'Matters Could Escalate' Economist Raghuram Rajan Warns of Currency Conflict

In a SPIEGEL interview, renowned Chicago-based economist Raghuram Rajan discusses the dangers of a global currency war, the risks of persistently low interest rates and the growing income and wealth inequality in the United States

SPIEGEL: Professor Rajan, the tensions between the United States and China are rising, several countries are trying to weaken their currencies. Is this the beginning of a global currency war?

Rajan: This is certainly a skirmish, with countries using different tools to get an advantage. The industrial economies are using ultra-loose monetary policy, while the emerging markets are using currency intervention and capital controls.

SPIEGEL: Where are the risks?

Rajan: The tools they are using will create distortions -- both ultra-loose monetary policy and intervention risk creating excess liquidity and asset price bubbles. If capital is too cheap, we will tend to use it too much. If the exchange rate is too low, we will focus on producing for exports. And if tempers boil over, we could get ugly protectionism.

SPIEGEL: China has kept its currency artificially undervalued against the dollar for years. Are the Chinese using unfair means?

Rajan: It is detrimental to China's development. Undervaluation of the currency is a form of subsidy for export companies. But they are beyond the stage where they need protection because they can already stand on their own feet. So to keep the currency undervalued is creating distortions in the economy, and this is neither efficient nor fair.

SPIEGEL: China, in other words, should increase the value of the yuan?

Rajan: It should, but an increasingly assertive China is likely to take its time doing so. An increasingly impatient US Congress, seeking to outsource the blame for slow American growth, may act. China may make cosmetic moves to fend off action. But matters could escalate. Far better would be for Asian emerging markets to put pressure on China and also accompany that pressure by increasing the value of their currencies in a coordinated manner.

SPIEGEL: How could these currency conflicts be defused?

Rajan: I think this has to do with more than just currencies. It is very convenient for industrial countries to point to currency intervention as the problem, because they are not directly guilty of that. Is it any surprise that China resists an international agreement where the sole focus will be exchange rates? But industrial countries are not beyond reproach on the kind of policies they have been following in recent years. Let us remember where this crisis originated ...

SPIEGEL: ... in the United States when the real estate bubble burst and the financial crisis broke out. So you think the equivalent of the Chinese policy of an undervalued currency is the American policy of cheap money.

Rajan: In some ways, this is a zero sum game because everyone is trying to get at the same sources of demand. We need better global dialogue on a whole gamut of policies, with nothing being taken off the table. But there is no appetite for that.

SPIEGEL: If China allows the yuan to rise, as you suggest, what would the Americans have to do? How should the United States change its monetary policy?

Rajan: There are still hidden fractures that threaten the global economy. The United States papers over it with an extreme degree of stimulus which creates conditions for excessive consumption and investment. We are pressing too hard on the accelerator here. Just look at the interest rates: They remain at a very low level, which is quite unusual. We are witnessing a recovery, but it is a false, unstable recovery.

SPIEGEL: Do the central banks really have a choice? If they raise interest rates, then the economy is likely to fall back into recession. This happened in the United States before, after the Great Depression in 1937.

Rajan: Economists are still debating whether the Federal Reserve Bank was responsible for the slump in 1937 or whether it was the rise of wages, unionization and regulation. I do not propose any overnight increase in interest rates, and certainly not to a high number like 5 percent. That would be irresponsible. I just think that sustained low interest rates are dangerous. They encourage the people to run up debt and to invest in risky assets. We are moving from crisis to crisis.

SPIEGEL: Isn't it too early to think about higher interest rates? The problems are far from being solved. In Greece or Ireland, for example, the situation is still fragile and cause for worry.

Rajan: That's true. But as worries settle down we shouldn't wait too long to start the process of raising rates. Right now, there is not even a debate about whether this is an appropriate idea. People are focused too much on the benefits of low interest rates without considering the costs. The economy is drifting from bubble to bubble. We already made this mistake once, after 2002. There is the danger that we will repeat this mistake.


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