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Keep calm, don t expect quick fixes and above all don t unleash a trade fight with China
Oct 14th 2010
IN RECENT weeks the world economy has been on a war footing, at least rhetorically. Ever since Brazil s finance minister, Guido Mantega, declared on September 27th that an international currency war had broken out, the global economic debate has been recast in battlefield terms, not just by excitable headline-writers, but by officials themselves. Gone is the fuzzy rhetoric about co-operation to boost global growth. A more combative tone has taken hold (see article). Countries blame each other for distorting global demand, with weapons that range from quantitative easing (printing money to buy bonds) to currency intervention and capital controls.
Behind all the smoke and fury, there are in fact three battles. The biggest one is over China s unwillingness to allow the yuan to rise more quickly. American and European officials have sounded tougher about the damaging dynamic caused by China s undervalued currency. Last month the House of Representatives passed a law allowing firms to seek tariff protection against countries with undervalued currencies, with a huge bipartisan majority. China s unfair trade practices have become a hot topic in the mid-term elections.
A second flashpoint is the rich world s monetary policy, particularly the prospect that central banks may soon restart printing money to buy government bonds. The dollar has fallen as financial markets expect the Federal Reserve to act fastest and most boldly. The euro has soared as officials at the European Central Bank show least enthusiasm for such a shift. In China s eyes (and, sotto voce, those of many other emerging-market governments), quantitative easing creates a gross distortion in the world economy as investors rush elsewhere, especially into emerging economies, in search of higher yields.
A third area of contention comes from how the developing countries respond to these capital flows. Rather than let their exchange rates soar, many governments have intervened to buy foreign currency, or imposed taxes on foreign capital inflows. Brazil recently doubled a tax on foreign purchases of its domestic debt. This week Thailand announced a new 15% withholding tax for foreign investors in its bonds.
Jaw-jaw, please
For now, these skirmishes fall far short of a real currency war. Many of the weapons look less menacing on closer inspection. The capital-inflow controls are modest. In the rich world only Japan has recently resorted to currency intervention, and so far only once. Nor is there much risk of an imminent descent into trade retaliation. Even in America, tariffs against China are still, with luck, a long way off both because the currency bill is milder than it sounds and because it has yet to be passed by the Senate or signed by Barack Obama.
Still, there is no room for complacency. Today s phoney war could quickly turn into a real dogfight. The conditions driving the divergence of economic policies in particular, sluggish growth in the rich world are likely to last for years. As fiscal austerity kicks in, the appeal of using a cheaper currency as a source of demand will increase, and the pressure on politicians to treat China as a scapegoat will rise. And if the flood of foreign capital intensifies, developing countries may be forced to choose between losing competitiveness, truly draconian capital controls or allowing their economies to overheat.
What needs to happen is fairly clear. Global demand needs rebalancing, away from indebted rich economies and towards more spending in the emerging world. Structural reforms to boost spending in those surplus economies will help, but their real exchange rates also need to appreciate. And, yes, the Chinese yuan is too low (see article). That is hurting not just the West but also other emerging countries (especially those with floating exchange rates) and indeed China itself, which needs to get more of its growth from domestic consumption.
It is also clear that this will not be a painless process. China is right to worry about instability if workers in exporting companies lose their jobs. And even reasonable choices such as the rich world s mix of fiscal austerity and loose monetary policy will have an uncomfortable impact on small, open emerging economies, in the form of unwelcome capital inflows. This flood of capital will be less devastating to them than the harm they would suffer if the West descended into deflation and stagnation, but it can still cause problems.
Collective Seoul-searching
All this cries out for a multilateral approach, in which institutions such as the IMF and the G20 forge consensus among the big economies. The hitch is that the multilateral route has, so far, achieved little. Hence the chorus calling for a different line of attack one that focuses on getting tough with China, through either retaliatory capital controls (such as not allowing China to buy American Treasury bonds) or trade sanctions. And it is not just the usual protectionist suspects: even some free-traders reckon that economic violence is the only way to shock China out of its self-harming obstinacy (and to stop a more widespread protectionist reaction later).
This newspaper is not convinced. The threats look like either unworkable bluffs (how can China be stopped from buying Treasuries, the most widely traded asset in the world s financial markets?) or dangerous provocations. Confronted with a trade ultimatum, the Beijing regime, puffed up in its G2 hubris, may well reckon it is cheaper politically to retaliate to the United States in kind. That is how trade wars start.
