Market concerns about impending currency wars appear to be reaching new extremes.
Not a day goes by almost without some warning from the IMF or a government spokesman about the consequences of the world slipping into such "beggar thy neighbour" currency policies, competitively depreciating the value of their currencies against one and other.
Although the basis for such concerns appears to be relatively thin at the moment, at least by historical standards, there is always the danger the world could talk its way into a currency crisis, which would carry severe consequences. Intervention by the Bank of Japan (BoJ) to depress the yen a fortnight ago appears to have sparked off the latest debate and this week the bank again moved to ease monetary policy, this time by cutting its already wafer-thin key interest rate and proposing a new fund to buy government bonds and other assets.
In recent weeks, the central banks of Thailand, Indonesia and Korea have also been suspected of depressing the value of their respective currencies and Brazil has tightened its capital controls in an attempt to reduce inflows into the Brazilian real. At the same time the pressure on the Chinese to allow greater appreciation of its currency, the yuan, is mounting in both Washington and Europe. So far, however, the amount of intervention by the BoJ has been relatively light compared with the past. Intervention by the bank between 1993 and 2000 was estimated to be worth at least US$250 billion (Dh918.31bn). However, its intervention of a fortnight ago was just $25bn, compared with $67bn when the BoJ last intervened in 2004.
Even so, there is the clear prospect of more to come should its initial efforts not succeed in weakening the value of the yen. At the root of the problem is the US monetary policy of zero interest rates and quantitative easing, injecting enormous amounts of dollars directly into the global financial system, which is having the effect of distorting markets around the world. This is serving to bring down US interest rates to unprecedented low levels, depressing the value of the world's largest reserve currency, the US dollar, in the process. In so doing, the fresh liquidity in the financial system hunts for "carry", or higher returns, in emerging markets around the world, pushing these currencies ever higher and thus threatening the nascent recoveries that are under way. Accordingly, those countries respond to these inflows by seeking to depress their own currencies, giving way to a vicious circle of foreign exchange intervention, capital controls and, ultimately, protectionism and slower growth, possibly even a return to recession.
Other distortions are also observable in asset markets that don't even have much by way of intrinsic returns, such as gold or the yen. As the cost of borrowing dollars gets ever cheaper, speculative flows are attracted to these markets simply on the basis that it is assumed the wall of money will take them ever higher. It goes without saying that such speculative frenzies are inherently unstable and risk reversing sharply when interest rates do eventually begin to normalise.
In this latest wave of anxiety the markets are being exercised by thoughts of renewed quantitative easing in the US, when the Federal Reserve meets to set monetary policy next month. Here, too, perceptions may be running ahead of reality as the economic data of late has begun to improve a little compared with that seen in the summer. However, as is so often the case, perception can easily become reality if it is left unchecked and the momentum is now clearly on the side of the "doves" on the Federal open market committee.
The New York Fed president Bill Dudley has noted that US jobs growth and inflation was "unacceptable", giving the broadest hint yet that fresh quantitative easing is on the way. The amount and extent of Fed buying of US treasuries remains uncertain and is unlikely to be a repeat of the huge purchases that occurred last year when it bought more than $1 trillion, doubling the size of its balance sheet.
Nonetheless, the effect of such buying a second time round will be highly significant and probably influential. Other central banks may follow the US's lead (including the Bank of England) setting in train a chain of events that could ultimately be difficult to contain as more countries seek to keep pace with the dollar's decline. Although unlikely just yet, ultimately, it cannot be ruled out that the European Central Bank might be forced into renewed monetary easing either, given the austerity measures being implemented across the euro zone that will slow economic growth next year.
Ultimately, relative monetary policy adjustments are the stuff that driveforeign exchange markets most of the time, so the emphasis on these issues today as uniquely concerning appears to be a little exaggerated. Still, with politicians fanning the flames, the more the situation lends itself to exaggeration and hyperbole. And by those means it is easy to see how dangerous the environment can become, with currency wars or crises becoming an almost self-fulfilling prophecy.
That weak growth and persistent global imbalances are resulting in political tensions is in no doubt and these tensions are manifesting themselves in efforts to divert attention from problematic domestic agendas to easier global targets. With US Congress squaring up to China last week ahead of mid-term elections in November and the French president Nicolas Sarkozy seeking to distract attention from his own problems at home by championing global currency co-ordination at the next gathering of the Group of 20 leading and emerging economies, there does seem to be a political incentive to make the currency markets the scapegoat for leadership failings elsewhere.
If "war was the continuation of politics by other means", according to the German military theorist Carl Clausewitz, then currency wars may be viewed as the extension of military conflict by other means, now that the resort to war to settle differences is thankfully largely a thing of the past. Yet employing such tactics is not without its own risks: the chances of US import tariffs actually being imposed on China may still be quite slim and the likelihood of a new Plaza Accord, designed to regulate the foreign exchange markets, being imposed on currencies would also appear to be quite low.
But the mounting rhetoric surrounding currency markets today could easily lead to policy missteps that would ultimately result in weaker economic growth, not the recoveries they are purporting to assist. Tim Fox is the chief economist at Emirates NBD. He is writing here in a personal capacity