Hamish McRae: We must stay out of this US-China tussle

In currency wars, as in real wars, non-combatants sometimes get caught in the crossfire. And so it may be for Europe and the UK after an increasingly noisy series of skirmishes between the US and China. This is not yet a war and it is profoundly in the self-interest of both the world's largest and second largest economies that the present hostilities should not develop into that. But countries make mistakes, sometimes with grave consequences. Come to how we are affected in a moment; first, what is happening?

It is a classic case of two countries framing economic policies for short-term domestic purposes without regard to the interests of their principal trading partner. The US has run up a huge deficit with China, with China lending the US the money to do so. So the US got the cheap Chinese goods, while China built up its export industries. Now China is the US's biggest creditor and is still piling up more and more dollars, despite the fall in demand from US consumers as the recession has bit.

The US wants a currency revaluation of the yuan, the idea being to make Chinese goods less competitive. But the effect of this would be to devalue the assets that China has built up in US securities. So China sees the US has having been grossly irresponsible with over-expansionary monetary and fiscal policies and is now wanting to cheat it by cutting the real value of its debts. And the US sees China as having followed an overly aggressive export policy, boosting its own industry at the expense of the US.

And, of course, both are right and both are wrong. Both are right that the other has not behaved in a responsible way. Both are wrong in ignoring their own culpability, you might even say stupidity. If China has been over-aggressive, the US has been overly self-indulgent. I don't think there is much point in trying to apportion blame; what matters is what is going to happen.

We are heading into the most dangerous period. We are in the very early stages of recovery and there is every likelihood that there will be some kind of setback in the next few months. So the US will be under great pressure to lash out, either directly by imposing some sort of restriction on Chinese imports or indirectly by a new round of quantitative easing to pump more money into the economy, which will have the effect of pushing down the dollar. China will be under pressure to use its status as banker to the US as a lever, perhaps by buying fewer US treasury securities.

My guess is that both sides will pull back. Let's hope so. But there is already collateral damage. Gold is at an all-time high in dollar terms, a classic indicator of distrust in the currency. More significantly for most people, the maize price has shot up, pushing up other food prices. The oil price is remarkably strong for the period of the economic cycle, with demand still depressed in almost the whole of the developed world.

For Europe, the main effect has been to push the euro up against the dollar, which may be acceptable for Germany, currently experiencing booming demand for its exports – the Chinese like their Audi, Mercedes and BMWs. But it puts even more pressure on the weaker members, including Greece, Portugal, Spain and Ireland.

And us? Well, the UK is in a curious position in that we have been pursuing currency depreciation by stealth. We don't shout that we are actively trying to cheat foreign lenders by paying them back in depreciating currency but that is the effect of our policies. We use euphemisms such as having a "competitive currency". Our inflation is at the top end of the developed world. It is not the official policy to try and cheat savers, foreign and domestic, but the effect, of near-zero interest rates and a retail price index of 4.6 per cent, is to steal money. No wonder people don't trust governments.

But we are not in the same position as the US in that unlike them we do not see ourselves in an antagonistic trade and currency relationship with China. Maybe we should. Over the past 12 months we have run a trade deficit with China of more than £20bn, a figure that has been rising relentlessly for two decades. But we have a surplus on trade in services including, incidentally, the education of Chinese students in our universities, so we may be nearer square on the deal than at first sight appears. (Did you know there are more Chinese students in the UK than in the US?)

If the US/China relationship were to develop into a currency war everyone would be damaged. Over the next 20 years China will gradually overtake the US as the main economic power. Managing that transition will be extremely difficult. Every trading economy in the world stands to lose, not just the two protagonists, if they fail to behave in an honourable and orderly way to each other. But this is a tussle that we have to stay out of as far as we can for as long as we can.

An inflationary fiddle

We now know the key September inflation numbers, 3.1 per cent for the Consumer Price Index (CPI) and 4.6 per cent for the Retail Price Index (RPI). And it is the September numbers that the government uses to upgrade benefits the following spring – except that this time, for the first time ever, it plans to use the CPI rather than the RPI for most benefits. The obvious reason is to save taxpayers' money. The switch is forecast to save an annual £6bn by 2014-15. But the government also defended the change on the grounds that CPI provided a better measure of the "inflation experience" of benefit recipients. Leaving aside the hideous expression, is this fair both to recipients of benefits and to taxpayers? Well, the Institute for Fiscal Studies has done a study on this published yesterday. The bottom line is that if, when prices change, people are good at switching to cheaper lines, then the CPI is acceptable because that is one of the main reasons it works out lower than the RPI. But it wouldn't be a clear improvement on the present system and in some ways would be worse.


For further reading

A tale of 3 indices: further thoughts on benefit indexation – IFS October 2010.