The world economy faces a new threat. Instead of a banking collapse or too much debt, fears are growing that countries are using their currencies as an economic weapon.
History suggests that's never a good thing.
If too many countries try to weaken their currencies for economic gain — sparking a "currency war" — that could stifle business confidence and investment, sow turmoil in financial markets and derail a fragile global economy.
Following their meeting in Moscow this weekend, financial representatives from the world's leading 20 industrial and developing countries warned that "excess volatility of financial flows and disorderly movements in exchange rates have adverse implications for economic and financial stability."
Why is everyone talking about currencies?
— Since the start of the financial crisis, central banks around the world have been trying to stimulate their economies by keeping interest rates extremely low. The goal is to encourage consumers and businesses to borrow and spend more. One way central banks drive down rates is to use their power to print money to buy up large quantities of bonds. But by boosting the amount of currency in circulation, there is a side effect: it can drive down the value of that currency relative to others.
As a country's currency falls, its exports become cheaper, while those of its neighbors become relatively more expensive.
Japan, the world's third-largest economy, is currently under the harshest spotlight. To get its economy motoring again after a two-decade bout of stagnation, the government has said it would like to see inflation move higher. Markets have interpreted this as a signal that Japan's central bank is prepared to take actions that would result in driving down the yen, to boost exports and also put upward pressure on prices. Earlier this week, the yen fell to a 21-month low against the dollar and a near three-year trough against the euro.
So is Japan actively trying to weaken the yen?
— Yes and no. Though it's not directly intervening in the foreign exchange markets by selling yen and buying other currencies, strong comments from the new Japanese government have convinced markets that the Bank of Japan will create more money. Japan's Finance Minister Taro Aso insists the government isn't focused on exchange rates, but he has noted that the weakening yen has "brought huge benefits to the export sector" and that the world "has been awed" by the recent surge in share prices.
Why is that bad?
— A falling yen will help exporters, such as Sony and Toyota, and boost Japan's economy. And it will it tend to push prices - and ultimately wages — higher. But if other countries respond to the falling yen by devaluing their currencies — to maintain the competitiveness of their own exports — Japan will be back to square one and the world economy could suffer.
Sharp fluctuations in the value of currencies can hurt business confidence and investment. Prices for imported raw materials and components would be volatile, profits will be hard to come by as prices fluctuate wildly and the value of any investment a company makes in another country could quickly be wiped out.
Who's been feeling the effect of Japan's actions so far?
— The euro, the currency used by the 17-strong group of European Union countries, has seen the biggest move on the foreign exchange markets. As the region moved on from its crippling debt crisis last summer, the euro has slowly gained in value. But since the change of government in Japan, its value against leading currencies such as the yen and U.S. dollar has shot up — last December it was worth 113.19 yen and $1.29 and now it's at 124.93 yen and $1.33.
A rise in the value of the euro will do little to help the eurozone's businesses — and will hardly help getting it growing again. Figures Thursday showed that the economic output of the region shrank at an annualized rate of around 2.5 percent in the last quarter of 2012.
What's been the reaction from other major economies?
— Politicians have voiced concerns about the euro's rise versus other major currencies — most notably French President Francois Hollande, who indicated he was open to calls for a more managed exchange rate. European Central Bank President Mario Draghi said last week that the bank will monitor the economic impact of the euro's rising value. Several analysts took that to mean the ECB could cut interest rates to bolster growth, which in theory could weaken the euro — an indirect tit-for-tat response to the yen's fall, some say.
Earlier this week, the volatility in the currency markets prompted the Group of Seven leading industrial nations, which includes the U.S, Germany as well as Japan, to warn about the effects of volatile movements in exchange rates.
Might other countries try to manipulate their currencies in response to Japan?
— There is no sign of that — so far. Speaking in Moscow Saturday, International Monetary Fund Director Christine Lagarde dismissed the possibility of an international currency conflict, saying that she was witnessing "currency worries, not currency wars."
But a country fixing the value of its currency is not without precedent.
In Sept. 2011, Switzerland took action to arrest the rise of its currency, the Swiss franc. The rise was triggered by the debt crisis in the eurozone — investors were looking for somewhere safe to park their cash and the Swiss franc has traditionally fulfilled that role. The Swiss intervention was viewed as an attempt to protect the country's exporters.
U.S. politicians have for years accused China of keeping its currency, the renminbi, artificially weak in order to industrialize fast. And many countries believe the U.S. long ago abandoned the "strong dollar" policy in a dash for growth.
How bad could a currency war get?
— Since World War II, one of the key objectives of international economic policymaking has been to avoid a repeat of the 1930s, when countries around the world engaged in a tit-for-tat battle with their exchange rates. That decimated global trade, accentuating the depression and providing another catalyst to war.
Assuming the world doesn't descend into a similar abyss, a currency war can still harm the global economy. For example, central banks, particularly in the developing world, may resort to controlling the amount of capital that can be moved out of a country to affect exchange rates.
"Increasing impediments to the free flow of capital might be thought to lower the potential growth of the world economy," said Stephen Lewis, chief economist at Monument Securities.
Can the world's leaders and central bankers calm the situation?
— As many analysts had expected, this weekend's G-20 meeting in Moscow finished on Saturday with a warning on the dangers of competitive devaluations and a pledge that it will "not target our exchange rates for competitive purposes, will resist all forms of protectionism and keep our markets open."
The G20 communique — and the G7 statement earlier this week — failed to single out one country's actions for criticism.
Sung Won Sohn, an economics professor at the Martin Smith School of Business at California State University, said that should come as no surprise.
"Many countries including China, Japan and the United States all have issues related to exchange rates," he said. "People in glass houses should not throw stones."