Currency Wars

Author: Uri Dadush
Originally published by the Carnegie Endowment for International Peace

With leaders at the Group of 20 meeting of economic powers in South Korea failing to reach a blockbuster deal to ease economic tensions, the threat of a global currency war continues to loom large. Big disagreements remain over China’s exchange rate policy and the U.S. Federal Reserve’s decision to pump billions of dollars into the American economy.

In a Q&A, Uri Dadush assesses fears that the world is on the brink of more economic turmoil and analyzes what policy makers should do to prevent a currency or trade war from breaking out. Dadush argues that the threat of a currency war is real and it’s only a short step to an epidemic of protectionist measures. Instead of squabbling over current account deficits and surpluses, countries need to refocus on the impediments to sustainably increasing their domestic demand and give the recovery more time to take hold.

• What is the danger that a currency war could break out?
• Why did the U.S. Federal Reserve resort to quantitative easing to pump money into the economy?
• How have emerging markets responded to capital inflows? What measures are available to defend their economies against large influxes of capital?
• How have emerging markets responded to capital inflows? What measures are available to defend their economies against large influxes of capital?
• Should China take steps to revalue its currency?
• How can Europe help stop a global currency war?
• Following the G20 summit in Seoul, what can the Obama administration do to strengthen growth?
• Could a situation of competitive devaluation lead to wider economic or political problems?
• What should policy makers in developed countries and emerging markets do to calm economic tensions?

What is the danger that a currency war could break out?

The danger that a currency war breaks out is significant. There is a combination of factors from unemployment in the United States to the undervalued Chinese exchange rate to fears in emerging markets that an inflow of capital will prove destabilizing and hurt their competitiveness making it difficult for governments to effectively handle the situation.

On one side, the United States is unable to agree on fiscal stimulus, but it has a high unemployment rate that it can’t tolerate politically. With this in mind, it is using quantitative easing, export promotion strategies, and insisting that several other countries should allow their currencies to appreciate. In the eyes of many, this spells a weak dollar policy even though U.S. authorities strongly deny that they are looking for a lower currency. But it’s understandable that foreign policy makers are looking at the consequences of what the United States does rather than what U.S. leaders say.

On another side, several countries particularly in the emerging markets are under pressure to prevent their currencies from appreciating rapidly in the face of enormous amounts of capital coming in. But advanced countries are also concerned with the value of their currencies. Japan has seen a significant currency appreciation and Europe has seen ups and downs in the value of the euro, but feels that it needs a lower euro because of the major structural adjustments going on in countries on the edge of the European Union.

And last but not least, China is under pressure to revalue its currency. Beijing is concerned that if the renminbi is revalued too quickly it will hurt its large export sector. Despite China’s large contribution to supporting world growth in the wake of the crisis, its currency policy remains an extremely divisive issue.

If this combination of factors is not managed carefully, the situation could descend into an all-out conflict over currency levels as countries try to curb their currencies’ rise. And it’s a short step from a currency war of competitive devaluations to protectionism, and, in an extreme case, a trade war.

Why did the U.S. Federal Reserve resort to quantitative easing to pump money into the economy?

Given the gridlock in Congress on fiscal measures, it’s understandable that the Federal Reserve decided to pump $600 billion into the banking system in an attempt to fight unemployment and jolt the economy into recovery, but it creates a lot of other problems.

The United States has an unemployment rate of almost 10 percent and the country has seen the largest increase—by far—to its unemployment rate relative to other countries and relative to the country’s ten-year average. It has also seen an unprecedented surge in the share of long-term unemployment—the people who have been out of work for more than six months is now over 40 percent of unemployed workers. And there are estimates that underemployment, which includes discouraged workers and part-time workers who want to work full time, is around 17 percent.

The United States is less equipped than other countries to deal with people out of work because its unemployment and social benefits are among the least generous in advanced economies. While the benefits have been extended, they represent only a small part of a person’s previous income. And even today, unemployed American workers lose their healthcare coverage, whereas in Europe, healthcare is provided by the state.

