But heeding those calls would be a mistake, given the danger of deflation and the weakness of the U.S. economy. The cure would be worse than the disease. Raising interest rates now and plunging the economy back into recession is the last thing America, and for that matter the world, needs.
What emerging markets are learning, and why they are experiencing such discomfort, is that there is no possibility of their decoupling economically from the United States. Like it or not, if U.S. growth is weak, they are going to feel the negative effects through less rapid export growth. By manipulating their exchange rates or tightening capital controls they can put off the day of reckoning, but they cannot avert the inevitable slowdown. Emerging markets need to realize that having the Fed raise interest rates in order to stem the flow of capital in their direction would only substitute an even more serious problem for the current one.
Pursuing a new global-exchange-rate pact—a new Bretton Woods agreement—would be equally misguided. Stabilizing exchange rates would require equalizing interest rates in the United States and abroad in order to remove the incentive for one-way capital flows. It would require bringing national monetary policies into line. But because economic conditions differ across countries—and will surely continue to do so—balancing out the level of interest rates would be a mistake economically. As soon as evidence of adverse consequences developed, political support for such an accord would dissolve. Any scheme to stabilize exchange rates, like in the good old days before the recovery of international capital flows, would quickly come to grief. This is a caution to those like French President Nicolas Sarkozy who have proposed a new Bretton Woods agreement as their contribution to the currency debate, and to those like World Bank President Robert Zoellick who have alluded, however obliquely, to the desirability of returning to the gold standard.
THE ONLY feasible solution is for emerging markets to accept the inevitable: the relative price of their exports rises and that of American exports falls. The question is whether these countries ultimately want to take this adjustment in the form of currency appreciation or inflation.
History shows that inflation is more socially disruptive. Not everyone’s wages will rise at the same rate, and those who are left behind will feel aggrieved. China already experiences scores of protests and demonstrations each year by workers angry that their wages are not keeping up with the rising cost of living. The last thing the government needs is to provoke more such outbursts. The “daylight-savings time” approach of using the exchange rate to bring about this adjustment (appreciating the currency rather than relying on wages to rise piecemeal) will mean everyone’s real incomes rise together because imports become cheaper as the exchange rate appreciates.
Emerging markets object that currency appreciation will hammer their exports and injure their manufacturing industries, eroding the benefits of learning by doing and productivity spillovers. But not all manufacturing industries are hotbeds of knowledge creation and technological dynamism. An undervalued exchange rate, the policy traditionally used to subsidize exports, is undiscriminating—it subsidizes exports across the board. If governments in China and elsewhere are worried about the consequences of abandoning that policy for productivity growth, then they should substitute targeted subsidies—investment tax credits, employment credits and the like—for that select subset of manufacturing industries where the positive productivity spillovers are concentrated. Some exporters would certainly be left out. It is those potentially disadvantaged exporters who are lobbying so intensely against the shift in currency policy. It is their pressure that is rendering their governments reluctant to move. But it is the only way for healthier growth to continue.
The United States needs to make it worth emerging markets’ while to do the right thing. First, the World Trade Organization, partly with impetus from the United States, bars the selective subsidization of exports. But if the alternative is wholesale subsidization through the maintenance of an undervalued exchange rate—the status quo—then what does the United States have to lose? Under present circumstances, it would be prudent for the WTO to look the other way and for the United States to let it.
The other big worry of these countries is that America will not maintain the value of the U.S. debt securities that they have accumulated in the course of intervening to keep their currencies down. They fear that in response to a mounting debt burden, the Fed will turn to inflation, eroding the value of the U.S. government’s debts. Or the United States could decide to repay principal and interest on Treasury bonds held by foreigners with low-interest securities rather than cash. Either response would amount to debasement of America’s external obligations.
Reassuring foreign central banks and governments with big investments in American Treasury securities would require Washington to put in place a credible plan for balancing the federal government budget. It would require putting the social security trust fund on a sustainable footing. It would require solving once and for all the problem of Medicare and Medicaid costs. Not only would emerging markets be reassured, but the United States itself would be better off.
Averting a currency war, then, is simple. Doing so doesn’t require some grand bargain between the United States and China. It only requires each party to recognize what is in its self-interest. Restoring peace and harmony to the financial sphere doesn’t require an outbreak of international cooperation. It only requires an outbreak of common sense.
Barry Eichengreen is the George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley. He is the author of Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System (Oxford University Press, 2011).Image: Essay Types: Essay