Anyway, to focus on America and China is to misunderstand the nature of the problem. The currency wars are about more than one villain and one victim. Rather, redouble multilateral efforts behind the scenes, especially by bringing in the emerging countries hurt by China s policy. Brazil and others have only just begun to speak out. South Korea is hosting the G20 next month. Use the Seoul summit as a prompt, not to create some new Plaza Accord (today s tensions are too complex to settle in a grand peace treaty of the sort hammered out by just five countries in New York in 1985) but as a way to clarify the debate and keep up the pressure. It will get fewer headlines; but this is a war that is best averted, not fought.
A third area of contention comes from how the developing countries respond to these capital flows. Rather than let their exchange rates soar, many governments have intervened to buy foreign currency, or imposed taxes on foreign capital inflows. Brazil recently doubled a tax on foreign purchases of its domestic debt. This week Thailand announced a new 15% withholding tax for foreign investors in its bonds.
Jaw-jaw, please
For now, these skirmishes fall far short of a real currency war. Many of the weapons look less menacing on closer inspection. The capital-inflow controls are modest. In the rich world only Japan has recently resorted to currency intervention, and so far only once. Nor is there much risk of an imminent descent into trade retaliation. Even in America, tariffs against China are still, with luck, a long way off both because the currency bill is milder than it sounds and because it has yet to be passed by the Senate or signed by Barack Obama.
Still, there is no room for complacency. Today s phoney war could quickly turn into a real dogfight. The conditions driving the divergence of economic policies in particular, sluggish growth in the rich world are likely to last for years. As fiscal austerity kicks in, the appeal of using a cheaper currency as a source of demand will increase, and the pressure on politicians to treat China as a scapegoat will rise. And if the flood of foreign capital intensifies, developing countries may be forced to choose between losing competitiveness, truly draconian capital controls or allowing their economies to overheat.
What needs to happen is fairly clear. Global demand needs rebalancing, away from indebted rich economies and towards more spending in the emerging world. Structural reforms to boost spending in those surplus economies will help, but their real exchange rates also need to appreciate. And, yes, the Chinese yuan is too low (see article). That is hurting not just the West but also other emerging countries (especially those with floating exchange rates) and indeed China itself, which needs to get more of its growth from domestic consumption.
It is also clear that this will not be a painless process. China is right to worry about instability if workers in exporting companies lose their jobs. And even reasonable choices such as the rich world s mix of fiscal austerity and loose monetary policy will have an uncomfortable impact on small, open emerging economies, in the form of unwelcome capital inflows. This flood of capital will be less devastating to them than the harm they would suffer if the West descended into deflation and stagnation, but it can still cause problems.
Collective Seoul-searching
All this cries out for a multilateral approach, in which institutions such as the IMF and the G20 forge consensus among the big economies. The hitch is that the multilateral route has, so far, achieved little. Hence the chorus calling for a different line of attack one that focuses on getting tough with China, through either retaliatory capital controls (such as not allowing China to buy American Treasury bonds) or trade sanctions. And it is not just the usual protectionist suspects: even some free-traders reckon that economic violence is the only way to shock China out of its self-harming obstinacy (and to stop a more widespread protectionist reaction later).
This newspaper is not convinced. The threats look like either unworkable bluffs (how can China be stopped from buying Treasuries, the most widely traded asset in the world s financial markets?) or dangerous provocations. Confronted with a trade ultimatum, the Beijing regime, puffed up in its G2 hubris, may well reckon it is cheaper politically to retaliate to the United States in kind. That is how trade wars start.
Anyway, to focus on America and China is to misunderstand the nature of the problem. The currency wars are about more than one villain and one victim. Rather, redouble multilateral efforts behind the scenes, especially by bringing in the emerging countries hurt by China s policy. Brazil and others have only just begun to speak out. South Korea is hosting the G20 next month. Use the Seoul summit as a prompt, not to create some new Plaza Accord (today s tensions are too complex to settle in a grand peace treaty of the sort hammered out by just five countries in New York in 1985) but as a way to clarify the debate and keep up the pressure. It will get fewer headlines; but this is a war that is best averted, not fought.
What should replace Bretton Woods 2?Oct 15th 2010
America must save more
Laurence Kotlikoff our guest wrote on Oct 15th 2010, 12:46 GMT
THE US is saving less than nothing, indeed, -1.5% of national income in 2009. A reasonable domestic net investment rate, and one we had a few years back, is 8% of national income. But if we Americans aren't saving anything, we can't invest anything. In recent years, foreigners, fortunately, have been making up the difference. This is why the US has been running huge current account deficits. Our current account deficit is simply the difference between what foreigners invest in the US and what we Americans invest abroad. If more capital flows in from abroad than flows out, the difference shows up as net imports. So our failure to save is producing major trade imbalances.
