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A currency war is the great temptation of international finance, and a new one has begun. Whether it spins out of control like the great currency wars of the 1930s and 1970s, or is contained at an early stage, depends on policy choices and our will to implement them.

It’s easy to understand the temptation. Growth runs on a four-cylinder engine of consumption, investment, government spending and net exports. Consumption is now treading water because of the feedback loops among consumer debt, negative home equity and unemployment. Investment, despite some recent strength, is hurt by high taxes and lack of final demand. Government spending helped to paper over weakness in 2010, but is now hitting a wall of grass roots opposition, debt ceiling acrimony and drastic cuts at the local level.

With three cylinders sputtering, attention turns naturally to the fourth – exports. And the fastest, easiest way to goose exports is by cheapening one’s currency. This has been U.S. policy since President Obama, in his January 2010 State of the Union Address, announced the National Export Initiative (NEI) - designed to double exports in five years. Since U.S. businesses were unlikely to get twice as smart or twice as productive so quickly, cheapening the currency became the not-so-hidden way to achieve this goal. The most recent GDP numbers show exports rising at a 4% annual rate, indicating some early success in this initiative.

The cheap dollar policy was warmly embraced by Ben Bernanke, who as a new recession dawned in 2007 due to collapsing money velocity and an emerging liquidity trap, desperately staved off deflation with massive liquidity infusions. One of Bernanke’s Princeton mentors, Lars Svensson, wrote a seminal paper in 2003 on the “Foolproof Way” to escape a liquidity trap in which he said, “Even if the ... interest rate is zero, a depreciation of the currency provides a powerful way to stimulate the economy.” Bernanke’s own writings on the Great Depression argue that the countries that devalued their currencies earliest were first to emerge from the worst of the depression. Those who waited to devalue suffered longer. Since devaluation steals growth from trade partners, this is like saying that if I steal your wallet, I’ll be better off - yet it is Bernanke’s preferred model.

Currency wars, like real wars, follow Von Moltke’s dictum that “no plan survives contact with the enemy.” Unintended consequences conspire against the brightest minds, and currency devaluation sometimes proves less effective at increasing exports than expected.

For example, due to complex global supply chains, few sophisticated goods are today produced entirely in one country. Some estimates show that the Chinese value added to of the cost of an iPhone imported into to the U.S. is less than 8% of the final price. This means that a 50% devaluation of the yuan against the dollar will only affect the price of an iPhone by 4%, if that. Devaluation of the dollar may also lead sooner than later to higher input costs, competitive devaluations, tariffs, embargoes and global recession as in the 1970s.

The main battle in the new currency war is the confrontation between the U.S. and China. In China’s view, a pegged exchange rate between the dollar and the yuan enabled both countries to make decisions on foreign direct investment, portfolio investment, reserve policy and trade in an atmosphere of certainty and stability. It was a throwback to the Bretton Woods period when fixed exchange rates fostered spectacular global growth amid price stability. The Chinese did not reckon with the U.S. desire to steal their wallet with a cheap dollar. To that end, the Fed’s tortured path through QE, QE2 and Operation Twist is best understood not as conventional monetary easing but as a concerted effort to break the China peg.

The inflation the Fed’s critics have been looking for in the U.S. since 2007 was actually exported to China, as the People’s Bank of China frantically printed yuan to soak up the dollars being pumped out. Recently the PBOC cried uncle in the face of Chinese inflation and revalued the yuan. The damage was not just confined to China, but also effected countries from South Asia to Brazil hit by friendly fire from Fed-inspired commodity price inflation. Bernanke changed beggar-thy-neighbor to beggar-the-world.

The Fed won this round in the currency wars, but is likely to regret it. Once the Chinese no longer import our inflation, it will come back to haunt the U.S. exactly as inflation haunted Nixon, Ford and Carter in the 1970s. The 1970s currency war was aimed at Germany and Japan, both of which remain export powerhouses to this day. So much for the idea that a cheap dollar helps the balance of trade.

Making categorical predictions on the outcome of a currency war is a fool’s errand. In fact, there are four completely possible outcomes to today’s untenable situation, each with its own indications and warnings. The first scenario is a world of multiple reserve currencies where the dollar’s percentage of global reserves drops from the current level of 60% to 40% while the euro rises to 40% and other leading currencies make up the remainder. Barry Eichengreen of Berkeley points out that multiple reserve currencies were the norm in the 1920s and 1930s, as the dollar and sterling shared the limelight. Yet he fails to consider that both were anchored to gold at the time. The world has never seen multiple reserve currencies without an anchor. Instead of one central bank (the Fed) abusing its privileges, we might have many.

