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Euro banknotes lay on top of various other currencies in this file photo.

Kacper Pempel/Reuters

A new currency war may be on the verge of breaking out, if one hasn't already.

Last Thursday, European Central Bank boss Mario Draghi reduced the benchmark interest rate by a quarter point, taking it to a record low of 0.25 per cent (meaning he has only one cut left in his arsenal). He did so not to weaken the euro – he was more worried about fighting an alarming disinflation trend. But he and Europe's struggling economies were pleased that the cut removed the currency's forward momentum.

"As you know, the exchange rate is not a policy target for the ECB," he said at a press conference last month. "The target for the ECB is medium-term price stability. However, the exchange rate is important for growth and for price stability. And we are certainly attentive to these developments."

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Before the rate cut, the euro had been on a four-month roll, gaining about 5 per cent against the dollar. The ECB's move dropped its value by about 1.5 per cent, though it has clawed back some of its losses. On Monday, it gained almost 0.4 per cent to $1.34.

Attempting to push currencies down seems all the rage among central banks. On the same day that Mr. Draghi made his move, the Czech Republic intervened in the currency market to weaken the koruna. It worked; the currency fell more than 4 per cent. New Zealand and Australia have warned that their currencies are too high and China is trying to keep the renminbi down to protect its exporters. The U.S. dollar, while up a bit, is still weak.

In Europe, there is no doubt that a high euro is incompatible with a compelling economic recovery. The euro zone's bounce back is more alleged that real. The 17-country region is out of recession, though barely, but growth forecasts are being scaled back as unemployment remains at record high levels – 12.2 per cent – and debt keeps piling up because of budged deficits. The climbing euro does not help. It rose to $1.60 just before the 2008 financial crisis, making the European recession all the worse. The lower it is, the better as long as he recovery remains anemic.

In theory, currency devaluations work. Historically, countries like Italy, Spain and Greece used periodic devaluations to pump up their otherwise uncompetitive economies. With the euro in place, that option is no longer available. Instead, the weak euro zone countries are pinning their recovery hopes on internal devaluations – falling unit labour costs – and a weaker euro to juice up their economies.

Two problems arise in this scenario. All of the weak euro zone countries naturally want to export their way to recovery. But if everyone adopts that strategy, it won't work – all countries cannot be export machines.

The other problem is Germany, whose current account surplus is already at record or near record levels. A weaker euro would allow it to export more. If the higher exports are not rebalanced with higher domestic consumption, all bets are off for the European recovery. Germany is already benefiting from a euro that is weak compared to old Deutschmark standards. According to a recent article in the Financial Times, Germany is using a currency that is 10 per cent weaker now than it was in 1999, when the euro was launched, when the currency is adjusted for price inflation.

While currency wars can backfire, there is little doubt that the euro zone will pray for a weaker currency. If it loses enough value, there will be competitive devaluations elsewhere. This could get ugly.

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