Gold News

Currency Zugzwang!

This currency war is like a giant game of money chess. But who's winning...?

REGARDLESS of how bad things get this week, just be thankful you're not the Greek finance minister, writes Dan Denning for the Daily Reckoning Australia.

Vassilios Rapanos resigned his post four days after being appointed. He'd been in the hospital after collapsing on Friday, probably after getting his first look at the real state of Greek finances.

Greece will be one of the items on the agenda at this week's European Union summit. The coalition led by new Greek prime minister Antonis Samaras pledged to renegotiate the terms of the previous bailout deal between Greece and the EU. That was the $163 billion deal.

As if that wasn't enough uncertainty for the EU, Spain has formally requested a $125 billion bailout for its banks. Cyprus joined the bailout queue overnight, too. Bloomberg reports that the island nation needs around $5 billion to recapitalize its banks after losses taken on Greek government bonds. Fittingly, Cyprus will assume the rotating Presidency of the EU on July 1.

The whole crisis is proceeding as expected. Marginal institutions at the periphery get locked out of the credit markets. Money flees to the core of the financial system. Anyone at the margin, or exposed to it, is left in no man's land.

In 2007, the firms at the periphery were US subprime lenders. Surprisingly, it turned out that emerging market stocks were at the periphery too. The risk is that emerging markets get smashed again. No one is going to sit around and debate whether the Chinas and Indias of the world can thrive without Europe. Money will walk while everyone else talks.

The institutions at the periphery today are governments that can't bailout their own banking systems without help from the outside. The problem is acute in Europe because the 17 countries that use the Euro currency don't have the option of printing money or unilaterally devaluing the currency to inflate away the debt and/or increase export competitiveness.

But all that is a bunch of blah, blah, blah. Let's think about today's currency events as moves in a war, or a giant game of currency chess, if you will. Let's assume the US Federal Reserve is playing its own game: lower short and long-term interest rates in order to keep 30-year mortgage rates low (allow refinancing of outstanding mortgages at lower rates) and especially in order to allow the Federal government to finance $1.5 trillion annual deficits as US households and businesses deleverage.

Good for you Fed. Well played. But the trouble is, the Fed effectively runs the rest of the world's monetary policy. The rest of the world is on the US Dollar standard. Low US rates mean everyone else has to competitively devalue (lower rates) to retain the established order. The Dollar is, as an ex-US Treasury Secretary once said, 'our currency but your problem.'

It's a problem now for Europe. And for China. The Fed's quantitative easing gambit has put the rest of the world's currency players in the position of Zugzwang, where any move results in a weaker position. In chess, you're in Zugzwang when you must make a move that damages your overall position. Europe is in Zugzwang now.

Any move to strengthen the fiscal union results in political weakness. Any move to allow weak banks to fail results in a weaker Union and a weaker currency. In game theory, the Europeans are losing the game. So who is winning?

Well, so far you'd have to say the Fed. But don't count out the Chinese just yet. The Dollar peg has forced the Chinese to match US monetary policy. The result, until recently, was a property bubble. The Chinese know they need to get off the Dollar system. 

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Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

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