Time for a Fightback in the Currency Wars

This op-ed by C. Fred Bergsten and Joseph E. Gagnon appeared September 4, 2012, in the Financial Times. Immediately following is a slightly longer version that elaborates on some of the key points.

The most overlooked cause of the economic weakness in the United States and Europe is what we call the "global currency wars." If all currency intervention were to cease, we estimate that the US trade deficit would fall by $150 billion to $300 billion, or 1 to 2 percent of gross domestic product. Between 1 million and 2 million jobs would be created. The euro area would gain by a lesser but still substantial amount. Countries that were engaged in intervention could offset the impact on their economies by expanding domestic demand.

China is by far the largest currency aggressor but has not been the major perpetrator of late. Three distinct groups are now involved. First are other Asian countries, including Japan, Singapore, Taiwan, Korea, Hong Kong, Thailand, and Malaysia. Second are major oil exporters including the United Arab Emirates, Russia, Norway, Saudi Arabia, Kuwait, and Algeria. Third are rich countries near to the euro area, most notably Switzerland but also Denmark and Israel. If Mitt Romney is elected US president, he will be able to label many countries as currency manipulators on his first day in the Oval Office, not just China, as he has promised.

These countries all exhibit rapidly growing levels of foreign currency reserves as well as significant current account surpluses. They buy US dollars and euros to suppress the value of their own currencies, keeping the price of their exports down and the cost of their imports up. Thus they subsidize exports and tax imports, enabling them to maintain or increase trade surpluses and pile up foreign exchange reserves. These tactics, in effect, export unemployment to the rest of the world. China has largely curtailed its currency aggression, at least for now, but many other countries remain highly active.

The currency wars started a decade ago and led to record trade imbalances. US and European policy makers tried to counter the effects and save jobs by encouraging a housing bubble. When the bubble popped, jobs disappeared. The US and Europe then adopted monetary and fiscal stimulus measures but prolonged financial deleveraging has offset much of their impact.

Some have criticized the United States for fuelling the currency wars through its unconventional monetary policy known as quantitative easing. However, that US initiative is conducted entirely in dollars and is intended to boost consumption and investment within the United States rather than to curb imports. Any impact on the exchange rate is secondary.

Moderate amounts of foreign exchange reserves help countries protect against adverse economic shocks. But reserve purchases by currency aggressors long ago exceeded the amounts that could be described as prudent. Governments in many developing economies and a few higher-income countries bought nearly $1.5 trillion of reserves and other foreign assets last year.

Our analysis suggests that the combined trade balances of countries actively purchasing foreign currency are $1 trillion higher as a result.

What can be done? The rules of both the International Monetary Fund and World Trade Organization forbid currency manipulation to maintain trade surpluses. These should be implemented at long last. Brazil has taken initiatives to this end and many other developing countries that run trade deficits, and lose from the currency wars, should join. The United States and the euro area should lead the effort. New bilateral and regional trade agreements, such as the Trans-Pacific Partnership, should include such rules.

If the preferred multilateral remedies continue to fail, revealing a huge gap in the international economic architecture, the aggrieved countries should act together to induce currency aggressors to mend their ways. The most direct action would be countervailing currency intervention through which the US Federal Reserve and the European Central Bank buy foreign currencies to offset the exchange rate impact of others' aggression. Another option would be a surcharge on imports from currency aggressors, as adopted unilaterally by the United States in 1971. A third approach would be to impose a transactions tax or a withholding tax on US and European assets accumulated by the aggressors. Given the huge costs of currency aggression, such measures may become necessary to resolve this global systemic problem and allow recovery in the United States and Europe.

The single most overlooked cause of the economic weakness in the United States and Europe is the global currency wars. If excessive currency intervention were to cease, the US trade deficit would fall by $150 billion to $300 billion or 1 to 2 percent of GDP. One to two million jobs would be created. The euro area and a number of other countries, both high income and developing, would gain by lesser but still substantial amounts. Countries formerly engaged in intervention could offset the impact on their own economies by expanding domestic demand, as China is already doing.

