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Decimal Digest
11 Feb 2013

Currency wars – lessons from an evolutionary game theory approach

“History starts as farce and ends up as tragedy” – a character in movie Argo.

Since Mr. Abe has become the Prime Minister of Japan, he has put unprecedented pressure on the seemingly independent central bank to weaken the internal value of the JPY (higher inflation). Whether the BOJ succeeds in weakening the internal value of JPY is a matter of speculation and great interest, the external value of JPY has certainly taken a beating.

The most interesting part of this whole Japanese objective of creating domestic inflation is the list of global dignitaries who have an opinion on this matter. The first of the block was Bundesbank chief Jens Weidmann who said a few weeks ago "We are witnessing disturbing abuses, for example in Hungary or in Japan, where the new government is interfering massively in the affairs of the central bank, calling forcefully for a more aggressive monetary policy". Others, like the ECB’s Asmussen carefully weighed in, while stressing the importance of global cohesion in this matter, by stating, "We have well-established fora of economic governance like the G7 or the G20 and we should use them… We should not fall back to a situation where everyone is looking after his own interests"

Many others, including the Deputy Governor of Chinese Central Bank Mr. Yi, Brazilian Finance Minister Guido Mantega, and the Korean Central Bankers made noises similar to those by Weidmann and Asmussen. French President Mr. Hollande went a step further by saying that “The eurozone must, through its heads of state and government decide on a medium-term exchange rate…. We can’t let the euro fluctuate according to the mood of the market."

We had seen a nice working partnership between G20 nations in 2009, which helped create a recovery from the abyss in early 2009. So, what has happened? Why should we now see fractures in this global cohesive working relationship? We can find an answer to this question by looking at application of game theory to the evolution of “cooperation and fairness” in the natural world within the context of Darwinian “survival of the fittest” regime.

In game theory, one of the famous construct is the Prisoners Dilemma, in which although the two parties in the game can benefit by cooperating, they end up working against each other and as a result destroying value for both of them.

What is more interesting is that if this game of Prisoners Dilemma is played again and again, under varying degrees of tolerance for obnoxious behavior of the other party, a pattern of repeated war & peace emerges, as shown in the diagram below:

Game Theory : War & Peace

Source: Based on work by Martin Nowak1

Based on comments by various dignitaries, it is possible that the global economic order is just passing from the phase of cooperation to defection (wars). If this new order does indeed emerge, individual nations will try to gain an upper hand by unduly depreciating their currency. The first salvo in this new war has already been fired by Mr. Abe. The timing and severity of response of other nation states will depend on how quickly he succeeds in depreciating the JPY. The efforts of Japan may look farcical right now; but tit for tat responses from other nations carry the risk of the whole situation becoming a tragedy for the global middle class, as inflation weathers away their life’s savings, never mind the nominally performing financial markets.2

1The readers who are interested in the mathematical construct behind the recurrence of war & peace among competing agents (be it animals or nations) can look up work of Martin Nowak and other scientists in this field.

2The quote from the movie Argo at the start of this article is a possible misrepresentation of Karl Marx’s famous quote: ““Hegel remarks somewhere that all great world-historic facts and personages appear, so to speak, twice. He forgot to add: the first time as tragedy, the second time as farce.” We think even this misquote is a powerful indicator for current economic order.


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