Who would win a currency war?

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Tim Geithner could reveal today whether or not his Treasury Department will formally label China a “currency manipulator.” There is mounting political pressure for the U.S. to take stronger action against China’s currency policy. Being perceived as “soft” on China won’t help the Democrats in upcoming November elections. And a record U.S. trade deficit with China in August will shine an even brighter spotlight on Beijing’s refusal to allow the yuan to appreciate. ((UPDATE: Treasury delayed issuing the currency report.)

However, formally labeling China a “manipulator” would not achieve very much, in my opinion. Such a step would not only further sour already strained Washington-Beijing relations, but also do little towards convincing Beijing to become more flexible with the yuan. And, more importantly, the fact is that China and the U.S. are heading towards a kind of currency war anyway, due to the upcoming course of U.S. economic policy. Is this a war the U.S. can win?

The coming “war” will be an outgrowth of changes in Federal Reserve policy. There is widespread consensus that the Fed will undertake a new round of “quantitative easing,” nicknamed QE2, in which the Fed will buy up Treasury bills to flood the economy with even more liquidity. The goal is to prevent deflation and boost the sagging recovery by pushing banks to lend and companies to invest and hire. But there is a side effect that directly impacts China’s yuan policy. By increasing the amount of dollars available in the world, the Fed would depress the value of the dollar. Mere anticipation of the Fed’s new strategy has already weakened the dollar on world markets. That, in turn, places more strain on the yuan, making Beijing work extra hard to stop the yuan from appreciating against the dollar. In other words, there’s something of a contest of wills coming up – can the U.S. flood the world with enough dollars to force China to loosen its grip on the yuan?

Martin Wolf of The Financial Times, in an extremely smart analysis of the potential impact of the Fed’s probable policy, says yes. Because the U.S. can create as many dollars as it wishes, Wolf argues, the U.S. can force the rest of the world to adjust to its own policies, not vice versa. Here’s how he explained it:

To put it crudely, the US wants to inflate the rest of the world, while the latter is trying to deflate the US. The US must win, since it has infinite ammunition: there is no limit to the dollars the Federal Reserve can create. What needs to be discussed is the terms of the world’s surrender: the needed changes in nominal exchange rates and domestic policies around the world…China objects to the huge US fiscal deficits and unconventional monetary policies. China is also determined to keep inflation down at home and limit the appreciation of its currency. The implication of this policy is clear: adjustments in real exchange rates should occur via falling US domestic prices. China wants to impose a deflationary adjustment on the US, just as Germany is doing to Greece. This is not going to happen.

Of course, not everyone agrees that the U.S. can be successful. Yiping Huang, an economist at Peking University, wrote in The Wall Street Journal that China’s capital controls would allow it to resist the Fed’s efforts:

U.S. unilateral monetary intervention is unlikely to work either. The U.S. can’t sell dollars to offset China’s intervention in foreign-exchange markets because China has capital-account controls, and it would be impossible to source enough yuan.

Whether Fed monetary easing will press China to release the yuan or not, I’m not a fan of the thinking that the U.S., by using (or should we say, abusing) the global position of the U.S. dollar can or should impose its will on the world economy for its own good. That mindset is exactly what angers Americans about China’s resistance on the yuan. Furthermore, Fed policy would impact just about every economy in the world, in most cases much more than China’s. Especially vulnerable will be emerging markets that have generally played by the rules – those with relatively free currencies and open borders to capital flows. These economies will likely see an influx of new Fed-created dollars, due to their strong growth prospects or higher interest rates, pushing up the value of their currencies (and possibly feeding other ills, like asset bubbles). That will force policymakers throughout the emerging world to react, increasing the likelihood that they will step in to control the value of their own currencies. In other words, Fed policy could intensify a worldwide currency war.

The battle over currencies is already intensifying. Japan and South Korea have been bickering this week over comments by Japanese officials criticizing Seoul’s policy of intervening in currency markets to restrain the pace of appreciation of the won. Japanese Prime Minister Naoto Kan bunched China and South Korea together, saying both needed to follow “responsible actions within common rules” on their currency policies. Kan’s comment falls into the people-in-glass-houses category, since Japan has taken steps to stop the yen’s rise as well and is threatening further action. On Tuesday, Thailand acted to control the appreciation of the baht, in part by reinstating a tax on foreign investment in Thai government bonds.

As Wolf rightly points out, all of these moves and countermoves in different countries in regard to their currencies are part of a grander effort – to push the necessary economic adjustments needed to restore healthy growth onto others. Those countries with current account surpluses (China, Japan) want to delay the reforms needed in their domestic economies to become less dependent on exports and stimulate domestic demand. The U.S. and other deficit nations want to export their way out of trouble rather than adjusting prices and consumption at home. But these attempts to hoist responsibility onto others won’t resolve the giant imbalances that underpinned the Great Recession or restore the world economy to stable growth. What’s needed is a grand international agreement aimed at working out the imbalances in a cooperative manner than allows everyone time to adapt to the new economic realities. The upcoming G20 summit in Seoul in November is just the forum to forge such an agreement, and it already has done so, but only in principle. What we need is a real, working arrangement. But the increasingly contentious state of affairs in global economic relations is not likely to produce such a consensus anytime soon.

So the title of this post is actually a trick question. Who will win a currency war? The correct answer is: Nobody.