The second important element in the Federal Reserve’s decision is that politicians in Washington are not able to agree on the continuation of fiscal stimulus. Even if the Bush-era tax cuts are extended to the entire population, the stimulus in 2011 will be smaller than 2010 and this could take off 1 percent of the country’s growth rate next year. After the midterm elections, the likelihood of a new fiscal stimulus is extremely low.

So the U.S. Federal Reserve sees itself as the only game in town to deal with a very difficult situation for many Americans. The problem is that quantitative easing is interpreted internationally as a key part of a weak dollar policy despite U.S. leaders saying otherwise.

How have emerging markets responded to capital inflows? What measures are available to defend their economies against large influxes of capital?

The issue of large capital flows to emerging markets is the result of fundamental trends as well as short-term policy issues. The first factor is the very low policy interest rates in the United States, Europe, and Japan. Interest rates in the United States and Europe dropped during the economic crisis and Japan has had low interest rates for years.

The second basic factor underpinning these flows is the slow growth in industrialized countries and concerns about their rising public debts, which reduce investor confidence in these countries’ prospects. And the third factor is that emerging markets—bar Eastern Europe—have performed remarkably well for the most part. Emerging economies are growing rapidly, straining capacity, and their public debt levels have declined while debt levels have gone up in advanced countries.

The combination of lots of liquidity in the system and the perception that there is a large growth differential between advanced and emerging economies has led to the surge of inflows into emerging markets. The inflows have risen to extraordinary levels in the last several months. While America’s quantitative easing exacerbated the problems and it may be the straw that breaks the camel’s back, it’s not the main reason for the inflows.

Developing countries essentially have three types of measures to protect their economies from large flows of capital—lower spending, intervene in foreign exchange markets, or adopt capital controls.

The most orthodox reaction is to consolidate spending and thus reduce inflationary pressures. By lowering government spending or increasing taxes, there will be a dampening effect on interest rates. On the one hand, this will attract less capital flows and, on the other, reduce inflation. But these measures take time to enact, are politically difficult, and in many cases run counter to achieving other objectives, such as investing in education or infrastructure.

The second method is to intervene directly in the foreign exchange markets. As countries buy up dollars and euros in exchange for local currencies, they are also typically concerned with inflation and overheating. In order to offset the inflow of money, countries tighten monetary policy by selling government bonds or increasing the reserve requirements of banks. There are costs associated with intervening in foreign exchange markets, however, as it basically maintains the country’s interest rate differential with the rest of the world and can encourage more inflows. Furthermore, countries keep accumulating reserves with a very low return. Regardless, many countries prefer to do this than to see their exchange rate appreciate.

The third type of policy is to impose capital controls—this is generally considered a last resort. For example, countries can put a tax on the most volatile and speculative inflows. Capital controls, too, have large costs, as they distort markets directly and investors soon find ways around them.

Most developing countries are employing a mixture of all three methods. Countries are withdrawing fiscal stimulus and building up reserves rapidly, and several are imposing capital controls, notably Brazil and Indonesia.

Is there a risk that emerging economies will overheat?

The risk that emerging economies will overheat is significant. Some economies are clearly overheating—with large exchange rate appreciations and inflation—and the list consists of important emerging markets, including Brazil, Indonesia, and Argentina.

This is a movie we’ve seen before. Surges in asset prices and housing prices eventually mean that prices will no longer reflect the underlying realities on the ground. And these waves of capital inflows will at some point stop or reverse when advanced countries raise interest rates. While this is not around the corner, things could get out of hand before this happens.

Should China take steps to revalue its currency?

China should take steps to revalue its currency at a faster rate. The change should be along the lines of what happened before the global economic crisis—in a three-year period China allowed its currency to appreciate by 20 percent. While this may still be too slow given the current circumstances, this would be a noticeable improvement.

