Inflation, Deflation, and global currency wars

America is involved in many wars right now, lets list them shall we?

1. Iraq
2. Afghanistan
3. Libya (See War Powers Resolution, and how law is ignored. )
4. War on terrorism (Bin-laden...recent military action)
5. War on drugs ( Mexico's border is flaring up badly )
6. Currency War
7. Arguably, a global simmering trade war

Wow, thats quite a bit of wars! The first three are relatively easy to grasp by most people. The countries involved are "over there" and we send military to change a political situation.

The next two are a bit more complex, as it is arguably everywhere in the world. The shape and form however to bubble to the forefront when clashes occur. It could be in the form of the bad guys killing people, or a counter attack by the good guys (USA). Again, within reason, graspable.

The last two are very subtle wars, Currency and Trade wars. Each take their own form and shape of political maneuvering, like a very big chess game. Spectators watching may not easily grasp all the various possible moves and 10 moves ahead the players are planning for.

The USA made some very shrewed policy changes in it's day, one of the least recognized is what Nixon was able to do. At that time, the US dollar was the defacto standard for currencies. However, the US dollar was convertible to gold. America had started accelerating it's budget imbalances, and other countries were asking the US for larger and larger gold conversions.

Nixon's administration assessed the situation and realized the world would have no choice, but to support the dollar even if it became a pure fiat currency. At that time, America was a manufacturing and military powerhouse. The shackles of money tied to shiny rocks was eliminated, and America could do what it wishes with it's currency.

The chess play here is simply this. Say, other countries want to trade with America. And lets say that America gives US dollars in exchange for goods at a rate that is "unfair" to the other country. Let's assume America isn't providing valuable goods back to the same country and the deficit is basically IOU's in the form of dollars.

Countries COULD turn around and dump the US dollars, in exchange for other goods and services from other countries. It could even invest that money back into the USA by purchasing assets. But if they did so, that would apply pressure on THEIR FIAT currencies to rise, as their currency would gain strength relative to the over-printing of US dollars.

This you would think is a good thing, and in many ways it is. But the net effect would be that countries exports would go up in cost relative to any other country that is prices relative to US dollars. Over time, as the US deficits spends more, their currency would rise high enough to cripple exports.

What to do? Simple, keep US Treasuries or cash and sit on it. Each year allow your holdings of US dollars to build. Since the global currency system is based on fiat currencies, each currency floats RELATIVE to each other. And since historically (since WW2) the trading patterns have been dependent on US dollars, the world has been forced, and WILL CONTINUE to be forced to finance the US over-consumption and lack of production.

Fast forward to today, and the US is deficit spending 1.5 trillion per year in ADDITION to the revolving bond debt that matures on the outstanding 14 trillion of debt.

Now, lets turn to China!

China's currency does not float, and China aggressively locks their currency to a very specific level to US dollars. So while other countries may somewhat try to keep their currency stable to US dollar trade, they do allow a bit of flexing to help ease economic imbalances. (think Euro hitting all time highs against USD).

China however does not. So what possible effect could this have? China's command economy dictates that politicians set policy to maintain the currency imbalance with respect to the USA. This has the unfortunate side effect of excessive credit and currency in their own country, resulting in inflation.

Inflation in China is high right now, and China has been fighting hard to keep prices stable for it's exports, including to the USA. This relationship has been maintained since Reagan, and is partially responsible for the US corporation exodus to China.

Well today, I see a crack in this relationship. China is allowing electric costs to rise. That will in turn force manufactures to charge more. That will result in prices from China to rise. (think Walmart, or Apple) Apple btw, to their credit is heading this off by diversifying suppliers. And despite the US economy being in a fragile state, we may see prices rise in stores, beyond the recent food and gas price surges.

The situation is of course, unsustainable. But that won't stop everyone from keep on doing what they are doing know. The US will continue to deficit spend high amounts. China will continue to try to keep it's currency stable vs the USA. But once rising prices start snowballing out of china, this game will change in shape, form, size, and velocity.

The global economy will take a turn for the worse as China tries to redirect rising prices back out to America and the world.

We live in interesting times.