Back in the good old days of international trade currencies were generally tied to a commodity, such as gold. This fact made it imperative that a country retained adequate currency reserves for its own use. Should trade with another country become unfavorable and money start to flow out too fast, tariffs would be created or raised to form a financial barrier with the intention of protecting the nation's monetary reserves. This is called protectionism.
Often the country who was on the favorable end of the trade would become upset that the opposing country's new tariffs were cutting into their good fortune and they would slap on tariffs of their own in retaliation. This is called a trade war.
It has been stated recently by a noted economist, that protectionism has come to an end. I would argue that is has taken a new form.
We are now living in an era of largely digital currencies that are not tied to commodities and there have never been more free trade agreements between countries around the globe than right now. The concern among governments regarding the physical flow of money out of their nations is no longer as pointed as in past times, simply because their own governments can create more currency at a keystroke.
Free-floating digital currencies provide governments a wide range of flexibility compared with past times. It is very tempting for those governments that are feeling a trade imbalance that is not in their favor or those wishing to stimulate their economies to simply weaken their currency. This appears to be what we are seeing with the policies and interests of Japan's new leader Abe and the downward pressure that Japan has recently been placing on the yen.
Since the rise of modern global free trade agreements its has become unpopular and much more politically risky for governments to use tariffs as a tool of protectionist policies. However, human nature has not changed and the desire to protect one's own nation in times of distress from outsiders is still alive and well and is becoming visible in the more modern version of protectionism.
Whereas protectionism in past times was often carried out via the use of tariffs with the intent of guarding a nation's monetary supply from outflows, it would appear that now it would be fair to call weakening one's currency for trade benefits the more modern and increasingly popular form of protectionism.
It is also fair to ask whether currency weakening is about a country's internal monetary policy or about trade. Certainly both are affected. International trade agreements and messy international incidents can be sidestepped by weakening one's currency rather than raising tariffs but the risks internally to the nation and to its trade partners are potentially much greater than the use of tariffs.
Is is fairly easy to see that a currency war could start with a country focusing monetary easing measures on their own internal stimulus. Suddenly, that country's trade partners awaken to the fact their currency situation is no longer favorable enough for their own trade in reference to the country that has taken monetary easing action and the currency weakening wars begin.
The old protectionism tool of tariffs and the more modern version of protectionism (monetary easing/currency weakening) carry different potential risks and side effects.
The old protectionism (the use of tariffs) generally led to a contraction of a country's GDP because overall economic activity decreased.
The modern protectionism (monetary easing/currency weakening) carries the danger that it will appear for a time as if economic activity is increasing because of monetary easing. This could go on until it is pushed too far and inflation kicks in.
This type of situation would be most dangerous for the countries with the highest debt load. As inflation rises, more and more people will join the ranks of the poor as they can no longer afford the necessities. The government then has to increase assistance programs which grows the nation's debt. This then leads to higher taxes and slower growth and more stimulus is needed. A vicious cycle forms, that will in time likely cause sovereign debt holders to lose faith in a country's credit and could cause interest rates to rise dramatically.
At the present time, Japan appears to be following a path of currency weakening that could be the start of a currency war. Please see this Nasdaq news link on Japan's new leader's view.
Recently, a very profitable currency trade has been to go long the EUR/JPY cross. This trade will likely continue to be profitable for some time, especially if Germany and the ECB stick with their stance of austerity in reference to monetary policy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.