China is by far the largest currency aggressor but has not been the major perpetrator of late. Three distinct groups are now involved. First are other Asians including Japan, Singapore, Taiwan, Korea, Hong Kong, Thailand, and Malaysia. Second are major oil exporters including the United Arab Emirates, Russia, Norway, Saudi Arabia, Kuwait, and Algeria. Third are advanced-economy neighbors of the euro area, most notably Switzerland but including Denmark and Israel, who resist appreciation against the euro as much as the Asians resist appreciation against the dollar. If Governor Romney is elected president, he will have a number of candidates to cite as currency manipulators on his first day in office.

Table 1 identifies the 15 most active currency aggressors over the past decade. These countries all exhibit excessive and rapidly growing levels of reserves along with significant current account surpluses. Several other countries, including Brazil and India, have actively purchased foreign exchange but do not qualify as currency aggressors because they run current account deficits and are taking defensive rather than offensive action.

These countries buy dollars and euros to suppress the value of their own currencies, keeping the price of their exports down and the cost of their imports up. Thus they subsidize exports and tax imports, enabling them to maintain or increase trade surpluses and pile up foreign exchange reserves. These tactics effectively export unemployment to the rest of the world, costing millions of jobs in other countries. China has largely curtailed its currency aggression, at least for now, but many other countries remain highly active.

The currency wars started a decade ago, causing record trade imbalances. US and European policymakers tried at first to counter the effects and save jobs by encouraging a housing bubble. When the bubble popped, jobs disappeared. The United States and Europe then adopted a series of monetary and fiscal stimulus measures but prolonged financial deleveraging has offset much of their impact. Strong policy action is needed to end the currency hostilities.

Some have criticized the United States for fueling the currency wars through its unconventional monetary policy known as quantitative easing. However, that US initiative is conducted entirely in dollars and is intended to boost consumption and investment within the United States rather than to curb imports. Any impact on the exchange rate is secondary. Currency aggressors operate in foreign assets and the primary effect of their policy in most cases is on exports and imports.

Moderate amounts of foreign exchange reserves help countries protect against adverse economic shocks and, in some cases, security threats. Exporters of a non-renewable resource like oil have a right to build up a moderate amount of foreign assets to provide for future generations. But purchases of reserves and other foreign assets by currency aggressors long ago exceeded the amounts that could be justified by such considerations. Governments in many developing economies and a few higher income countries bought about $1 trillion of reserves last year. Based on the price of oil and the growth of sovereign wealth funds (SWFs) in the ten years through 2010, we estimate that SWF assets of oil exporters may have grown $400 billion to $500 billion last year, so that overall purchases of foreign assets by governments in 2011 were nearly $1.5 trillion. We think a reasonable level of asset purchases would be around $400 billion to $500 billion, consisting of savings by oil exporters and modest reserve accumulation in those countries for which reserves are not excessive. Thus, we estimate that excessive currency accumulation last year was around $1 trillion.

Our analysis suggests that eliminating this excessive currency accumulation would be associated with a reduction in the trade balances of currency aggressors by nearly $700 billion. Because the dollar and the euro are the main currencies being purchased, the lion's share of the corresponding strengthening of trade balances would accrue to the United States and the euro area.

What can be done? The rules of both the International Monetary Fund and World Trade Organization forbid currency manipulation to maintain trade surpluses and should be implemented at long last. Brazil has taken initiatives to this end and many other developing countries, who run trade deficits and lose from the currency wars, should join. The United States and the euro area, as major victims due to the international roles of their currencies, should help lead the effort. New bilateral and regional trade agreements, such as the Trans-Pacific Partnership and any new trans-Atlantic pact, should include such rules.

If the preferred multilateral remedies continue to fail, revealing a huge gap in the international economic architecture, the aggrieved countries should act together to induce currency aggressors to mend their ways. The most direct action would be countervailing currency intervention through which the Fed and the European Central Bank buy foreign currencies to offset the exchange rate impact of others' aggression. Another option would be a surcharge on imports from currency aggressors, as adopted unilaterally by the United States in 1971. A third approach would be to impose a transactions tax or a withholding tax on US and European assets accumulated by the aggressors to deter further reserve buildups. Given the huge costs of currency aggression, such measures may become necessary to resolve this global systemic problem and permit reasonable economic recovery in the United States and Europe.