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.

10 Responses to “Currency Wars and Global Rebalancing”

  1. You’re right, US isn’t a developing country and the dollar’s role as lead currency is secure.
    But this doesn’t alter the fact that the huge current account deficit of the US isn’t sustainable in any way. And, always relying on the effective demand by US-Americans is a dangerous strategy.

  2. Ilene Grabel says:

    Agreed, Matias. Two things to add:
    1) There is also the matter of the right that developing countries have to use their exchange rate as a developmental policy tool. On balance it is a good thing to see several countries appropriating this kind of policy space at the present juncture. This might send a message that it is time to rethink institutional and policy arrangements that effectively cede or compromise the opportunity to deploy this policy tool (such dollar- or euro-ization, full liberalization of international capital inflows…).
    2) It may be that these unilateral currency moves by some developing countries stimulate serious discussions about ‘new global financial architecture.’ Certainly the G20 seems to have lost interest in this important matter, but it might be that unilateral currency moves by key developing countries puts the issue of the need for new architecture back on the table. We can hope….

  3. Jane D'Arista says:

    A good critique of the Krugman position, Matias – you’re right to point out that the US is not a developing country. But in so much of the discussion now about currencies and exchange rates, I am distressed to see that no one is putting the problem of imbalances and the inability of the reserve currency country to act as a source of demand in a monetary context. A monetary system based on a reserve currency is deeply flawed and can only survive for a limited amount of time as Triffin and Kaldor pointed out. The result of the key currency role of the dollar, as Kaldor noted in 1971, is that “the products of American industry are increasingly displaced by others, both in American and foreign markets” so that “maintaining prosperity requires ever-rising budgetary and balance of payments deficits”. The conclusion he saw is where we are today: “a nation of creative producers [transaformed] into a community of rentiers increasingly living on others, seeking gratification in ever more useless consumption, with all the debilitating effects of the bread and circuses of Imperial Rome”.
    The point also to be made is that a reserve currency system benefits finance, not the real economy, and the financial crisis is hurrying the process of making the US a failed economy. We do need to worry about that and choose a policy response that will help address the problem. Ending the dollar’s role as key currency and creating a new international monetary system in which no country must undertake such a terrible burden is, in my view, the critical policy response for the US and the global economy.

  4. Thanks for the great comments. I didn’t say that the dollar would be the reserve currency forever. But it is now. According to Hamilton and Chinn an appreciation of the renminbi of 10% would lead to a reduction in the US trade deficit of around $45 billion. Even in the best scenario, with a large foreign trade multiplier, this would be too small to have a significant effect in the employment situation.

  5. Marie Duggan says:

    The US can fund the current account deficit, but nonetheless, it causes a shift internally from manufacturing toward finance, and because of this destroys the standard of living of the working class.

  6. Hi Marie:
    That’s something that Jane also points out and is correct. But it doesn’t need to be so. Industrial policies, and employment policies that favor labor can be done even with a current account deficit. And also note that even if the i-phone, for example, is produced in China, most of the value added stays in the US ( The weakness of the labor force in the US is to blame for the stagnation of living standards here. So, okay, Keynes and Kalecki, rather than Prebisch is what the US needs!

  7. pearse derrig says:

    It’s very straight forward. Developed countries, with declining demographic trajectories, must consume “tomorrow’s” goods today. Capital production cannot keep pace to pay for the consumption. Consumption decreases. Currency can be devalued as a temporary measure to off-set the inherent trade imbalance with the producers.. And a viscous cycle ensues with additional currency devaluations when deemed required. The end game; a transfer of wealth to producing economies until developed countries re-tool for production and are able to compete. Even then, the emerging countries have the advantage, they’ve been at it all-the-while the consumers are waking-up to their new reality. The race is effectively over before it begins, no matter the strategy employed by consumer economies, including conflict.

  8. Francis Anthony says:

    The exchange rate, in the international trade is a self adjusting factor. It is indeed just that US is demanding China, allow its currency to appreciate. China has been building its surplus at the expense of US trade deficit. Over $1 Tril deficit isn’t a joke. China cannot be selfish in its behaviour while there are many Americans loosing homes, jobs and their livelihoods. Yes china is a developing country in normal terms but $1 Tril plus surplus in its reserves puts it near other developed countries. Yes US demands needed to be considered and US should go ahead with minimum 25% tariffs on China goods and this should be a good lesson to others that everyone should shoulder the burdon in shouldering responsibility of ” Live and let others too …..Then the world would be a better place to live

  9. Santiago says:

    Hi Matías: I found the argument very interesting. Here are two comments to your article in our blog (in Spanish).

  10. Charles says:

    The tongue is the enemy of the neck.