The second scenario is a world in which all currencies can only be used locally, and world trade, accounting, invoicing and reserve balances are maintained in special drawing rights or SDRs issued by the IMF. An SDR is just paper money backed by nothing and printed by the IMF acting in its role as a proto-world central bank under G20 direction. A detailed blueprint for this SDR system was released by the IMF in January 2011 and deserves scrutiny.

The third scenario is a return to the gold standard on a global basis as the result of a new Bretton Woods style conference. The implied price of gold, using combined M1 for the U.S., China and the euro-system with 40% gold backing, is $7,000 per ounce.

The last scenario is chaos - resulting from a complete loss of confidence in the dollar. Chaos would not be anyone’s desire or plan, but it could very well result from some combination of denial, wishful thinking and persistence in the use of non-dynamic paradigms by central banks.

What could be done if currency war chaos emerged? In the event of an unexpected and catastrophic dollar collapse, the U.S. has two secret weapons to restore monetary order to the world. The first is the International Emergency Economic Powers Act of 1977, the successor statute to the Trading with the Enemy Act of 1917. FDR used the 1917 law in 1933 to order Americans to surrender their private gold on pain of imprisonment and close every bank in the country. IEEPA gives a U.S. president today similar dictatorial powers on easy to establish predicates.

The second secret weapon is 8,000 tons of gold controlled by the U.S. Army at West Point and Fort Knox. Taken together, IEEPA and the gold hoard could be used to create a new gold-backed currency that would be in high demand (of course, it would be far better to commence a multi-year, expert study of the best way to return to the gold standard). The U.S. gold hoard gives America a feasible Plan B in the event of a currency collapse and an enormous advantage over gold weaklings such as China, Brazil, Russia and Japan. Interestingly, the other gold superpower is the 17-member euro-system with over 10,000 tons – more than the U.S.

The national security community is not oblivious to the dangers of a dollar collapse, and understands the importance of a strong dollar to our defense posture and America’s ability to project power. In fact, recent defense secretaries and intelligence directors have sounded the alarm and tried to do something about it.

Secretary of State Clinton has made explicit the linkage between economic strength and diplomatic strength, while in 2009 the Pentagon sponsored the first ever financial war game at the top secret Applied Physics Laboratory near Washington, D.C. There, kinetic methods were banned, and the contestants struggled for power using currencies, stocks, bonds, commodities and derivatives. I was part of the game design team and a war game participant on the China team. Some of the tactics used and results achieved, especially the use of gold to usurp the role of the dollar, surprised the generals and spies in attendance. Unfortunately, the Fed and Treasury continue to go their own way, weakening the dollar by continuing obsolete Keynesian and Monetarist dogma, and seeming oblivious to the new world of complexity theory and asymmetric warfare.

The path to economic growth is not through a weak dollar but through a sound, stable dollar and a business climate that favors entrepreneurship, innovation, education and technological adaptation. The policies needed are straightforward: reduce or eliminate capital gains and corporate income taxes, flatten the personal income tax, cut government spending, break up the big banks and close the insolvent ones, repeal Dodd-Frank and Sarbox, reenact Glass-Steagall, ban most derivatives and make finance the servant of commerce and not a grotesque end-in-itself. Banking should be a boring utility-like function, not a rent-seeking high wire act. Interest rates should be raised immediately to reward savers and make dollar deposits the destination of choice for global capital flows.

I did not become an advocate of a gold standard by predilection. In fact, decades in fixed income markets at banks and hedge funds left me with a natural affinity for the workings of federal finance and the importance of King Dollar. But our current weak dollar policies and the instability of the system as a whole have given investors no choice but to maintain some gold allocation as proof against an almost inevitable dollar catastrophe - or until the political system, against all odds, produces a new Volcker and a new Reagan.

The dollar, for all its faults and weaknesses, is the pivot of the entire global system of currencies, stocks, bonds, derivatives and investments of all kinds. While all currencies represent some store of value, the dollar is different. It is a store of value in a nation whose morals and ethics are historically exceptional and therefore a light to the world. The debasement of the dollar cannot proceed without the debasement of those values and that exceptionalism.

James Rickards is the author of the just-released, New York Times and national bestseller: Currency Wars: The Making of the Next Global Crisis.

Source: The Pending Currency War And What We Can Do About It