Commentary Type

Who Caused the Currency Wars?

Op-ed in the Project Syndicate


The world is on the brink of a nasty confrontation over exchange rates-now spilling over to affect trade policy (America's flirtation with protectionism), attitudes toward capital flows (new restrictions in Brazil, Thailand, and South Korea), and public support for economic globalization (rising antiforeigner sentiment almost everywhere). Who is to blame for this situation getting so out of control, and what is likely to happen next?

... [A] great deal of responsibility for today's global economic dangers rests with the United States for three reasons.

The issue is usually framed in terms of whether some countries are "cheating" by holding their exchange rates at an undervalued rate, thus boosting their exports and limiting imports relative to what would happen if their central banks floated the local currency freely.

The main culprit in this conventional view is China, although the International Monetary Fund (IMF) is a close second. But, considered more broadly, the seriousness of today's situation is primarily due to Europe's refusal to reform global economic governance, compounded by years of political mismanagement and self-deception in the United States.

China certainly bears some responsibility. Partly by design and partly by chance, about a decade ago China found itself consistently accumulating large amounts of foreign reserves by running a trade surplus and intervening to buy up the dollars that this generated. In most countries, such intervention would tend to push up inflation because the central bank issues local currency in return for dollars. But, because the Chinese financial system remains tightly controlled and the options for investors are very limited, the usual inflationary consequences have not followed.

This gives China the unprecedented-for a large trading country-ability to accumulate foreign exchange reserves (now approaching $3 trillion). Its current account surplus peaked before the financial crisis of 2008 at around 11 percent of GDP. And its export lobby is fighting fiercely to keep the exchange rate roughly where it is relative to the dollar.

In principle, the IMF is supposed to press countries with undervalued exchange rates to let their currencies appreciate. The rhetoric from the Fund has been ambitious, including at the recently concluded annual meeting of its shareholders-the world's central banks and finance ministries-in Washington. But the reality is that the IMF has no power over China (or any other country with a current account surplus); the final communiqué last weekend was arguably the lamest on record.

Unfortunately, the IMF is guilty of more than hubris. Its handling of the Asian financial crisis in 1997-98 severely antagonized leading middle-income emerging-market countries-and they still believe that the Fund does not have their interests at heart. Here, the West Europeans play a major role because they are greatly overrepresented on the IMF's executive board and, despite all entreaties, simply refuse to consolidate their seats in order to give emerging markets significantly more influence.

As a result, emerging-market countries, aiming to ensure that they avoid needing financial support from the IMF in the foreseeable future, are increasingly following China's lead and trying to ensure that they, too, run current account surpluses. In practice, this means fervent efforts to prevent their currencies from appreciating in value.

But a great deal of responsibility for today's global economic dangers rests with the United States for three reasons. First, most emerging markets feel their currencies being pressed to appreciate by growing capital inflows. Investors in Brazil are being offered yields around 11 percent, while similar credit risks in the United States are paying no more than 2 to 3 percent. To many, this looks like a one-way bet. Moreover, US rates are likely to stay low because America's financial system blew itself up so completely (with help from European banks), and because low rates remain, for domestic reasons, part of the postcrisis policy mix.

Second, the United States has run record current account deficits over the past decade, as the political elite-Republicans and Democrats alike-became increasingly comfortable with overconsumption. These deficits facilitate the surpluses that emerging markets such as China want to run-the world's current accounts add up to zero, so if one large set of countries wants to run a surplus, someone big needs to run a deficit.

Leading Bush administration officials used to talk of the US current account deficit being a "gift" to the outside world. But, honestly, the United States has been overconsuming-living far beyond its means-for the past decade. The idea that tax cuts would lead to productivity gains and would pay for themselves (and fix the budget) has proved entirely illusory.

Third, the net flow of capital is from emerging markets to the United States-this is what it means to have current account surpluses in emerging markets and a deficit in the United States. But the gross flow of capital is from emerging market to emerging market, through big banks now implicitly backed by the state in both the United States and Europe. From the perspective of international investors, banks that are "too big to fail" are the perfect places to park their reserves-as long as the sovereign in question remains solvent. But what will these banks do with the funds?

When a similar issue emerged in the 1970s-the so-called "recycling of oil surpluses"-banks in Western financial centers extended loans to Latin America, communist Poland, and communist Romania. That was not a good idea, as it led to a massive (for the time) debt crisis in 1982.

We are now heading for something similar, but on a larger scale. The banks and other financial players have every incentive to load up on risk as we head into the cycle; they get the upside (Wall Street compensation this year is set to break records again) and the downside goes to taxpayers.

The "currency wars" themselves are merely a skirmish. The big problem is that the core of the world's financial system has become unstable, and reckless risk taking will once again lead to great collateral damage.

Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT.

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