Currency Bubble

Reading through the article ("As Dollar's Value Falls, Currency Conflicts Rise" by Graham Bowley, The New York Times, 20 October 2010), this shows that even on the world stage, countries are still govern by the the fundamental principal of Adam Smith, it being self-interest.

United States and Europe, each still facing recessionary issues could only have weaker currencies in the near term. However, their currencies are unable to depreciate due to the intervention of central banks from export-reliant nations. These central banks would buy the Dollar and Euro to weaken their own respective nations' exchange rate.

Exchange rate intervention has always been a debatable issue. Countries who use exchange rate intervention to smooth out huge fluctuations, preventing sudden appreciation/depreciation of the currency but still enabling market forces to decide on the long term exchange rate is considered good. For others who use exchange rate intervention to decide upon their own preferred rate is frowned upon as the long term rate is not determined by market forces.

With the current exchange rate intervention done by central banks of export-reliant countries, they are making their own currencies to be weaker than the Dollar and Euro. This may seem like an excellent short term idea, so that their own exports are cheaper and they would be able to foster a export-growth GDP. However, when there is huge influx of capital flows moving from United States and Europe to these export-reliant nations, exchange rate intervention is going to create negative repercussions for the long term.

Grahman talks about the points on asset bubbles in the stocks and property markets in the article, these I would not mention again. I would just make a simple example of what I want to bring forth.

"Hot money" always seek the highest return if not higher return. Since the interest rate in United States is near or is zero, there is little incentive to place money in Dollar denominated deposits. "Hot money" would flow to export-reliant nations who have higher interest rates. Of course, the "hot money" would be converted to the local export-reliant nation's currency. This is now a great bargain since the export-reliant nation has a weaker exchange rate. These flows would continue till it is deemed that the risks of placing in the export-reliant nation is greater than the interest rate return.

If all of a sudden, there is a reverse flow of "hot money" from export-reliant nation to United States due to improved changes in the economic fundamentals of the United States, the export-reliant nation will need to keep selling Dollars and buy back its own currency. Now, if the "hot money" received earlier is greater than the export-reliant nation's currency reserve, there would be grave consequences. The export-reliant nation could go bust and have an exchange rate so low that prices of imports will skyrocket, causing economic hardship for its citizens. This in turn may result in social and political unrest.

Central bankers need to discuss and arrive at a decision on how best to resolve this current unprecedented challenge ever since the Gold Standard was abolished.