If we keep saving so little, we'll continue to run current account and trade deficits. This will be true regardless of whether we try to fix our exchange rate or let it float. Economics isn't ultimately about pieces of paper of different colors and how many are printed. It's about fundamentals. And America's fundamentals look fundamentally awful. This may be dawning on foreign investors. Last year the current account deficit fell by 40%, and this decline in net foreign investment in the US, coupled with the drop in our national saving rate, translated into a domestic investment rate (net domestic investment as a share of national income) of only 1.9%. This is the lowest rate of domestic investment since 1934!
The US desperately needs to stop living beyond its means and to start saving. But even were we to save 8% of our net output each year, we'd still likely run large current account deficit over time simply because the Chinese are saving at rates above 30% and will continue to do so for many years. That plus their growth rate means they will have a growing stock of assets to invest in our country and other countries as well as at home. We need to face up to the fact that China has 2.5 times the population of all the developed countries combined and once their per capita GDP reaches our level, China will be the developed world. The US, Japan, and the EU will be bit players. And China will want to invest a good chunk of its wealth in the US If we are smart, we will welcome this. More Chinese capital available for use in the US means higher wages for US workers.
Breton Woods 3, 4, ... It doesn't matter. We can't paper over these physical realities. Bashing the Chinese for pegging their exchange rate to ours is simply avoiding the problem. The fact that the Chinese are maintaining a fixed or slowly changing exchange rate with respect to the dollar doesn't mean they are reaping an unfair trade advantage. Delaware has a fixed exchange rate with Kansas and no one accuses one state of promoting its exports relative to its imports. And the US has run fixed exchange rate policies in the past with major trading partners without being accused of engaging in unfair trade.
We need to bear in mind that prices and wages in countries adjust to produce real terms of trade how much products from one country swaps for in terms of products in another country (e.g. 1,000,000 Chinese-made silverware sets for 1 U.S.-made Corvette). If China were to follow America's exhortations, which are verging on extortions, and, say, cut its money supply in half and, thereby, double the value of its currency, measured in dollars, so that, at the current internal Chinese price (the price in yuan) for silverware, it takes American importers twice the number of dollars to buy a set of silverware, something will give. What will give is that the internal Chinese price in yuan of silverware will fall in half leaving the silverware just as cheap as it was initially when measured in units of Corvettes. Real terms of trade ultimately aren't affected by exchange rate policies. So America's starting an argument over exchange rates is silly, unless it's cover to start a trade war, which will end up with the US
imposing tariffs on China. Then a silly argument, conducted by supposedly first-rate, professional economists, will turn into a very dangerous one.
The dollar should cede ground to other reserve currencies
Yang Yao our guest wrote on Oct 15th 2010, 9:31 GMT
THE current global monetary system is heavily dominated by one single currency, the US dollar, that is not subject to the constraints of any international arrangements. This dominance allows the US to attract large amounts of liquidity in good times, and to dilute its debts through aggressive monetary policy in bad times.
Not many people are happy with this system, but the road to an alternative is unclear. The call for a global reserve currency will be proven only rhetoric in the end. A reserve currency, as many have conceived, cannot circulate; nor can it be used as an investment vehicle. In the end, a real currency is needed to preserve the value of savings stored in the form of the reserve currency.
Unless a global central bank were created, there would be no hope for a global reserve currency to replace the US dollar. However, creating a global central bank may not be a good solution even if it is possible. The recent crisis facing the euro rings the bell for any optimism.
In the end, a solution to replace the so-called Bretton Woods 2 that may naturally emerge from the current world order is the competition, and hopefully cooperation, among several major currencies. Besides the dollar, the euro has played a significant role in global trade and finance. The Japanese yen and the British pound are also around although they have not reached significant primacy. The Chinese yuan may take some share if the Chinese authorities open up the country s capital account. Currencies in other emerging markets also have hope. The competition among several major currencies will help preventing liquidity from concentrating in a few countries and will constrain irresponsible behaviour in the management of individual currencies.
On top of that, some binding multilateral mechanism is needed to coordinate the exchange rates among the major currencies, especially in bad times. The G20 is a potential venue for such a mechanism. However, the current floating system is inadequate for this mechanism to function; it gives a legitimate reason for the US to dump its domestic problems to the rest of the world by devaluing the dollar.
