I have been talking for some time about a ‘rip off’ that the US will attempt to make against China, that it could take a belligerent form (default) or a traditional and less likely to cause a war option (devaluation of the dollar). It seems to be playing out and going for option two.

Competitive currency devaluations are alive and well in the world, why? Well, in early 09′ I wrote about it on the Paddy Power Trader blog:

“One way of paying bond holders back (but not ‘rewarding’ them) is via a devalued currency with an inflationary environment thrown in, in fact the big robbery of this century is going to be (as it was in the past as per the 1870s first, and then via Presidential Executive Order 6102 in the 1930’s) a dollar based one, the only way the US can pay its debts is to essentially rip off the debt holders, domestically that won’t be so bad, but internationally it will hurt many economies, in particular China. Personally I don’t see the great depression, I see something more akin to the 70’s. Deflation won’t be the long term story, inflation will be as it always has been.”

I have kept this belief and think it will go as follows: The US dollar goes for QE2, you can already see dollar debasement in gold and commodity prices (Oil will likely go over $100 in the next 12 months) and at the same time the Euro tries to follow the road down. The other nation in the room is China who have kept their currency artificially low and rely on this for their own survival while running a huge surplus.

This structural imbalance can’t/won’t last, and because of this you just have to line up the dominoes and walk down the path that makes sense from the perspective of what is most likely to happen. Will Americans change their standard of living and willingly work hard to repay China or will they just devalue?

There are things to consider, for instance – a strong currency will only inhibit exports short term, just look at the Mark and Yen price sine the 70’s and it proves that point. Strong currency also makes imports cheaper reducing inflation, a weak currency typically has to offer higher rates in order to maintain investor interest – this is what Ireland did in the early 90’s.

Strong currency also attracts investors due to appreciation and that keeps rates low as well as avoiding the inflation/deflation mix. Devaluation hurts people domestically who have their savings in the national currency.

So even though the USA will favour a cheaper dollar (and they can get away with a brand of seigniorage due to dollar hegemony) it will still hurt regular Americans in the workforce.

However, it will also address the imbalance that China is unwilling to see undone, namely that of them holding a huge surplus while everybody else is a debtor.