The Specter of Protectionism World Faces New Wave of Currency Wars

An American bill imposing punitive tarifs on countries that undervalue their currencies is set to unleash a new trade war between the US and China. But in fact the whole global currency system is in a state of jeopardy. As confidence in the dollar drops, private investors are putting their faith in gold. By SPIEGEL Staff.
The US accuses China of undervaluing its currency.

The US accuses China of undervaluing its currency.

Foto: PETAR KUJUNDZIC/ REUTERS

At first glance, the new bill sounds perfectly innocuous. "H. R. 2378 -- Currency Reform for Fair Trade Act" was on the agenda of the US House of Representatives late last Wednesday afternoon. Fair trade -- who could object to that?

But as the representatives started debating, it didn't sound harmless anymore. In fact, it sounded like war.

"International trade is a high-stakes, cutthroat business. And every time we simply talk, the other side acts. And every time they act, an American loses a job," said Xavier Becerra, a Democratic congressman from California.

Timothy Murphy, a Republican from Pennsylvania, went one step further: "We are about to lose our position as a global leader when next year China overtakes us as the biggest manufacturer in the world. The trouble is that China has never really accepted the basic rules of fair trade."

Democrat Linda Sanchez from California argued: "Opponents say that this bill will start a trade war. I say, we are already in a trade war. And China is using cannons and we're standing here shooting (air gun) pellets."

Verbal Attacks

There was one verbal attack right after the other, for roughly an hour. Speaker after speaker condemned the alleged "currency manipulators" from China who supposedly subsidize their products by keeping their currency artificially low. They all want to see H. R. 2378 passed into law.

A closer look at the fine print also reveals that the draft legislation is far from harmless. The bill calls for the US Department of Commerce to start imposing -- even without approval by US President Barack Obama -- punitive tariffs on certain countries. The initiative specifically targets countries that have "a fundamentally undervalued currency," "persistent global current account surpluses" and very large currency reserves -- in other words, China.

The bill passed the House by a vote of 348 to 79. "This is a stronger message than any previous one," says Nicholas Lardy from the Peterson Institute for International Economics.

Rediscovering Protectionism

The trade conflict between Beijing and Washington has thus entered a new, acute phase. One month before the high-stakes mid-term congressional elections, America's representatives, alarmed by nearly 10 percent unemployment and a gloomy economic outlook, have rediscovered an old friend: protectionism.

At the same time, they have pointed the finger once again at their favorite enemy: China. They are demanding that China finally adjust its currency so that Chinese products are no longer much cheaper than those manufactured by its US competitors.

Things are heating up in the conflict between the US and China: verbally, legally and politically. The economic power of the 20th century wants to cut the 21st century's economic giant down to size. The question is whether it is even still strong enough to do so -- and whether such a conflict won't end up harming everyone.

For a long time, the US economy has been dependent on cheap products made by the Chinese and on their currency reserves that bolster the value of the dollar. Until now, both sides have benefited from this system. One side lived beyond its means and paid with printed pieces of paper called dollars, the other side used this paper to purchase US government bonds, allowing it to accumulate huge currency reserves.

But things can't continue like this forever. Imbalances in world trade are growing increasingly large, and the global currency system is getting out of control.

American Hypocrisy

There is, however, also a fair amount of hypocrisy behind the latest American initiative. Nobody has controlled the currency markets as much as the US has in the past. The US Federal Reserve still continues to print dollars to finance skyrocketing government debt. The fact that this erodes the value of the US currency is something that the Americans seem not to care about. Of course, this makes imports into the US more expensive, but it also makes American exports cheaper and enhances the competitiveness of US companies.

Ultimately, though, exchange rates reflect the interconnectedness of today's world. When one side wins, the other loses, and vice versa. Recently, the euro suddenly rose, even though only a few months ago the financial world was speculating over the decline of the European common currency -- and the problems of the euro-zone countries have by no means been solved. The European Central Bank under President Jean-Claude Trichet is still purchasing government bonds from ailing euro countries to help maintain their value.

Nonetheless, risk premiums for Irish government bonds soared to new heights last week as the cost of bailing out the country's troubled banks rose to a massive €45 billion. In a number of euro-zone countries, tens of thousands have taken to the streets to protest planned austerity measures, giving rise to doubts over whether the proposed restructuring of state finances in these countries will actually succeed. That would normally be enough to drag down the euro -- if the economic outlook in the US weren't even gloomier.

Upside Down

Japan is also facing major difficulties. The economy still hasn't managed to recover, and the country continues to suffer from deflation and enormous government debt. Normally, all of this would pull down the value of the Japanese currency, but the exchange rate of the yen to the dollar is also rising because the Chinese, out of fear that the US currency will continue to fall, are increasingly investing their currency reserves in yen as well.

Nothing is as it should be on the global currency markets. It seems as if the world has been turned upside down -- and has become very dangerous. Indeed, for better or for worse, the well-being of entire countries depend on the value of these currencies, meaning that instability on the currency markets also threatens the structure of the global economy.

If the exchange rates are manipulated, imbalances increase and problems become more marked -- until they ultimately escalate. That would threaten to spark a currency crisis that could bring down entire economies.

Sucked into the Maelstrom

By itself, no country or currency zone could escape the maelstrom of such a crisis, as all countries are interconnected via their exchange rates. This is partly what makes it so dangerous when a country devalues its currency to boost its economy. If one side secures such a competitive advantage for itself, it automatically puts the other side at a disadvantage. If the other side reacts with a devaluation, this triggers a downward spiral where everyone is the loser. Economists call such a fateful development a deflationary spiral, a term from a dark, bygone era of economic history. It's a term which suddenly appears to be relevant again.

Brazilian Finance Minister Guido Mantega is already talking about an international currency war. "The advanced countries are seeking to devalue their currencies," Mantega said in a speech last week. "This threatens us because it takes away our competitiveness."

Brazil intends to resist a looming revaluation of its currency. Earlier, Japan massively intervened on the currency market.

Switzerland also sees itself as a victim of the weak euro and dollar. A great deal of capital is flowing into the country, threatening the competitiveness of the alpine nation's export industry. Time and again over the past few months, the Swiss central bank has purchased euros in an attempt to clip the wings of the soaring Swiss franc.

Death of the Gold Standard

The world has already experienced a tragic deflationary spiral once, which transpired during the turbulent years between the world wars. Up until then, the gold standard was in place nearly everywhere. People could exchange their money for a predetermined amount of the precious metal. Prices and exchange rates remained relatively stable for many years, and global trade flourished. But after the outbreak of World War I, the system didn't work anymore because the national economies had drifted too far apart.

The widespread poverty and unemployment that came with the Great Depression finally forced the countries to make a radical transition. On Sept. 20, 1931, the UK dropped the gold standard. Within just a few months, the pound had lost nearly a third of its value against the dollar. This produced the desired effect: The British economy recovered quickly.

But the UK had revitalized its economy at the cost of its neighbors who had stuck to the gold standard, meaning that their currencies became relatively expensive. Economists call this type of protectionist policy "beggar thy neighbor."

The reaction came quickly. In the spring of 1933, the US unpegged the dollar from gold -- and the US currency plummeted by 40 percent. Additional countries in the so-called gold bloc followed suit, and in the end, 25 countries had abandoned the gold standard.

Birth of a New System

Nobody could win this race, and it pulled down the entire world economy. Between 1929 and 1933, the volume of world trade fell from $3 billion to $1 billion.

In order to put an end to this currency chaos, representatives from 44 countries attended a conference in Bretton Woods, New Hampshire, in July 1944. They agreed to a new currency structure that was to ensure a regulated system of world trade. This system was designed to make it impossible to use currencies as weapons in global competition.

The dollar was chosen as an anchor and, from then on, the other currencies were moored to it. The US committed itself to converting the reserves that every country held in US currency to gold at a fixed price of $35 per ounce. The system collapsed in 1971 when the US could no longer maintain this commitment: It had printed too many dollars to pay for the Vietnam War.

Since then, there have been no more established rules, and everything is done according to the law of the jungle. So far, the US has been the strongest player. Thanks to the dollar, the world's undisputed reserve currency, the Americans have been able to live beyond their means for decades. They have been able to amass excessive debts -- because there is always someone who is willing to foot the bill.

Nowhere to Flee to

Although the value of the dollar has fallen over the past decades, the decline has been much less than what would have been economically justifiable. As long as the US is seen as a comparatively secure country, other nations will continue to place their reserves in dollars, thereby bolstering the US currency. But how long can the US continue to be seen as an economically secure country, if it fails to bring its government debt under control and keeps trying to solve its economic problems by bringing down the value of its currency?

The US still benefits from the fact that China and other emerging economies cannot shift their dollar reserves to other currencies without causing themselves massive damage. Not to mention the fact that there is nowhere to flee to -- after all, not even the euro offers a safe haven.

Private investors can flee, though. They are increasingly viewing major currencies with mistrust and purchasing gold as a result. The price of the precious metal continues to set new records. Last week, it soared to over $1,300 (€943) a troy ounce, meaning that it has more than quadrupled in price since the turn of the millennium. Now that the financial crisis has led to a sovereign debt crisis, it is becoming increasingly clear just how fragile the foundation of the world economy is -- and why new regulations are urgently needed.

Not surprisingly, there are increasing calls for a second Bretton Woods and a new world economic system with established rules. This is a recurring topic at G-20 summits.

The Role of China

The big unknown variable in such a future system is the role played by China. No new approach will last long if it doesn't include the yuan, also known as the renminbi. The crucial question is whether China is prepared to gradually allow its currency to float more freely.

Up until now, the country has been unprepared to take this step -- despite assurances made by the Chinese leadership on June 19 that it would end the fixed exchange rate with the dollar. The strong revaluation of the yuan that the Americans had hoped for has not occurred. Since then, it has only risen in price against the dollar by approximately 2 percent. China's central bank continues to steer its "people's currency" within a very narrow range.

The Chinese see the pressure from Washington as an attack on their sovereignty. It is true that experts in the Chinese central bank are debating the advantages that would come with an exchange rate reform, in order to free China from its dependency on exports. But if the communist leadership made too many concessions to the US, it would have to fear an enormous outcry from the patriotic Chinese public.

From the Chinese point of view, only a cautious revaluation would be an option. The Chinese want to avoid at all costs suffering the same fate as their neighbor Japan. After caving in to pressure from the US, in 1985 the former Asian superpower agreed to increase the exchange rate against the dollar. Within one year, the value of the yen had increased by some 60 percent. In order to balance out the negative consequences of the revaluation for the country's export industry, the Bank of Japan lowered interest rates to nearly zero, thereby triggering a huge speculative bubble on the stock exchange and the real estate market. Even today, Japan has still not recovered from the prolonged crisis that ensued.

The pressure on Japan also failed to bring the US much relief. American industries, particularly in the automotive sector, still couldn't effectively compete with manufacturers like Toyota and Honda.

Looking for a Scapegoat?

So it is questionable whether a reevaluation of the yuan would do the Americans much good. Between 2005 and 2008, the Chinese currency gained 21 percent, but the US trade deficit remained at record high levels. The problem is that Americans don't save enough -- and they have difficulties selling their own products around the world.

Even a devaluation of their own currency didn't help the Americans. Since 2002, the value of the dollar has slipped by over 30 percent against the euro.

That should have actually fueled the export economy. Instead, the US now has trade deficits with at least 90 countries, meaning that it imports more from those nations than it exports to them. Does this mean that the Americans are merely looking for a scapegoat for their own economic failure?

Before sanctions can be imposed on China, the Senate has to approve the proposed legislation. "It's important to recognize that we're not going to have a trade war, we're not going to have a currency war," said US Treasury Secretary Timothy Geithner.

That -- assuming Geithner's assessment is correct -- is the good news. The bad news is that there will be no new regulations for the global currency system, either. And it will continue to remain unclear what role the yuan will play in the future.

The result? Unstable currency markets will remain, also in the future, a permanent threat to the global economy.

ALEXANDER JUNG, ARMIN MAHLER, GREGOR PETER SCHMITZ, WIELAND WAGNER

Translated from the German by Paul Cohen
Mehr lesen über
Die Wiedergabe wurde unterbrochen.