A better alternative is to adopt a mixed system in which the major currencies form some sort of an alliance to coordinate their exchange rates and other currencies choose either to float against the major currencies or to peg to them. The coordination needs not to require completely fixed exchange rates among the major currencies, but needs to be sufficiently real to place constraints on them.
The dollar should cede ground to other reserve currencies
Yang Yao our guest wrote on Oct 15th 2010, 9:31 GMT
THE current global monetary system is heavily dominated by one single currency, the US dollar, that is not subject to the constraints of any international arrangements. This dominance allows the US to attract large amounts of liquidity in good times, and to dilute its debts through aggressive monetary policy in bad times.
Not many people are happy with this system, but the road to an alternative is unclear. The call for a global reserve currency will be proven only rhetoric in the end. A reserve currency, as many have conceived, cannot circulate; nor can it be used as an investment vehicle. In the end, a real currency is needed to preserve the value of savings stored in the form of the reserve currency.
Unless a global central bank were created, there would be no hope for a global reserve currency to replace the US dollar. However, creating a global central bank may not be a good solution even if it is possible. The recent crisis facing the euro rings the bell for any optimism.
In the end, a solution to replace the so-called Bretton Woods 2 that may naturally emerge from the current world order is the competition, and hopefully cooperation, among several major currencies. Besides the dollar, the euro has played a significant role in global trade and finance. The Japanese yen and the British pound are also around although they have not reached significant primacy. The Chinese yuan may take some share if the Chinese authorities open up the country s capital account. Currencies in other emerging markets also have hope. The competition among several major currencies will help preventing liquidity from concentrating in a few countries and will constrain irresponsible behaviour in the management of individual currencies.
On top of that, some binding multilateral mechanism is needed to coordinate the exchange rates among the major currencies, especially in bad times. The G20 is a potential venue for such a mechanism. However, the current floating system is inadequate for this mechanism to function; it gives a legitimate reason for the US to dump its domestic problems to the rest of the world by devaluing the dollar.
A better alternative is to adopt a mixed system in which the major currencies form some sort of an alliance to coordinate their exchange rates and other currencies choose either to float against the major currencies or to peg to them. The coordination needs not to require completely fixed exchange rates among the major currencies, but needs to be sufficiently real to place constraints on them.
Luhe Soulidvas wrote:
Oct 18th 2010 8:44 GMT
You said it right, "Bretton Woods 3 should be a system of freely floating exchange rates to avoid the tension, uncertainty, and distortion associated with highly diverse economic conditions and policy regimes existing in today's economy."
But, if it isn't? We are dealing with the real world, not a text book exercise when the coeteris paribus axioma would prevail. Then what?
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GuillermoMarraco wrote:
Oct 18th 2010 9:59 GMT
The dollar is not overvalued, but overprinted. It has the same effect as overvaluation for USA, (contrary to any other currency overprinting), because the dollar is the international currency.
The dollar as international currency benefited USA, as allowed to import anything in exchange of paper, but the low hanging fruit is already collected, and USA refuses to recognize it, and stop trying to grow imported wealth. It s already on the frontier of GDI, but tries to preserve his inertia to it.
Freely floating exchange rates are only compatible with control over dollar printing, a sovereign right that USA is unable to resign.
If countries were able to agree on resigning currency sovereignty, currencies should be centrally managed, but it requires clear rules and guarantee of protection for weak countries against the powerful ones.
The double standard that the core countries follow in international law in the United Nations implies that the most powerful countries are not to be trusted with currency management.
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heidicass wrote:
Oct 19th 2010 12:58 GMT
Time for free fall. What should be freely floating exchange rates in the world of freely printed fiat money?
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FARUKBIL wrote:
Oct 19th 2010 6:13 GMT
A widely larger portion of international trade is based on dollar. Oil trade is in dollar. Furthermore precious and industrial metals are mostly quoted ın USD. The rich world, the West is still aloof due to the enduring trauma of the Depression. It looks like the economies of the Pacific shores, and the BRIC will exhaust most of oil production in the next decade. The currency wars may end up with deflation mostly in the demographically aged therefore demand shorted European zone. To prevent this either the system invents a new currency; lets say with WTO/IMF, that allows free trade and convergence or the system let each country freely play on its currency through national central banks.Both may be alternative models. However, neither seems possible in the foreseeable future, because both engage a much different set of power on globe. Faruk Bil