Investment professionals are carefully analysing recent central bank policy announcements, particularly those which have lately caused sharp and sudden moves in several of the world’s largest currencies. Last week, headline news surrounding the plunging the Japanese yen and rising euro suggest investors have become increasingly worried that major world powers are initiating a race to debase their local currencies against each other.Last week in fact, Germany’s Finance Minister, Jens Weidmann warned that central banks may have lost their independence, publicly expressing his concern that governments have begun to target economic growth at the expense of rising inflation and weakening currencies in a race that no one can win.Japan may have fired the first shot in a new currency war. Indeed, the Bank of Japan spooked markets last week after newly-elected Japanese Prime Minister Shinzo Abe pushed a major economic stimulus package which included $117 billion in new spending in addition to expanding its already massive bond-buying programme.This latest announcement is an effort to revive the flagging economy and improve employment levels by boosting exports. Since last September, the Japanese yen has now fallen 14 percent against the greenback, a two-and-half year low and 16 percent against the euro.The term “currency war” dates back to 2010 when Brazil’s Finance Minister, Guido Mantega publicly condemned one of several massive American bond-buying programmes, arguing that flooding the market with extra dollars would pressure export-dependent emerging markets struggling with rising relative currency values.China was later brought into the scuffle when the US accused China of keeping the Chinese yuan down to improve its export volumes. US Treasury Secretary Timothy Geithner declared that China presents a “formidable challenge” to the global trading system since it subsidises the cost of key imports and keeps its exchange rate artificially low.Currencies are again back in the headline news causing investors to contemplate their next moves.For example, while many financial analysts had written off the euro as a very unhealthy currency due to Europe’s seemingly endless credit crisis, earlier in this month the euro staged a major rally when the European Central Bank (ECB) left rates unchanged at its regular policy meeting. Rather than falling into oblivion as some experts had predicted, the euro has actually risen to a eleven-month high against the US dollar. Oddly enough, the ECB’s statement last fall declaring that the central bank would do whatever it takes to save the euro had the unintended consequence of strengthening the 17-nation currency at a time when its hurts most.To explain: When a country’s economy is stuck in a low gear, government looks for a way out. The case of Japan actually highlights two ways that governments attempt to stoke growth: increase spending (fiscal policy) or increase the money supply (monetary policy). Other methods include improving productivity, lowering taxes or reducing regulations; but these methods are less popular at the moment. Effectively, over the last few years, the main tool governments have employed is “quantitative easing”, also referred to as “money-printing” by central banks.Quantitative easing, or QE, is a form of monetary policy used to help control national economic growth and inflation. The desired result is a moderately growing economy with low inflation. Most countries are happy with a reasonable growth rate that leads to business formations, job creation, a rising national income and Gross Domestic Product (GDP). Of course an advancing economy with high inflation is not that helpful, as the bigger paychecks are merely eaten away by inflation through the higher prices paid for goods and services.Central banks such as the Federal Reserve increase their balance sheets by buying bonds and other securities in the open market for cash. The cash (or really electronic entries for cash) is then released into the system creating more currency units for banks to lend, ultimately ending up in the hands of the citizens who can spend them and keep the wheels turning.Money printing further helps growth in the short run through currency devaluation. Like any other commodity, the value of a country’s currency is based upon supply and demand. The more currency printed, the greater the supply of the currency, and thus the lower its value. The lower the value of a country’s currency, the cheaper its goods are from the standpoint of customers in other countries. Relatively cheaper goods increases the country’s exports and therefore growth rate.But what happens when almost all of the world’s largest economies are stuck in low gear at the same time? The worst possible outcome is an outright currency war where everyone loses. One consequence of the 1930s Great Depression was countries impeding international trade by imposing tariffs, invoking import quotas and creating exchange controls to protect their local markets. Widespread protectionism probably increased the number of years required to exit from the darker days of that era.Playing currency trends and protecting assets against potential dislocations comes back to maintaining a well-diversified portfolio focused on higher quality securities. Taking bets outside one’s own borders creates a risk that the other country’s currency depreciates faster than your own. On the other hand, clearly some countries do a much better job of managing their finances than others.In a way, investors have a better chance than ever to vote with their feet by diversifying internationally through foreign stocks, bonds and cash reserves of those nations less inclined to spend above their means. A plethora of Exchange Traded Funds (ETFs) and mutual funds with foreign currency exposure makes the job relatively easier than before.Besides international diversification, commodities are a natural place to look to for preserving the real purchasing power of money. Perhaps it is no coincidence that the price of gold has increased by over 400 percent in last decade of unprecedented money-printing. Real assets which can protect wealth have historically included precious metals, real estate, agricultural goods and raw materials. Also, the companies which make, mine and sell and manage them have proven to be decent hedges against inflation.Regardless of how events unfold this year, it appears that the value of paper money is going to be as much a political tool as a medium of exchange. Politicians are sometimes sensible but often erratic and unpredictable as witnessed by the recent shenanigans surrounding America’s “fiscal cliff” negotiations. Now is a good time to think about preserving wealth both in nominal and real (inflation adjusted) terms.Bryan Dooley, CFA is a senior fund manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.