LESSON 20: ARE FOREIGN EXCHANGE STRATEGIES A WAY TO ESCAPE INFLATION?

LESSON 20: FOREIGN EXCHANGE IS (WAS) AN OPTION TO ESCAPE RISING INFLATION

There is good news and bad news. The good news is that it has never been easier in economic history to diversify your wealth across different foreign currencies. The bad news is: It may not help you to escape the next inflation crisis. Let me explain.

High inflation is likely to weaken a country’s currency. Therefore, foreign exchange (FX) considerations should be included in an inflation risk management strategy.

A strategy of FX diversification showed promising results during past inflation crises in history:

Germans who diversified their wealth into more stable currencies (e.g., US dollar, UK pound) during the German period of hyperinflation reduced their inflation risks substantially. In fact, sophisticated people managed to turn inflation risks into inflation opportunities. The most famous example has been discussed in a previous LI article: Hugo Stinnes, who became one of the richest Germans by smartly leveraging inflation opportunities.

As the German mark deteriorated from 4.1 marks prior to World War I for one dollar (1914), to 4.2 trillion marks for one dollar in late 1923, holding German paper money was not an option. You could literally see the value of paper money “evaporating into air” minute by minute. ?

The 1970s high inflation period in the U.S. and U.K. provides a more recent learning experience.?During the early 1970s, officials in both countries were much less concerned about inflation than their counterparts in Germany. They engaged in dangerous monetary policy experiments falsely assuming that central bankers could finetune business cycles and controlling inflation rates through active monetary policies. Once inflation arrived, they were also less committed to fight inflation. German central bankers were adamant not to allow inflation to spread. Even if the necessary measures weakened the economy, German authorities would not compromise on their commitment to fight inflation. German central bankers at a time pursued policies that put the fight against inflation over any other goal and the German mark became an inflation safe haven.

The U.S. dollar weakened substantially against the German mark. Between 1970 and 1980, it lost half of its value against the Deutschmark (from 3.65 in 1970 to a low of 1.70 in 1980).

An investor who incorporated FX diversification into more stable currencies like the Deutschmark would have limited the impact of inflation on his net worth considerably. The execution of such a strategy would have been quite simple. For example, an investor could have switched part of his investments in U.S. treasury bonds to German securities or cash. While Germany also experienced some inflation during the 1970s, its commitment to fight inflation limited its CPI inflation rates to relatively low levels. ?

Foreign exchange strategies are particularly important in severe cases of inflation as the recent example of Venezuela illustrates. The US dollar has assumed a central role in the Venezuelan economy. ??

FX investments are very easy to execute. Today, retail investors in almost all countries of the developed world have access to FX investment instruments. These include savings accounts denominated in foreign currencies, access to investment in foreign government bonds, mutual funds that cover foreign stocks and bonds, and many other forms of international investments.

However, Governments tend to limit accessibility of investing in foreign currencies during times of high inflation. They do so to protect the value of the domestic currency and to avoid additional inflation increases due to higher import prices. We have recently seen such interventions in both Argentina and Venezuela. Also, we have seen foreign exchange restrictions and limitations during the 1920s in Germany and during the 1970s in the U.S.

Historically, foreign exchange strategies have been easy strategies to escape inflation risks. However, it is important to note that today the situation is significantly more difficult.

In the past, periods of high inflation were typically limited to a single country or a small region. These inflation crises were the results of poor political and monetary decision making. They were easy to spot and easy to escape. There is always the same list of poor policies and decisions that lead to periods of excessive inflation:

·????????Ultra-loose monetary policies and money printing

·????????Manipulation of interest rates and foreign exchange rates away from market equilibriums

·????????Prolonged periods of fiscal deficits and overspending

·????????Fiscal spending focused “give aways” and not on productive investments

·????????Extreme high levels of government and/or private sector indebtedness

·????????Overconfidence in the domestic economy and its competitiveness

·????????Overconfidence of central bankers in their ability to control inflation.

When you look at the above list, it becomes clear that these pro-inflationary conditions are present in almost all developed countries. In other words, almost all developed countries pursue a pro-inflationary policy. To my knowledge such a level of global synchronicity of pro-inflationary policies has never occurred in economic history. It is truly unprecedented and should be as a extremely risky experiment.

In the past, there were always many safe haven countries available options available to escape local inflation. Today, this list is very short. Germany is definitely not on the list anymore as it is subject to the European Central Bank’s pro-inflationary policies. Other countries that are still independent and did not join the pro-inflationary push have created powerful defense mechanisms to deter foreign investors seeking to escape inflation (e.g., negative interest rates).

Investors are reminded that foreign exchange markets are very volatile and may react swiftly to changes in inflation expectations. The dollar lost about half of its value against the Deutschmark during the 1970s inflation period. Under President Reagan and newly elected Federal Reserve Chair Volcker, the situation quickly changed after 1980 and the US dollar quickly regained most of its lost value. In fact, the market was surprised by the determination of U.S. officials to accept temporary economic weakness to win the fight against inflation.

In conclusion: Foreign exchange strategies were powerful tools in the past to contain inflation risks. In the future, this is likely to be different. We are navigating through unprecedented times. FX considerations need to be incorporated in a company’s or individual’s inflation strategy. However, doing so has become much more demanding in the modern world.

THIS PUBLICATION IS FOR INFORMATIONAL PURPOSES ONLY. IT IS PUBLISHED TO EXPRESS PRELIMINARY VIEWS BY THE AUTHOR TO INVITE FEEDBACK AND CRITICISM BY THE AUDIENCE. PLEASE USE THE COMMENT FUNCTION FOR CONSTRUCTIVE CRITICISM, GENERAL FEEDBACK, AND SUGGESTIONS. PRE-EDITED VERSION.

Copyright Dr. Wolfgang Hammes