The Law of Unintended Consequences

As I sat down at my desk this morning, one of the first things that I noticed was the further weakening of the Yen (Fig: 1), moving through the 115 mark to the US Dollar. It made me think of that old expression: “the law of unintended consequences”.

For those of you that are not familiar with this concept, it is “(A)n adage or idiomatic warning that an intervention in a complex system always creates unanticipated and often undesirable outcomes. Akin to Murphy’s Law, it is commonly used as a wry or humorous warning against the hubristic belief that humans can fully control the world around them.” [Source: Wikipedia – 2014]

So why am I mentioning this? As outlined in our previous Weekly Comment, the Bank of Japan (“BOJ”) has massively upped its quantitative easing (“QE”) programme (aka money printing) and with it the Yen has weakened against the US Dollar. It is this latest bout of central bank largesse that has led me to consider how actions within one economy often lead to opposing actions in another. The Yen has now weakened to a seven-year low in US Dollar terms and has depreciated by over 40% against the Euro, Korean Won and US Dollar since mid-2012 and by 50% against the Chinese Yuan.

Fig: 1 [Source: Bloomberg – November 2014]

One has to wonder what other Asian countries, especially China, will do now that the Yen has materially devalued? A weaker Yen might support the Japanese stock market, but what about future currency wars? Will the Koreans sit idly by, while one of their biggest trading competitors slashes their prices? And more importantly, what will the Chinese do? Their economy is slowing, as can be seen by falling property prices, GDP that could track 5% (as opposed to the 9% of old) and purchasing manager surveys that disappoint. A strengthening Renminbi will also worsen deflationary pressures and will make it more difficult for the Chinese central bank to encourage spending, especially in the domestic side of the economy. According to the high profile commentator Albert Edwards of Societe Generale: “Japan is at the epicentre of a currency maelstrom, a replay of the Asian financial crisis from 1997-1998, though this time the region is a much bigger part of the global economy. China cannot tolerate this kind of shock, when it already faces a credit crunch and has suffered a massive loss in competitiveness. Foreign direct investment into China has already turned negative.”

Let’s also not forget Germany, which also competes against Japan. Will the European Central Bank now also move towards full blown QE? A weak Yen also spells trouble for the rest of the West. A wave of deflation will wash in from the rapidly devaluing East. Given that profits growth is so anaemic in the West, monetary tightening, via strengthening exchange rates, could be enough to send U.S. and European profits into outright decline.

We sadly don’t have a crystal ball at MitonOptimal, but currency wars are a very real threat in the world today. It will probably lead to a race to the bottom as central banks all try to print faster than each other. This additional liquidity should underpin the market for a while still, but deflationary pressures may ultimately become too pervasive.