Is there a way out of the currency war?
Competitive devaluation is no longer a possible danger â€“ it is already here. Many people are worried that, after global stock market crashes and a collapse of most of the worldâ€™s banking system, a war over exchange rates completes a sequence of events that looks awfully like a rerun of the 1930â€™s. There is however one crucial difference. The Chinese role certainly makes matters more complicated, though it is as yet unclear whether it makes the outlook better or worse.
The key point to understand about the belligerents is this. In the context of purely self-interested beggar-my-neighbour economic policy, devaluation makes good sense for the Eurozone countries as a whole, the British, the Japanese, Swiss, Koreans… for everyone except the Americans. Whether they are deficit countries, like Britain, or surplus countries, like Switzerland, Korea or Japan, devaluation will increase demand for their exports and make their imports more expensive, giving a boost to their output and employment. And if other countries retaliate by counter-devaluation, they can tell themselves that their situation would have been worse if they had not taken the initiative and got their retaliation in first.
By contrast, Americaâ€™s situation is very different. As long as China keeps its exchange rate more or less fixed, the dollar is not a wholly US currency â€“ it is the currency of two countries, one massively in deficit , and one massively in surplus. The fact that they are separate countries in every other respect makes no difference. De facto, China and USA share a single currency every bit as much as France, Germany, Italy, Greece and the rest share the same currency, the Euro. The only difference is that in the Eurozone everyone uses Euros, whereas in the dollar zone the overwhelming majority use a dollar-certificate, a piece of paper bearing a picture of Mao Tse-tung and exchanging for about 15 U.S. cents.
It is hard to understand why China has voluntarily accepted this arrangement, which forces it to accept whatever monetary policy the U.S. Federal Reserve chooses. In any case, the implication is that the dollar cannot be devalued against one of its most important trading partners, because the two of them are bound together in a de facto currency union. In its desperate attempts to shake China off, like a celebrity trying to shake off a stalker, the Fed is printing more and more dollars, which are used by Americaâ€™s consumers to buy more and more Chinese exports, thereby sending the new dollars flooding into China to swell the reserves of the Peopleâ€™s Republic, which must now be approaching $3trn.
There are two consequences of this linkage. First, it is the struggle over the dollar/RMB which has caused the other countries to devalue their currencies. The more the US drives down the value of the dollar, the more the exchange rate of the RMB is dragged down relative to all the other currencies, so the harder it is for third countries to live with the competition from ever-cheaper Chinese products. It was hard for them before, but with a cheaper RMB, life becomes impossible â€“ so the Japanese try to devalue the Yen, the Swiss start to push down the value of their currency, and the Pound had already fallen a lot by the end of last year. In a sense, these other currencies are caught in the crossfire of the U.S.-China war.
The second consequence is this. China has now made a heavy investment in disaster. In the last few years, the worldâ€™s supply of dollars has expanded many many times faster than the U.S. economy. The result would have been a collapse in the value of the dollar, if China had not chosen to accumulate the massive excess supply in its own reserves.
Like second marriages, fixed exchange rate systems represent the triumph of hope over experience. History shows that in the end the dike never holds back the flood. When the dollarâ€™s value collapses and the upward pressure on the RMB can no longer be resisted, China will suffer double pain â€“ facing increased trade competition from a near-bankrupt USA with the dollar at its lowest-ever level, and at the same time losing hundreds of billions, possibly even a trillion dollars or more through the fall in the value of its reserves in terms of RMB (or indeed in terms of any currency other than dollars).
Ultimately, the only bright point in this sad situation is that, so far, there have only been threats of a trade war. In other words, competitive devaluation has prevented competitive trade protection. But that could change at any moment.
Is there a way out?
America needs to reduce its consumption and save far more, and it has made a small start in this direction, though it still has a long way to go. China needs to do the opposite, using its vast dollar reserves to finance a leap forward in building a 21st century physical and social infrastructure â€“ more and better roads, railways, hospitals and schools, and more of a social safety net to give households the confidence to spend more of their incomes. Rebalancing the economy will make the Chinese economy what it should already be – capable of generating its own growth independently of the rest of the world. Without these changes, its future is left in the hands of the Americans.