Thursday, September 30, 2010

The mechanisms of a currency war (21st century trade war)

Now that we know WHY countries want to debase their currencies, let's explore HOW they are doing it. If a sovereign central bank wants to devalue the local currency, they simply buy USDollars. Buying USDollars has the net effect of selling the local currency, driving down the value of that local currency. The intervention mechanisms are becoming more complex, as central banks are using derivatives in the foreign currency markets. But all things being equal, they buy the USDollar and short their local currency. The Fed and US Treasury are more than willing to print more USDollars to accommodate Congress, the Administration, and US government and consumer spending. The global financial system is built on a glut of USDollars--and the debt resulting from the creation of said dollars. Of course, this puts a higher burden on US taxpayers.

The world is awash with USDollars--that is the lighter fluid. Money velocity--the so-called multiplier effect of money exchanging hands, is the match. Once lit, prices rise as multiple dollars chase a finite supply of goods and services. This causes price inflation, something the Fed believes is under their control, as they attempt to fight a spiraling deflationary environment. The problem is that inflation can turn into hyperinflation overnight. A controlled fire can morph into an out of control, ranging combustion.

A depression is terrible, but hyperinflation is much worse, as it causes a complete loss of confidence in the currency.

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