OCTOBER 1, 2010
Beggar the World
Monetary instability is a threat to the global recovery
Brazil's finance minister caused a stir in financial markets earlier this week when he committed a Lady Godiva moment by declaring that "We're in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness."
Thanks for noticing. Now if only the world's political and finance leaders—especially in the world's leading economy, America—would do something about it.
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Since the financial panic began in 2008, global leaders have been at pains to stress their "cooperation" on numerous issues—stimulus spending, new bank rules, trade. Yet they still insist on going their own parochial, self-interested way on monetary policy and exchange rates. It's as if world leaders had consciously decided to deal with every economic issue except the most important one—the price of the global medium of economic exchange.
The result has been a world of monetary disruption and growing commercial and political disputes. Brazil has had to cope with surging capital inflows and a rising real, with government bond yields hitting double-digits. The rising yen has roiled Japanese politics and led its central bank to intervene. Other Asian nations—part of what is, or was, the dollar bloc—have taken to devaluation or interest rate adjustments to stop their currency shifts against the dollar.
Meanwhile, what Nobel economist Robert Mundell calls the world's single most important price—the euro-dollar rate—continues to fluctuate wildly. The nearby chart shows that the swings have become more frequent and severe since 2005, from 1.2 euros to the dollar to 1.6, then down to 1.25, back to 1.5 in a matter of months, down again to 1.2 and now back above 1.36.
Mr. Mundell—the father of the euro and the world's foremost expert on currency systems—recently said on Bloomberg TV that this "is a terrible thing for the world economy" and that "We've never been in this unstable position in the entire currency history of 3,000 years."
Such sharp currency moves lead to huge swings in prices, especially for commodities like oil. They disrupt business planning, as companies find it difficult to know what their real costs and return on investment will be. And they lead to the misallocation of resources, with investment decisions pegged as much to exchange-rate movements as to long-run productivity gains or potential breakthroughs in technology. Some $4 trillion now turns over daily in global currency markets.
The growing danger today is currency protectionism—what students of the 1930s will remember as competitive devaluation or "beggar-thy-neighbor" policies. As economic historian Charles Kindleberger describes in his classic "The World in Depression," nations under domestic political pressure sought economic advantage by devaluing their national currency to improve their terms of trade.
But that advantage came at the expense of everyone else. "As with exchange depreciation to raise domestic prices, the gain for one country was a loss for all," Kindleberger writes. "With tariff retaliation and competitive depreciation, mutual losses were certain."
We can see signs of similar behavior today, especially in the global economy's main potential flash point of U.S.-China relations. This week, the U.S. House of Representatives voted 348 to 79 to impose tariffs on Chinese goods if Beijing does not revalue its currency. Ominously, the vote was bipartisan. While the Senate has so far restrained itself, a similar rout in that body can't be ruled out after the elections—especially in the absence of Presidential leadership.
Yet so far President Obama and Treasury Secretary Timothy Geithner have been part of the political problem. They are feeding the Congressional stampede by publicly demanding that China revalue against the dollar (that is, that the dollar depreciate) to reduce the U.S. trade deficit, though Mr. Mundell and others say it would have no such effect. Japan revalued the yen starting 25 years ago under similar U.S. pressure, and the U.S. still runs a trade deficit with Japan. Asked yesterday if Mr. Obama would sign a tariff bill if it arrived on his desk, White House spokesman Robert Gibbs said, "I don't have any clarity on that."
That is for sure, because the root of this problem is also intellectual. For a decade, U.S. financial officials have behaved as if they don't believe U.S. monetary policy has any impact on the rest of the world. Yet dozens of countries peg their own monetary policies to the dollar, as a way to minimize currency fluctuations and attract foreign investment. China's currency peg to the dollar is fundamentally a way of subcontracting its monetary policy to the Fed.
Chairman Ben Bernanke's Fed has focused almost solely on the U.S. domestic economy, taking interest rates down nearly to zero and expanding its balance sheet in unprecedented fashion. This has flooded the world with greenbacks and is the source of much global monetary instability. The flight to other currencies has only accelerated in recent weeks as the Fed has floated that it might indulge in another round of "quantitative easing"—i.e., easier money to reflate the U.S. economy. The flight to gold, now at $1,309 an ounce, is another symptom of the same disease.
China's ambassador to the World Trade Organization, Sun Zhenyu, was speaking for much of the world this week when he said that "We are very much concerned about how the U.S. would take practical and responsible measures to prevent the dollar glut and maintain the stability of the currency."
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The larger threat here is to the dollar's role as a reserve currency and to the overall world monetary system. The two worst monetary disruptions in the last 100 years occurred when the world's leading economic powers abdicated a leadership role. In the 1930s, Kindleberger describes how the weakened British were no longer able to lead and the Americans were still unwilling.
Then in the early 1970s Treasury Secretary John Connally and Richard Nixon, for domestic U.S. purposes, leaned on compliant Fed Chairman Arthur Burns to help them blow up the Bretton Woods postwar system of fixed exchange rates. The great inflation of the 1970s followed. As Connally famously told Europeans concerned about exchange-rate fluctuations, the dollar "is our currency, but your problem."
Listen carefully, and you can hear similar currency war drums pounding in the distance today. The task of economic leaders ought to be to head these forces off before they produce a crisis akin to those in the 1930s and 1970s. A Treasury Secretary and Fed Chairman worth their titles would be heeding Kindleberger's Depression warning: "When every country turned to protect its national private interest, the world public interest went down the drain, and with it the private interests of all."
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