Currency war is the next phase of global conflict and Europe, the chief parasite, is defenceless

Europe has been warned. Any use of monetary levers to hold down the euro exchange rate will be deemed a provocation by the Trump administration.

Further cuts in interest rates to minus 0.5pc or beyond will be scrutinized for currency manipulation. A revival of quantitative easing will be considered a devaluation policy in disguise, as indeed it is, since the money leaks out into global securities and depresses the euro.

The Bank for International Settlements says €300bn of Europe’s QE funding reached London alone between 2014 and 2017.

If the ECB copies the Swiss National Bank and starts to amass foreign assets directly to cap currency strength Europe will face certain retaliation.

Whether the Swiss can get away with their policy for much longer is an open question. The SNB has foreign holdings of $760bn - near 120pc of GDP - and owns slices of Apple, Microsoft, Amazon, Facebook, and Exxon.

As the global economy falters we are entering the next phase of currency warfare. There is going to be an ugly fight for scarce global demand.

What is striking about Donald Trump’s tweets against the ECB this week is how quick he was to see the significance of Mario Draghi’s policy pirouette in Sintra - already dubbed ‘whatever it takes II’ by bond markets - and how quickly he pounced

The dollar is of course over-valued. The Federal Reserve’s broad dollar index reached a 17-year high in early June. The manufacturing trade deficit has ballooned to $900bn.

These imbalances have been made worse by Mr Trump’s own policies. His tax cuts at the top of the cycle have pushed the budget deficit to 4pc of GDP. They forced the Fed to jam on the brakes last year.

This ‘loose fiscal/tight money’ regime is the textbook formula for a strong currency. But the White House is not going to admit this. It is going to blame foreigners, and foreigners are not innocent either.

The eurozone is chief global parasite. It has been sucking demand out of the global economy with current account surpluses of €300bn to €400bn. China is a saint by comparison. This ‘free rider’ behaviour is the result of the euro structure and the austerity bias of the Stability Pact and German ideology amplified through currency union.

The rest of the world pays the price for euroland’s half-built experiment and its failure to stimulate, that is to say its failure to create a joint treasury with shared debt issuance that would make an investment revival possible in the depressed half of Europe.

National trade council adviser Peter Navarro,
right, in the Oval Office with Reince Priebus, then
White House chief of staff and President Donald Trump — National trade council adviser Peter Navarro, right, in the Oval Office with Reince Priebus, then White House chief of staff and President Donald Trump Credit: AP Photo/Evan Vucci

Mr Navarro has special twist on this: the warped mechanism of monetary union allows Germany to keep the implicit Deutsche Mark “grossly undervalued” and to lock in a beggar-thy-neighbour trade advantage over southern Europe. Hence Germany’s chronic current account surplus of 8.5pc of GDP.

Mr Trump’s White House has had enough of this and the battleground is over the currency. Democrats are singing from the same hymn sheet. Presidential candidate Elizabeth Warren has launched a campaign of “economic patriotism” with active currency management.

The Economic Policy Institute in Washington proposes buying the bonds of any country engaged in currency manipulation to neutralize the effect. The US Treasury is in charge of currency policy and can effectively order the Fed to support US foreign policy objectives.

It reminds me of the Reagan Doctrine during the Cold War: playing Moscow at its own game by sponsoring guerrilla insurgencies (Nicaragua, Afghanistan, etc). It bled the Soviet Union dry.

This is the new world order that Mario Draghi faces as he tries to stop the eurozone sliding into a deflationary quagmire. The ECB’s market measure of inflation expectations - 5-year/5-year swaps - have collapsed with all the nefast consequences this has for nominal GDP growth and Italy’s debt trajectory.

Yields on 10-year Bunds have crashed to minus 0.30pc. The bond markets are signalling an ice age. Clearly the decision to shut down the €2.6 trillion QE programme in January and declare mission accomplished - when Euroland was already in an industrial recession - was a policy blunder. It was forced upon Mr Draghi by hawks.

He is now taking revenge on the ECB’s governing council with a fait accompli. Unless the eurozone starts to recover “additional stimulus will be required”, and for good measure: “if the crisis has shown anything, it is that we will use all the flexibility within our mandate to fulfil our mandate,” he said in Sintra.

This pledge was made without first securing the consent of the Teutonic bloc. Angela Merkel’s Christian Democrats called it “an alarming signal for the ECB’s integrity”. This time Mr Draghi may have overreached in every sense.

The ECB can of course buy corporate bonds and bank debt (a shield for Italy). It can do some stealth monetisation of public debt. But plain-vanilla QE at this stage is tinkering. Little more stimulus can be extracted by pulling down the long end of the yield curve. The curve is near inversion already.

“It is ceremonial. The ECB is powerless. It is scrounging about trying to create a sense of action, but none of this has any effect,” says Ashoka Mody, a former bail-out chief in Europe for the IMF and author of Eurotragedy: a Drama in Nine Acts.

The deflationary cancer is now so deeply lodged in the eurozone that it would take Helicopter money or People’s QE - monetary financing of public works - to fight off any future global slump. Such action would violate the Lisbon Treaty and would test German political acquiescence in the euro project to destruction.

In truth, QE in Europe has always worked chiefly through devaluation. The euro’s trade-weighted index fell 14pc a year after Mr Draghi first signalled in 2014 that bond purchases were coming. That was powerful stimulus. When the euro climbed back up the eurozone economy stalled.

It takes permanent suppression of the exchange rate to keep euroland going. As the Japanese have discovered, it is very hard for an economy with near zero inflation and a structural trade surplus to stop its exchange rate rising unless it resorts to overt currency warfare. That is exactly what Mr Trump is not going to allow.

Every avenue of monetary stimulus is cut off in the eurozone. Only fiscal stimulus a l’outrance - 2pc or 3pc of GDP - will be enough to weather a serious crisis. That too is blocked.

“The ECB has masked the fragility over the last seven years and nobody knows when the hour of truth will come,” said Jean Pisani-Ferry, economic adviser to France’s Emmanuel Macron and a fellow at the Bruegel think tank.

“There is no common deposit scheme for banks. Cross-border investments are retreating. The vicious circle between banks and states could come return any moment,” he said.

Mario Draghi’s rhetorical coup in July 2012 worked only because he secured a partial approval from Germany for the ECB to act as lender-of-last resort for Italy’s debt (under strict conditions). That immediately halted an artificial crisis. The situation today is entirely different. The threat is a deflationary slump. The ECB has no answer to this.

Markets thought they heard a replay of ‘whatever it takes’ in Mr Draghi’s speech and hit the buy button. But economists heard another note in Sintra: a plaintive appeal for EMU fiscal union before it is too late.

The exhausted monetary warrior was telling us that the ECB cannot alone save the European project a second time.