Essay: A Vicious Circle

Formally, at least, the U.S. and China have avoided fighting an all-out currency war. Beijing has attempted to appease anger in Washington over its undervalued yuan by allowing it to (very) slowly creep upward against the dollar. The Obama Administration has sidestepped political pressure and delayed a decision, originally expected in mid-October, on whether or not to brand China a currency manipulator. Yet China and the U.S. are heading toward a currency war anyway and the rest of the world could be affected too.

The war will be a logical consequence of changes in Federal Reserve policy in the U.S. With unemployment stubbornly high and the recovery running out of momentum, the smart money is on the Fed undertaking a new round of quantitative easing, nicknamed QE2. This policy allows the Fed to "create" new money through purchases of Treasury bonds. The goal is to prevent deflation and push banks to lend and companies to invest and hire by making more cash available.

There is a side effect. By increasing the amount of dollars in the world, the Fed would depress the greenback's value. Mere anticipation of the Fed's strategy has already weakened the dollar in global markets. That, in turn, places greater strain on the yuan. China's central bank would have to intervene on an even bigger scale by buying more and more dollars to stop the yuan rising in value. (On Oct. 19, the bank hiked its benchmark interest rate, signaling it would not fight potential inflation by allowing the yuan to appreciate.)

Can the U.S. force Beijing to loosen its grip on the yuan simply by generating more dollars? In theory, yes. The Fed has the ability to produce as many dollars as it wishes, potentially placing limitless pressure on China to let the yuan appreciate. Otherwise, Beijing would have to keep amassing dollar currency reserves it doesn't need. In practice, however, the Fed is unlikely to keep the printing presses humming indefinitely. Its aim is to aid the U.S. economy, not undermine China's currency regime or destroy the standing of the dollar.

China won't be the only country tested by the Fed. Especially vulnerable are emerging markets that have generally played by the rules those with relatively free currencies and borders open to capital flows. These economies will likely see an influx of new Fed-created dollars, due to their strong growth prospects or higher interest rates. When those dollars get exchanged for rupees, rupiah or other currencies to buy stocks, bonds or other local assets, the value of these currencies is pushed up. (The influx could also feed asset bubbles.) Policymakers in emerging markets will be forced to react, increasing the likelihood that they will step in to either depress or restrict the appreciation of their currencies. In other words, Fed policy could intensify a worldwide currency war.

QE2 would be implemented when governments are already skirmishing over currencies. Japan has criticized South Korea for intervening in currency markets to restrain the pace of the won's appreciation. Japanese Prime Minister Naoto Kan bunched China and South Korea together, saying both needed to follow "responsible actions within common rules" on their currency policies. Yet Kan's comment smacks of hypocrisy since Japan has itself taken steps against the yen's rise.

These currency moves and countermoves are part of a wider effort to transfer the pain of reforming the global economy to others. Countries with current-account surpluses (like China and Japan) must spend more and save less, while those with deficits (like the U.S. and the U.K.) need to spend less and save more. By fiddling with currencies, however, the adjustments needed are being deflected. China acknowledges that it must shift from an invest-and-export growth model to one based more on domestic consumption. But its leaders want that transformation to take place slowly so as not to destabilize the country's economy. The U.S. and other deficit nations, on the other hand, want cheaper currencies to export their way out of trouble.

I don't subscribe to the thinking that the U.S. should impose its will on the world economy for its own sake. That mind-set is precisely what angers Americans about China's resistance over the yuan. Instead, an international agreement is essential to phase out the imbalances in a cooperative manner. The coming G-20 summit in Seoul is just the forum to hammer out such an agreement, not just in principle, as has already been done, but with firm commitments on targets and reforms.

Sadly, the increasingly contentious state of global economic relations is unlikely to produce such a consensus anytime soon. Instead, we could get a global currency war that would doom the already anemic recovery rather than help any of its combatants. That's a war nobody will win.