World Bank and IMF meeting this weekend in DC

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Bogie, Claude Rains Wouldn't Be Shocked by Rigged Currency Casino

When it comes to manipulating currency values, China is hardly alone in the world, writes Businessweek.com columnist Chris Farrell

By Chris Farrell

October 5, 2010, 9:25PM EST

FINANCE

The stakes will be unusually high when the global finance mandarins of the World Bank and the International Monetary Fund gather for their annual meeting this weekend in Washington, D.C. Their task in backroom negotiations and high-level corridor discussions is to head off an incipient currency war that could degenerate into a round of beggar-thy-neighbor policies reminiscent of the 1930s. (The famous phrase is attributed to Joan Robinson, the Cambridge University economist who may have been inspired by the popular 19th century card game Beggar-My-Neighbor.)

The Institute for International Finance, a global association that represents more than 420 of the world's major financial institutions, is nervous enough to publicly call for the first global currency pact since the Plaza Accord of 1985. "A core group of the world's leading economies need to come together and hammer out an understanding," said Charles Dallara, the managing director of the Institute for International Finance, on Oct. 4.

He's absolutely right. The current currency conundrum makes the risk of another downward spiral in the fragile global economy all too real.

For a while, it was striking how governments refrained from pursuing protectionist policies during the Great Recession. It seemed that a major lesson of its predecessor, the Great Depression of the 1930s—that nations' embrace of tariffs and other barriers to trade in an effort to protect domestic industry was a disaster for everyone—had been absorbed. That's still the case, but the current recovery has been so anemic that governments everywhere are under enormous pressure to grab a bigger slice of a diminished economic pie for their companies and workers by cutting the value of their currency.

Japan, South Korea, Taiwan, Brazil, and Switzerland have all intervened in the currency markets to lower the value of their money to stay competitive. The Bank of England looks favorably on a weak pound. U.S. officials talk a good game about maintaining the value of the dollar even as they hope its decline will shore up the nation's beleaguered manufacturing industries.

U.S.-CHINA TENSIONS

But with so many countries trying to tamp down the value of their currencies, the tension has flared into the open. The European Union is worried that the Continent's recovery will falter with the euro appreciating some 15 percent against the U.S. dollar and its shadow currency, China's yuan. (The yuan's value is pegged to the greenback; it is trading around 6.69 per dollar.) The U.S. House of Representatives passed on Sept. 29 the Currency Reform for Fair Trade Act that would allow the government to slap countervailing duties on imports from countries deliberately undervaluing their currencies (which rhymes with "China").

"We're in the midst of an international currency war, a general weakening of currency," warned Brazil's Finance Minister Guido Mantega on Sept. 28. World Bank President Robert Zoellick a week later said that he didn't think "we're moving into an era of currency wars but there's clearly going to be tensions." That's hardly a reassuring comeback.

The core of the global imbroglio is the contentious economic relationship between the world's two leading economies, China and the U.S. The political and economic leaders of both countries need to act as global statesmen and not parochial politicians. It isn't impossible that cooler heads will prevail. Yet there's no gainsaying that this looks like the most critical juncture in policymaking since the collective embrace of John Maynard Keynes and Milton Friedman following the collapse of Lehman Brothers in 2008.

The U.S. has long charged that the yuan is undervalued and China's "manipulated" currency gives its industries a huge advantage in the global competition for markets and profits. To be sure, China's government allowed the yuan to appreciate against the dollar by some 21 percent from 2005 to 2008, and it relaxed the peg again in June 2010. But the yuan is only up some 2 percent since the change in currency policy.

THE MANIPULATION TRADITION

Official "manipulator" tag or no, there's no question that China manages its currency to its advantage. However, the charge of manipulation is a bit reminiscent of Captain Renault's (Claude Rains) feigned surprise in the immortal film Casablanca that he was "shocked, shocked" to find gambling going on in the watering hole operated by Rick Blaine (Humphrey Bogart). When it comes to currencies, manipulation is the rule rather than the exception.

