Brazil: “The last time there was a series of competitive devaluations. . . it ended in world war two.”

“It’s no use throwing dollars out of a helicopter,” Guido Mantega, the finance minister, said on Thursday. “The only result is to devalue the dollar to achieve greater competitiveness on international markets.”

At a joint press conference with president-elect Dilma Rousseff, outgoing president Luiz Inácio Lula da Silva said on Wednesday he would travel to the G20 summit in Seoul with Ms Rousseff, ready to take “all the necessary measures to not allow our currency to become overvalued” and to “fight for Brazil’s interests”. “They’ll have to face two of us this time!” he said.

Ms Rousseff added: “The last time there was a series of competitive devaluations. . . it ended in world war two.”

–Brazil ready to retaliate for US move in ‘currency war’, FT

Is it just me or is it sounding a lot like the G-20 in Seoul is going to be a big mess? As I said last month, you should expect the rhetoric to escalate because this is a race to the bottom for the developed countries. First the rate reductions, then money printing, then the currency war, then the tariffs, then…. Obviously, the incoming Brazilian President’s hot rhetoric is in direct response to quantitative easing. So, this is a clear signal that QE will have unintended negative consequences for the emerging markets. Martin Wolf thinks America is going to win the global currency battle. Last month he wrote:

Aggressive monetary policy by reserve-issuing advanced countries, particularly the US, is an element in both processes. The cries of pain now heard around the world, as markets push currencies up against the dollar, partly reflect the uneven impact of US policy. Still more, they reflect the stubborn unwillingness to accept the needed changes, with each capital recipient trying to deflect the unwanted adjustment elsewhere.

To put it crudely, the US wants to inflate the rest of the world, while the latter is trying to deflate the US. The US must win, since it has infinite ammunition: there is no limit to the dollars the Federal Reserve can create. What needs to be discussed is the terms of the world’s surrender: the needed changes in nominal exchange rates and domestic policies around the world.

But doesn’t this just lead to the next phase of the competitive currency devaluation – capital controls and eventually tariffs? I don’t think this is a winnable war, frankly. The world is too interconnected. As America tries to inflate, it creates too many moving parts for the Fed to be able to control.  For example, look at oil, now closing in on $90 a barrel. As I remember it, the commodity bubble of 2008 was a direct consequence of easy money and it sows the seeds of its own destruction in terms of demand destruction and recession.

On a different note, I have been thinking about the end game here. In the past, it was mounting external imbalances which exposed fault lines in each monetary system after World War I.  The gold standard came to an end because of imbalances, particularly between Britain, France and the U.S as Britain re-pegged to gold at an inflated rate.  Bretton Woods came to an end for similar reasons. And remember, both of these monetary systems involved gold. It’s not like the gold standard protects the world from global imbalances.

What I think happens here is that governments always want to have their cake and eat it too.  Eventually some major actor in the global system comes up against a diminished global profile and tries to fight this with an inflationary fiscal policy that ends up debasing the currency. Imbalances build, but more critically, debt builds up too. And when a recession hits, the debt deleveraging asserts itself. It is axiomatic that the imbalances created by this situation would become a sore spot and create tension. Is it not just as axiomatic that this tension leads to a collapse of the monetary system?

My question is this: who is the leader that brings the world together and shows the fortitude to prevent this escalating to the next step of capital controls followed by tariffs. Is it Obama? Rousseff? Medvedev?  I just don’t see the scenario where this de-escalates. I’m having a tough time figuring out how this problem goes away. Perhaps a multi-year recovery and asset price boom will do the trick. In that scenario, emerging markets would outperform and productivity would increase, allowing the developing nations to handle the increased debt that their economic growth and turbo-charged asset markets would create. So, either the Fed successfully inflates asset prices, shifting some of the debt burdens abroad without retaliation or we are going to have serious problems.