As the massed tanks of the US Treasury Department move in to counter the heavy artillery of the People's Bank of China, and as the Bank of Japan unleashes a series of interventionist rockets to dissuade investors from buyingthe yen, the stage is set for an outbreak of currency wars.
Foreign exchange markets never have been, and never will be, free from state interference. While each country can define the value of its currency in relation to a basket of domestically consumed goods and services – typically through some form of inflation or money-supply target – it can also choose to define its currency's value with reference to currencies elsewhere in the world. In the late 1980s, for example, before the UK moved towards inflation targeting, the value of sterling was set relative not to the domestic price level but, instead, to the value of the Deutschmark.
What happens, however, if two countries cannot agree on the appropriate value for their mutual exchange rate? Then all sorts of accusations start to fly around. If a country is a successful exporter and runs a trade surplus, the typical accusation is that its currency is undervalued. If, instead, a country runs a trade deficit, the accusation runs the other way: its currency is overvalued and devaluation will, eventually, be required to balance the books.
The odd thing about this is that we don't choose to use the same language within a single currency zone, particularly where that zone is defined by a country's national borders. You don't hear many complaints about California's exchange rate against that of Texas, or Northumberland's exchange rate vis-à-vis Surrey's.
Yet there is still an implicit exchange rate, reflected in the relative prices of goods, services, labour and capital. And, even though no one bothers to record it, there is also a balance of payments position. Some regions have surpluses and others have deficits. Sometimes, markets can easily cope with these "imbalances", channelling capital in one direction and labour in the opposite direction. On other occasions, when markets don't function very well, we deal with these imbalances through the tax and benefit system and through regional policies of one kind or another. At the international level, however, mutual suspicion breeds economic hostility. Nation-states lock horns in international currency markets, trying to extract advantages from one another in a game that involves varying shades of protectionist endeavour.
China is apparently pursuing a mercantilist policy, deliberately undervaluing its exchange rate to deliver world export domination at the expense of workers and companies in the US and Europe.
The US may soon switch on its monetary printing press in a bid to churn out more dollars. The resulting devaluation of the greenback may benefit US exporters even as other nations lose out.
In the UK, policymakers proudly talk about the contribution that sterling's 2008 decline made to so-called "rebalancing", even though the UK's competitive gain simultaneously amounted to a huge competitive loss for the likes of Ireland.
At the heart of the problem is, of course, the Sino-US relationship. The Americans take the view that China's current account surplus stems from a policy of exchange-rate manipulation which can most obviously be seen through the huge increase in China's foreign exchange reserves in recent years.
These reserves constitute official Chinese purchases of foreign assets. The bigger they are, and the faster they rise, the more likely it is that the Chinese authorities are deliberately intervening to prevent their currency from rising.
If this then leads to a currency "undervaluation", Chinese exports to the rest of the world end up too cheap while foreign imports into China are too expensive. As a result, China's current account surplus is boosted through excessive exports and insufficient imports while America's current account deficit is raised for reverse reasons.
Are the Americans right? Certainly, my description is now part of the conventional Western wisdom, reflected in the beliefs of Americans, Europeans and the IMF. But the key underlying assumption behind this analysis is that imbalances exist only because of currency manipulation. The implication is that a rise in the Chinese renminbi would solve all ills. Put another way, there is only one price in the entire world that explains our totality of economic woes, and that price is the renminbi/dollar exchange rate.
It's at this point that the Chinese reject the conventional thinking. They could point to the yen's extraordinary rise over the last 40 years – from JPY360 against the dollar at the beginning of the 1970s to approaching JPY80 today – and note that, despite this huge appreciation, Japan's current account surplus has got bigger, not smaller. They could argue that America's prescription for China's economic rebalancing – a stronger currency and a boost to domestic demand – was precisely the policy followed by the Japanese in the late-1980s, leading to the biggest financial bubble in living memory and the 20-year hangover that followed. And they could argue that the demand for a renminbi revaluation is, in truth, a policy of American default.
America's current account deficit has to be funded by someone. Each year, the US needs loans from abroad to balance the books. Many of these loans come from China. China's holdings of US Treasuries and other assets making up its foreign exchange reserves are, in effect, claims on future US economic output. If the US wants to consume beyond its means today, it needs to pay back its creditors tomorrow.
A dollar devaluation changes all this. Because Chinese and other international creditors have lent to the US in dollars, a fall in the dollar will leave those creditors worse off. In renminbi terms, for example, Chinese holdings of Treasuries would be worth less.
From a Chinese perspective, then, a renminbi revaluation is, in truth, a dollar devaluation and, hence, an American act of default to its foreign creditors.
And that, I think, is why this latest outbreak of currency wars is so worrying. Underneath all the bluster, the rich Western world has over-consumed in recent years. It has too many debts. But rather than dealing with those debts – living a life of austerity, accepting a period of relative stagnation – the West wants to shift the burden of adjustment on to its creditors, even when those creditors are relatively poor nations with low per capita incomes.
And that rankles not just with the Chinese but also with many other countries in Asia and in other parts of the emerging world. During the Asian crisis in 1997-98, Western nations, under the auspices of the IMF, insisted that Asian nations, having borrowed too much, should now tighten their belts. But the US doesn't seem to think it should abide by the same rules. Far better to use the exchange rate to pass the burden on to someone else than to swallow the bitter pill of austerity.
No wonder the Chinese are not willing to play ball.
Stephen King is managing director of economics at HSBCReuse content