China confronts overheating pressures and an appreciation of the currency will help mitigate them. The problem is that if the currency appreciation is announced and anticipated, China will see more speculative inflows despite its relatively closed capital account. It’s a catch-22.

Still, in the end a gradual currency appreciation is in China’s interest because it will help rebalance its economy toward domestic demand and consumption. If China does this, it will alleviate the concerns about currency appreciation in other parts of the world, including the United States. But it’s also important to note that the perceived impacts of shifts in China’s exchange rate on America’s competitiveness are more imagined than real; the keys to U.S. competitiveness and current account deficits are to be found in Washington, not Beijing.

How can Europe help stop a global currency war?

The most important thing that Europe can do is to solve its own debt crisis.

Unfortunately, Europe has many problems beyond global currency tensions. Europe is structurally rigid and it faces a full-fledged sovereign debt crisis in the periphery. Right now, Portugal, Ireland, and Greece are in the eye of the storm, but the storm could get even worse and engulf bigger European economies.

Vulnerable European states need to undertake big reforms, austerity measures, and structural changes that make the labor market more competitive and flexible. To support this, Germany and a few other Western European countries need to adopt more expansionary fiscal and wage policies. Germany is very reluctant to do this.

While weaker European countries are now undertaking the necessary austerity measures because they have no choice, they will need to be supported by looser fiscal policy in Germany and other countries at the European core, as well as the continuation of highly expansionary monetary policy. The problem is that this goes completely against the political grain for German leaders.

Following the G20 Summit in Seoul, What can the Obama Administration do to strengthen growth?

For its part, the United States should continue its fiscal stimulus over the next year. Setting aside the political constraints, Washington should make sure that adequate funds are devoted to support the long-term unemployed and state and local authorities forced to significantly cut back on services. This will help sustain growth and, while it also adds to the country’s debt burden at the margin, it is a necessary investment in social cohesion.

At the same time, the United States should put less emphasis on quantitative easing and take pressure off of the Federal Reserve to solve the unemployment problem by itself. The combination of looser fiscal policy and less loose monetary policy will be beneficial for the United States and will also alleviate the challenges confronted by trading partners.

The United States should also—and this is no less important than the first two measures—reassure markets that the country will get its fiscal house in order over the medium term. Washington needs to develop a structure of taxation and expenditures that is more rational and sustainable. This will include higher consumption taxes—including a higher gas tax—a moderation of entitlement spending, and more efficient spending overall, including for defense. This is vital on its own merits but it will also give more room for temporary fiscal stimulus today by reassuring the markets that the United States will be in a good fiscal position in the coming years. To repeat, these are steps that the United States will eventually need to take anyway.

Could a situation of competitive devaluation lead to wider economic or political problems?

A set of uncontrolled competitive devaluations could lead to a world of inflation—in both emerging and developed economies—and stronger trade frictions. When leaders and citizens see countries being uncooperative on currency policies, it’s natural to consider trade measures.

Competitive devaluations could be the beginning of a global protectionist resurgence and it’s very difficult to predict the wider effects—it could have broad political and geopolitical implications. Some argue that the last time there was a bout of competitive devaluations it led to World War II—I don’t think we’re headed to World War III, but all countries need to be careful.

What should policy makers in developed countries and emerging markets do to calm economic tensions?

Countries should deemphasize the currency and current account issue, and instead policy makers, the International Monetary Fund, and the G20 should focus their attention on increasing domestic demand sustainably in countries where the potential exists.

The advantage of this is that it focuses on the real problem—a lack of demand in advanced countries. A great deal of global problems is found in the advanced economies themselves. The United States, Germany, and others can and should do more.

The world economy also needs a little faith. The global economy is doing better than one would guess by reading the headlines in major international newspapers—both economic growth and trade are set to grow faster this year than the ten-year average. The world recovery is advancing. If politicians give the economy time, maintain open markets, and continue sensible policy frameworks, the global economy will continue to heal.