Currency wars are brewing all over the place. You may have already heard about the major one -- a high-profile spat between the U.S. and China over the too-cheap Chinese currency. How these battles shake out will determine whether the global economy will move into harmony, or come apart at the seams.
For many years, the U.S. stood by a 'strong dollar' policy, which meant that a robust dollar was in America's best interests. The strong dollar enabled the U.S. to consume massive amounts of imports at a discount, which worked out just fine when the economy was doing well. It also allowed U.S. manufacturers to move jobs offshore to places where a weaker currency meant low wages.
That policy has come to an abrupt end. Congress is set to deliver a bill to President Obama that aims to amp up the rhetoric against China. If China doesn't let its currency rise in value (and economists believe it would need to rise +40% to achieve global parity), then the U.S. may start to enact steep tariffs on Chinese goods. That would be a clear positive for some domestic industries like steel-making and electronics, but would prove quite troublesome for any industry that wants to gain a foothold in the massive Chinese market. Chinese counter-moves that restrict access of U.S. goods would be almost inevitable.
For nearly 200 years, we have been taught that free trade and open markets are the key to rising global living standards. And myriad academic studies bear that out. But free trade theory assumes that everyone plays by a fair set of rules with regard to free-floating currencies and minimal trade barriers. In many respects, China is ignoring those rules by using a weak currency that is good for China and bad for its trading partners. These are known as 'Beggar Thy Neighbor' policies, and have led to major conflicts in past centuries.
Nobody anticipates these currency battles to escalate into an all out war, but recent comments from Brazil sure were heated. Brazil's currency has surged in 2010 to a point where its domestic businesses are becoming less competitive when compared to neighboring businesses in Argentina, Chile and Mexico. And that led Brazil's Finance Minister to tell the Financial Times this week that financial leaders are 'in the midst of an international currency war -- a general weakening of currency,' adding that the situation, 'threatens us because it takes away our competitiveness.'
In a similar vein, Japan has spent massive sums of money to buy back its currency -- the yen -- on foreign-exchange markets in a desperate, but perhaps futile, effort to weaken the yen and keep its exporters competitive.
Part of the burgeoning global currency problems stem from the fact that we've moved into a bi-polar world. Some countries consume lots of imports, while others focus on exports. The latter strategy worked fine for Japan for many decades, but with China emerging as the new global export powerhouse, Japan is now adrift with a domestic economy that generates minimal demand and an export economy that may flounder.
Policy makers are set to meet and likely pronounce an end to the currency wars. The G7, G20 and the IMF are set to meet soon and will express concerns that currency battles are detrimental to global growth. Even as these meetings yield diplomatic pronouncements, individual countries are likely to speak with much more vitriol and more likely to try to use policy tools to change the currency dynamics.
Yet even as policy makers look to take action against China and take steps to weaken their own currencies, the real long-term solution is to change consumption habits. In an ideal world, countries like China and Japan would develop much more robust levels of domestic spending to erase chronic trade surpluses. And countries like the U.S. would look to live with fewer imports to curtail trade deficits. That process is already underway as the U.S. starts to import less oil as auto fuel efficiency standards rise. And President Obama has stated a goal of doubling U.S. exports in the next five years. Trouble is, the only way that can happen is for the U.S. dollar to become a lot weaker. And despite repeated jaw-boning about other countries' currencies, the dollar remains relatively strong.
Judging by comments and actions by the Chinese government, it seems as there is a wish for the issue to simply continue to be ignored. But as recent events and comments in the U.S., Japan and Brazil underscore, currency conflicts look set to become more heated in the months to come.
[For a more thorough explanation of currency devaluation, how China manipulates its currency worth, and the economic impact following Argentina's devaluation, please read this educational article: How Money Manipulation on the Other Side of the World Could Affect American Portfolios.]
