Why the world faces a currencies war

To a large extent, it reflects the underlying structure of economies heavily geared to exports.

Angela Merkel has repeatedly stated that she sees no change to the export-driven German economic model in the near term. For Japan, falling living standards combined with an aging, falling population means increasing dependence on exports. For China, increasing wages pressures and domestic inflation means that rising production costs must be offset by other means, including an undervalued currency.

The problem of shifting models is great. In 1985, the Plaza Accord forced Japan to effectively revalue the yen, setting off a rise to 85 yen to the dollar from 230. The rise reduced Japanese export competitiveness and led to a recession.

To stimulate the economy, the Bank of Japan pumped large amounts of money into the economy. Rather than assisting, the money set off a commercial real-estate and stock-market boom that collapsed spectacularly at the end of 1989, plunging Japan into the "ushinawareta junen" — the Lost Decade. Aware of the Japanese experience and at risk of repeating it, China has fervently resisted revaluing its currency, despite pressure from the US.

Chinese Premier Wen Jiabao told a European business conference: "If we increase the yuan by 20%-40% as some people are calling for, many of our factories will shut down and society will be in turmoil. If China's economy goes down, it's not good for the world economy."

The unstable currency order creates distortions, frequently preventing action to deal with economic problems. For example, financial triage, cutting the unsustainable and unlikely-to-survive countries out of the euro, would restore their competitiveness through devaluation.

But Germany is unlikely to allow weaker countries to leave the common currency precisely to avoid a sharp increase in the value of the euro, making its exports less competitive. Contrary to popular view, the Germany has much to lose from changes in or abandonment of the euro.

The reintroduction of quantitative easing (it was called "printing money" in a less politically correct world) reflects, in part, attempts by policymakers to influence currency values.

Major reserve currencies such as the dollar, euro and yen provide some ability to offset changes in value by invoicing trade in their own currencies.

Unfortunately for minor currencies, the fact that trade continues to be denominated in the major ones creates difficulties where a one-day move in foreign exchange markets can wipe out the entire profit margin.

The higher volatility means the cost of hedging the risk of such currency moves is large, reducing profitability. The currency crisis highlights the "beggar thy neighbour" policies pursued by many economies. A global economic order where a few countries save and lend to finance their exports while others act as consumers of last resort is unsustainable. A system where each country seeks to maximise its own competitive position and financial security at the expense of trading partners is not viable.

An emerging toxic combination of inflexible global currency arrangements, a destructive cycle of currency devaluations, trade restrictions and the need of governments to rein in spending to balance budgets is reminiscent of the Thirties. They threaten a period of prolonged global economic stagnation.

Optimists must rely on Israeli politician Abba Eban's observation that "history teaches us that men and nations behave wisely once they have exhausted all other alternatives".

Satyajit Das is author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives