Currency war looms as G-20 delays issue

By Neeraj Salhotra     12/2/10 6:00pm

In light of the recent G-20 meeting in Seoul, it is worth examining one central, much talked-about, yet certainly unresolved, issue: exchange rates, or more specifically, the undervaluing and overvaluing of certain currencies and the impact of such policies. Of late, there has been much discussion about the U.S. policy of quantitative easing (QE) - which involves the Federal Reserve buying medium and long-term treasury bills to increase the money supply so as to decrease interest rates - as compared to the Chinese policy of intervention. Many people have suggested that the U.S. QE is simply a latent means to devalue the dollar, similar to Chinese ?currency manipulation.

In fact, Brookings Institute scholars Mauricio Cardenas and Eduardo Levy-Yeyati wrote: "QE2 is ultimately a euphemism for the weak dollar." Even former Federal Reserve Bank Chairman Alan Greenspan noted, "America is pursuing a policy of currency weakening." Upon closer examination, however, these assertions seem false: The U.S. policy is an expansionary monetary policy to avoid deflation, whereas the Chinese policy is currency manipulation to boost exports. The U.S. Federal Reserve Bank recently enacted a policy of spending $600 billion to buy medium and long-term treasury bills. Such a policy, often referred to as monetary expansion or quantitative easing, was pursued both to prevent deflation and to boost economic activity.

Currently, core inflation is at 0.6 percent, raising fears of a possible deflationary period wherein investors are encouraged to hold money as its value grows over time. By injecting money into the economy, the Fed hopes to boost inflationary expectations and encourage investments, since interest rates are so low. In other words, the U.S. is, as noted economist Martin Wolf said, sustaining the domestic economy through deleveraging.

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Nevertheless, increasing the money supply will also decrease the exchange rate and depreciate the dollar. However, that is not the primary objective of QE. Even if the central goal of QE were to depreciate the dollar, that would be fine, considering that, according to Peterson Institute scholars John Williamson and William Clive, the dollar is 2.5 percent stronger than the Fundamental Equilibrium Exchange ?Rate (FEER).

My point is simple: QE is a policy by which the Federal Reserve is trying to avert a deflationary spiral and to increase economic investment by reducing interest rates. Yes, QE does have a short-term side effect of depreciating the dollar. However, depreciation is not the primary goal of QE, and it is an acceptable side effect, considering the U.S. dollar is ?currently overvalued.

On the flip side, the Chinese policy of intervention is, as Paul Krugman, a Nobel Prize laureate in economics said, currency manipulation. Basically, the Chinese government prints money to buy foreign currency. This policy decreases the supply of the yuan while increasing the demand for other global currencies, in turn devaluing the yuan. According to Williamson and Clive, the yuan is devalued by more than 17 percent. Because the yuan is devalued, Chinese companies are able to export goods at a fraction of the cost that U.S. producers pay. In other words, by keeping the yuan weak and devalued, the Chinese government subsidizes exports. The opposite is also true; namely that China taxes imports to further boost its trade surplus.

China's policy is predatory, as it hurts the global economy, which is currently trying to recover from the greatest economic recession since the Great Depression. If China would allow the yuan to appreciate, exports would decrease and imports would increase; China's trade surplus would decrease but certainly remain positive. The global community would greatly benefit, as exports and, in turn, employment would increase. In short, China's policy of currency manipulation artificially devalues the yuan, promoting Chinese exports at the expense of every other country.

Now that we understand the problem, what action must the global community take? The solution is simple: Countries must refrain from artificially devaluing their currencies. While this increases the welfare for one country, it hurts the global economy and will only engender further currency manipulations. These devaluations can lead to a currency war: a situation where there are no winners and the economy as a whole is a big loser. Finally, those countries with currently overvalued exchange rates relative to their FEER must be allowed to devalue the currency.

It is worth asking: Did the G-20 take the appropriate steps toward ending the exchange rate issues and preventing a currency war? The answer is a resounding no. In the three-page communiqué, the only reference to currency is: "[We pledge to] move toward more market-determined exchange rate systems and enhance exchange rate flexibility to reflect underlying economic fundamentals." However, this statement is so vague and vacuous that nothing will come of it.

The G-20 meeting was a perfect opportunity for the global economic powers to address the currency issue; however, they just kicked the can down the road and pushed us closer to currency wars and protectionism. President Barack Obama claimed that, on the currency issue, the G-20 countries had hit singles, but in reality they struck ?out looking.

Neeraj Salhotra is a Sid Richardson College sophomore.

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