Currency Wars and Global Rebalancing

Matias Vernengo

Guido Mantega, the Brazilian Finance Minister, said recently that Brazil is in the middle of a currency war.  His preoccupation with exchange rate appreciation is not directed to global imbalances, in general, or China, in particular.  A more depreciated currency provides protection for domestic production, and makes domestic goods and services cheaper for foreigners.  In that view, a stable but competitive (i.e. depreciated) real exchange rate (SCRER), as Roberto Frenkel and Lance Taylor call it, would be an essential tool in the development strategy in developing countries.  The message is that competitiveness of domestic markets matters for development.

Paul Krugman, on the other hand, used to think that competitiveness was a dangerous obsession, since countries are not in economic competition with each other.  But the current unemployment crisis has led him to suggest that the US would be justified in raising tariffs on Chinese goods.  His new position is based on the idea that the so-called global imbalances, the big Chinese trade surpluses and the reciprocal deficits in the US, are, at least in part, to blame for the unemployment crisis at home.  Since the Chinese authorities have been unresponsive to the revaluation of the renminbi, then tariffs would be necessary to reduce American trade deficits, and to keep jobs from being exported.  While one should welcome Krugman’s willingness to change positions, and admit that managed trade is not just ‘pop internationalism’ and is respectable (a position held by Latin American structuralists like Prebisch long ago), he succumbs to the fallacy of treating the US as a developing nation.

Economists in developing countries have known for generations that the adjustment to the balance of payments is asymmetrical.  Whereas a developed country, particularly one with the reserve currency as the US, can run trade deficits and rely on its strong currency to finance them, developing countries are forced to adjust.  In other words, developing countries must contract the level of activity to reduce the need for imports.  The adjustment in developing countries is done by a recession not by deflation.  In the developed country there is no need for a recession.

In the recent crisis, Krugman seems to believe that the impossibility of using fiscal policy, for political reasons, renders the US similar to a developing country.  The problem is that there are severe consequences to reducing global imbalances by promoting protectionism against China.  The exceptional rate of growth in China has resulted from its ability to increase and diversify its exports.  China can of course rely more heavily on its domestic market, but that would upset the fast recovery in other parts of the periphery, like Africa and South America.  If China exports less, grows less and imports less, in particular commodities, then the recession would spread to the rest of the periphery.

Krugman thinks that developing countries must carry the burden of increasing global employment, because he thinks in terms of symmetrical balance of payments adjustment.  For him, if in the US there are deflationary pressures, “the situation is quite different… in emerging economies. These economies have weathered the economic storm, they are fighting inflation rather than deflation, and they offer abundant investment opportunities.”  In the US the deficit with China does not impose deflationary pressures, since the US can continue to carry deficits without being forced to adjust.  In fact, during this crisis the possibility of the euro becoming an alternative to the dollar seems less likely, and the role of the dollar as key currency, at least in the medium run, seems more secure.  Also, China by pursuing aggressive fiscal policy has allowed for significant recovery in the periphery, not inflation.  For example, those countries in South America that export commodities to China are faring much better than Mexico, which depends on US markets.

The employment gains in the US of China-bashing would probably be small, but the global losses are potentially large.  One of the key roles of the country with the reserve currency is to act as the source of effective demand in the midst of a crisis, and this role cannot and will not be performed by China.  The solution for the employment crisis in the US depends on the debunking of the Treasury view (the view that fiscal deficits are bad and reduce private spending) and on a renewed fiscal effort at home.  Keynes, not Prebisch, is what the US needs.