The 20th century alone has provided some rich examples. President Roosevelt abandoned the gold standard in 1933 (and the earlier countries dropped the gold standard, the quicker they recovered from the Depression). The legendary postwar Bretton Woods currency system was built on managing currencies (with "manage" a code word for manipulation). President Nixon depreciated the value of the dollar in 1971 by ending its convertibility into gold. And a quarter-century ago representatives from France, West Germany, Japan, the U.S., and Britain convened at New York's Plaza Hotel and hammered out an agreement to slash the dollar's value in an effort to defuse economic tensions with an emergent Japan.

So much for free-floating exchange rates.

It's also doubtful that an upward revaluation of the yuan would bring manufacturing jobs back to America, as its advocates hope. The wage gap between the two countries is simply too great for a shift in currency values to have much of an impact.

No, the real issue is that the currency dispute highlights a major fault line in the global economy. The dollar peg has allowed China's exporters to rack up huge trade surpluses while suppressing demand at home. The money earned abroad is converted mostly into U.S. dollar assets, such as Treasury securities. China's consumers aren't benefiting. At the same time the U.S. hasn't saved enough—and has consumed too much. (The Federal Reserve reports that total consumer credit outstanding was $2.4 trillion in July 2010; a decade ago it was $1.6 trillion.) It's well-known that this China needs to consume more and the U.S. save more. Both countries need to show investors concrete actions rather than rhetoric toward those goals.

FRANCE: CHINA OF THE 1920S

That's certainly a lesson from the experience of pre-Great Depression France. In a sense, France was the China of the 1920s. The industrial world went off the 19th century gold standard during World War I. (The classical gold standard was a system of de facto pegged exchange rates, according to Barry Eichengreen, economist at the University of California, Berkeley.) The belligerents went back on the gold standard when the guns went silent, but at different times and with different values. For example, Britain embraced its prewar stance on the gold standard, leading Keynes to famously argue that the value of sterling had been fixed at an unsustainably high rate. Britain ended up running large trade deficits while the French picked a lower value that encouraged trade surpluses, says Eugene White, economic historian at Rutgers University.

France also absorbed huge amounts of the world's gold reserves, increasing its share from 7 percent to 27 percent between 1927 and 1932. Its "gold hoarding" created an artificial shortage of reserves and put other countries under enormous deflationary pressure, according to Douglas Irwin, economist at Dartmouth University. (Substitute "dollar hoarding" and China for today.)

Trade tensions rose between Britain and France. Central bankers from the two cross-channel rivals, Germany, and the U.S. met at a private home of Ogden Mills, the wealthy U.S. Treasury undersecretary, on the north shore of Long Island in July 1927 to address the situation, but no deal was reached between the two. "The French forced everyone to have deflation," says White at Rutgers. "It was a major contributor to the Great Depression."

Instead, the Federal Reserve under its leader Benjamin Strong decided to support Britain by cutting U.S. interest rates in August. It was a major blunder that fueled America's speculative frenzy and the stock market was up 20 percent by yearend. The boom went bust in 1929. "Some historians," writes Liaquat Ahamed, author of Lords of Finance, "see the meeting on Long Island as the pivotal moment, the turning point that set in train the fateful sequence of events that would eventually lead the world into depression. … The Fed's move was the spark that lit the forest fire."

CHINA UNDER PRESSURE

This time around world leaders can't afford similar disagreements and policy mistakes. It won't be easy. China's mercantilism is deeply ingrained. Indeed, the Guanzi, an ancient collection of essays named for the minister of state Guan Zhong (he died in 645 B.C.), not only offered up perhaps the world's first articulation of the quantitative theory of money, but it also suggested how important mercantilism was to providing peace and prosperity to the empire. But in the 21st century, the world economy needs China's consumers to boost their demand for all kinds of goods, including imported ones. Yet with China's domestic savers earning a negative interest rate, consumer-level inflation stirring at a 3.5 percent pace, and demand suppressed, money is pouring into real estate instead. "It's like a pressure cooker," worries White. Unless the Chinese government revalues its currency "they're setting up their banking system for collapse," he says.

At the same time, America's political class needs to shift from indulging in deficit-hating rhetoric and embrace deficit-reducing specifics. It's time to map out a long-term savings plan. In the meantime, it remains up to central bankers to strike the kind of deal that buys the global economy time by boosting growth. For starters, let's hope their emissaries in Washington can do better this weekend than their peers did on Long Island in 1927.

http://www.businessweek.com/investor/content/oct2010/pi2010105_110226_page_2.htm

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