The currency markets - where impossible trinities go to die.
More often than not, devaluation of a country's currency acts as the outlet for failed domestic policy.
Three may be the magic number, but grouping things in threes has always caused problems. In the long history of schism within Christianity, the Trinity of father, son and holy ghost has often proved to be an issue of particular contention. Questions about whether Jesus was of the same body as God, or created out of nothing by God, occupied the debates and factions within the early church. The issue of the nature and purpose of the holy ghost or spirit also inspired much division.
By the seventeenth century, as scientific knowledge advanced, questions about the Trinity as a whole became more common, with some thinkers denying its existence in favour of a more abstract deism where god created the rules that governed the universe but was pretty much hands-off after that. Sir Isaac Newton was one such Trinity-denier, ironically given he was a fellow at Trinity College, Cambridge1.
Economics too has its trinities, the most important of which isn’t just problematic but impossible. A country cannot have a fixed exchange rate, free capital flows and a sovereign monetary policy all at once. Only two of the three can ever function simultaneously, hence its impossibility.
If one pegs one’s currency to another country’s, one loses control of monetary policy, especially the setting of interest rates. If one has free capital flows, one’s currency effectively floats in the foreign exchange markets. This is what makes this particular trinity impossible.
However politicians try, markets eventually make the reality of the impossible trinity abundantly clear. On the 16th September 1992, the pound sterling fell out of the European Exchange Rate Mechanism (ERM) in spectacular style, despite the best efforts of the then Chancellor of the Exchequer, Normal Lamont (photo above, incidentally with a youthful David Cameron in the background). Mr Lamont tried to fight the market by hiking interest rates to 15% intra-day, but by mid-afternoon, the market had won. Sterling devalued against its peg to the Deutschmark and effectively started to float in the foreign-exchange markets.
Much is made in market lore of George Soros as the man who broke the pound in 1992, but history is a little more prosaic. Italy had already been forced out of the ERM before ‘Black Wednesday’ in the UK, so those profiting from sterling’s devaluation clearly felt that what had happened to Italy would then happen to the UK2. Soros’ bet was just a spectacularly large and profitable one that history would repeat itself. The economic problem behind both events was the impossible trinity.
Economic history is replete with examples of countries’ currencies being used as the pressure-valve to relieve domestic economic woes. Despite the twentieth century being largely an American one in terms of economic dominance and in particular the centrality of the dollar in the global economic and monetary system, the US devalued the dollar twice, first in 1933 during the great depression and again in 1971 amidst the dual pressures of rising inflation and funding the Vietnam war, problems which were clearly linked.
While President Nixon initially suspended the convertibility of the dollar into gold in 1971 rather than devaluing the currency, the fact that gold rose from $35 to over $800 by the end of the decade amounted to the same thing. The current rise in the gold price, especially its unusual strength in the face of high US real interest rates, might suggest a similar process is underway now, reflecting growing political, central bank and investor concerns about the sustainability of the US fiscal position given the high stock of debt, the large primary deficit and the perpetual current-account deficits the US runs.
More intriguingly, some more far-sighted market commentators are suggesting that China may be about to devalue the yuan in order to re-galvanise China’s economy, mired as it is in the detritus of bad debt following the slow but painful unwinding of its property bubble.
In a recent article in the Financial Times (FT Link), market historian Russell Napier has suggested that China is moving in this direction as a means of gaining better control of its interest-rate policy, although it is unclear what the author thinks will happen with respect to China’s famously closed capital account, even as capital flows form part of the impossible trinity the country is currently struggling with3.
The yuan has been drifting lower, but what makes Mr Napier’s article stand out is that rather than a renminbi devaluation being deflationary, the likely reaction to a weaker Chinese currency will be further tariffs and trade restrictions on Chinese goods leading to a further fracturing of the global trading system into one of friends and enemies. The outcome of this would probably be inflationary rather than deflationary.
As the late, great investor Charlie Munger was quoted as saying, “Show me the incentives, and I’ll show you the outcome”. The gold-fever currently gripping Chinese retail investors, some of which has been encouraged by official sources, may well in part be explained in terms of front-running an anticipated yuan devaluation. The recent rally in commodity prices more generally, most notably in copper, may be driven by similar sentiments.
What is clear is that if the devaluation of currency is going to be used as part of a range of policies to reduce the real value of debt and to increase nominal GDP growth, whether explicitly against other fiat currencies or implicitly against the monetary metals, then investors need to expect a period of much more intense market volatility as well as to think more clearly about their asset allocation decisions given the changing political and economic environment.
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Alec Ryrie, Protestants - The Radicals Who Made The Modern World, Harper Collins, 2017, p156.
Bernard Connolly, The Rotten Heart of Europe, Faber & Faber, 1995, p184.
Russell Napier, China is moving towards full monetary independence, Financial Times, 18/04/2024.