs of the European bailouts. By helping to prop up the euro, China helps Germany avoid the losses it would suffer if the euro collapsed, including catastrophic damage to German banks. It is a no-lose situation for China and one that secures its Eurasian flank while it fights the United States head-on. China’s main front in the currency wars is the United States, and it has so far avoided a conflagration on the Eurasian front. This is due both to European weakness and Chinese finesse.

  The United States likewise supports the euro, and for the same reasons as China: a catastrophic collapse of the euro would weaken its value relative to the dollar and hurt U.S. exports that compete with European exports in markets of the Middle East, Latin America and South Asia. China and the United States not only want the euro to survive; they also want to see it gain strength relative to the dollar and yuan in order to help their own exports. Europe, China and the United States are united in their efforts to avoid a euro collapse despite their mixed motives and adversarial postures in other arenas.

  This much unity of purpose probably means that the euro will muddle through the current crisis and remain intact for the foreseeable future, despite potential bond restructurings and austerity plans. Whether this balancing act can be continued and whether China’s charm offensive in Europe will be maintained remains to be seen. If the euro actually does collapse, China could suffer massive losses on its bond positions, a revaluation of the yuan and lost exports all at the same time. China may yet come into confrontation with Europe on a number of issues, but for now it is all quiet on China’s western front.

  Global Skirmishes

  Apart from the big three theaters in the currency war—the Pacific (dollar-yuan), the Atlantic (euro-dollar) and the Eurasian (euro-yuan) —there are numerous other fronts, sideshows and skirmishes going on around the world. The most prominent of these peripheral actions in the currency war is Brazil.

  As late as 1994, Brazil maintained a peg of its currency, the real, to the U.S. dollar. However, the global contagion resulting from the Mexican “Tequila Crisis” of December 1994 put pressure on the real and forced Brazil to defend its currency. The result was the Real Plan, by which Brazil engaged in a series of managed devaluations of the real against the dollar. The real was devalued about 30 percent from 1995 to 1997.

  After this success in managing the dollar value of the real to a more sustainable level, Brazil once again became the victim of contagion. This time the crisis did not arise in Latin America but from East Asia. This new financial crisis broke out in 1997 and spread around the world from Thailand to Indonesia, South Korea, and Russia and finally came to rest in Brazil, where the IMF arranged a monetary firewall with emergency funding as the Fed frantically cut U.S. interest rates to provide needed global liquidity. In the aftermath of that financial storm, and under IMF prompting, Brazil moved to a free-floating currency and a more open capital account, but it still experienced periodic balance-of-payments crises a
nd required IMF assistance again in 2002.

  Brazil’s fortunes took a decided turn for the better with the 2002 election to the presidency of Luiz Inácio Lula da Silva, known as Lula. Under his leadership from 2003 through 2010, Brazil underwent a vast expansion of its natural resource export capacity along with significant advances in its technology and manufacturing base. Its Embraer aircraft became world-class and catapulted Brazil to the position of the world’s third largest aircraft producer. Its huge internal market also became a magnet for global capital flows seeking higher returns, especially after the collapse of yields in U.S. and European markets following the Panic of 2008.

  Over the course of 2009 and 2010, the real rallied from fewer than 2.4 reais to the dollar to 1.69 reais to the dollar. This 40 percent upward revaluation of the real against the dollar in just two years was enormously painful to the Brazilian export sector. Brazil’s bilateral trade with the United States went from an approximately $15 billion surplus to a $6 billion deficit over the same two-year period. This collapse in the trade surplus with the United States was what prompted Brazilian finance minister Guido Mantega to declare in late September 2010 that a global currency war had begun.

  Because of the yuan-dollar peg maintained by China, a 40 percent revaluation of the real against the dollar also meant a 40 percent revaluation against the yuan. Brazil’s exports suffered not only at the high end against U.S. technology but also at the low end against Chinese assembly and textiles. Brazil fought back with currency intervention by its central bank, increases in reserve requirements on any local banks taking short positions in dollars, and other forms of capital controls.

  In late 2010, Lula’s successor as president, Dilma Rousseff, vowed to press the G20 and the IMF for rules that would identify currency manipulators—presumably both China and the United States—in order to relieve the upward pressure on the real. Brazil’s efforts to restrain the appreciation of the real met with some short-term success in late 2010 but immediately gave rise to another problem—inflation. Brazil was now importing inflation from the United States as it tried to hold the real steady against the dollar in the face of massive money printing by the Fed.