Can Anyone Win a Currency War?

Michael Pettis has a unique perspective on the Chinese economy. As a professor of finance at Peking University’s Guanghua School of Management, he also takes time to blog about the economic forces within China and how they may impact the rest of the world.

In his post, “What happens if the RMB is forced to revalue,” he points out that the Chinese response to the global financial crisis “seems to be a panicky process of stomping on the accelerator when things began to slow down, and then as the economy overheats … stomping on the brakes.”

But recent talk of a “currency war” doesn’t make managing the Chinese economy any easier.

I have always argued that the only way to avoid a real deterioration in trade relations is for the major economies to come to a grand bargain and agree to adjust over an eight to ten year period, although I have also always been very pessimistic that this would happen.

China must carefully balance its needs to build domestic spending without creating a financial bubble – and reduce its reliance on exports without creating high unemployment. Tough challenge, and timing is everything.

This is the problem China faces. It must raise the value of the renminbi as part of its rebalancing towards greater domestic consumption, but if it does so too quickly, the rebalancing will occur not as an increase in consumption relative to rising production, but rather as a drop in production relative to declining consumption.

This may seem like a confusing point, but it is worth understanding. China can rebalance with high unemployment as well as with low unemployment, and the difference has to do with the speed of the rebalancing.

If China adjusts too quickly, consumption will actually decline, and production will decline even faster. In that case China rebalances (consumption rises as a share of GDP), but under conditions of rising unemployment.

Pettis explains that if the US overreacts, the yuan could rise faster than the Chinese economy can absorb leading to a misallocation of resources.

This will not benefit China. It will fuel even more real estate, manufacturing and infrastructure overcapacity without having rebalanced consumption. Expect, for example, even more ships, steel, and chemicals in a world that really does not want any more.

From the perspective of unemployed workers in the US, we’re not overreacting at all because it’s cheap Chinese goods that are partly responsible for our economic woes.

That’s one reason why the House of Representatives passed the Currency Reform for Fair Trade Act bill – although it’s unclear if the Senate will consider it or if Obama would sign it.

Grown up behavior?

Pettis hopes for “grown up” behavior, but isn’t expecting it.

China and other surplus countries like Germany and Japan need to understand that their policies are causing real damage in the US, and the US needs to understand that the surplus countries simply cannot adjust fast enough to suit the US, but neither side is very interested in understanding the other.

An optimal solution will require real grown-up behavior on the part of the major economies, who must agree to resolve the trade imbalances carefully and with determination.  Of course grown-up behavior is probably too much to ask from countries that have displayed so little of it to date.

One thing about a currency war is that it can be remarkably counterintuitive. American consumers enjoy access to inexpensive Chinese products. Chinese consumers, on the other hand, find US goods too expensive because the yuan is pegged to the dollar.
So we’re supposed to punish our consumers because China is punishing theirs?

After World War II, the Bretton Woods System provided the much needed stability in a world where much of Europe lay in ruins.

Perhaps a new currency system is something to consider. I have no idea if the world’s leaders have the courage or political capital to pull it off, but I think it probably beats fighting a currency war that we’re unlikely to win.