The Plaza Accord was a success if measured solely as an exercise in devaluation, but the economic results were disappointing. U.S. unemployment remained high, at 7.0 percent in 1986, while growth slowed considerably to only 3.2 percent in 1987. Once again, the quick fix had proved chimerical and, once again, there was a high price to pay in the form of inflation, which took off with a lag after the Plaza Accord, shooting back up to 6.1 percent in 1990. Devaluation and currency wars never produce either the growth or the jobs that are promised, but they reliably produce inflation.
The Plaza Accord was deemed too successful by the parties and occasioned one last adjustment to put the brakes on the dollar’s rapid decline from the heights of 1985. The G7, consisting of the Plaza Accord parties plus Canada and Italy, met at the Louvre in Paris in early 1987 to sign the Louvre Accord, meant to stabilize the dollar at the new, lower level. With the Louvre Accord, Currency War II ended, as the G7 finance ministers decided that, after twenty years of turmoil, enough was enough.
By 1987, gold was gone from international finance, the dollar had been devalued, the yen and mark were ascendant, sterling had faltered, the euro was in prospect and China had not yet taken its own place on the stage. For now, there was relative peace in international monetary matters, yet this peace rested on nothing more substantial than faith in the dollar as a store of value based on a growing U.S. economy and stable monetary policy by the Fed. These conditions largely prevailed through the 1990s and into the early twenty-first century, notwithstanding two mild recessions along the way. The currency crises that did arise were nondollar crises, such as the sterling crisis of 1992, the Mexican peso crisis of 1994 and the Asia-Russia financial crisis of 1997–1998. None of these crises threatened the dollar—in fact, the dollar was typically a safe haven when they arose. It seemed as though it would take either a collapse in growth or the rise of a competing economic power—or both—to threaten the supremacy of the dollar. When these factors finally did converge, in 2010, the result would be the international monetary equivalent of a tsunami.
CHAPTER 6
Currency War III (2010–)
“The purpose . . . is not to push the dollar down. This should not be regarded as some sort of chapter in a currency war.”
Janet Yellen,
Vice Chair of the Federal Reserve,
commenting on quantitative easing,
November 16, 2010
“Quantitative easing also works through exchange rates.... The Fed could engage in much more aggressive quantitative easing . . . to further lower . . . the dollar.”
Christina D. Romer,
former Chair of the Council of Economic Advisers,
commenting on quantitative easing,
February 27, 2011
Three supercurrencies—the dollar, the euro and the yuan—issued by the three largest economies in the world—the United States, the European Union and the People’s Republic of China—are the superpowers in a new currency war, Currency War III, which began in 2010 as a consequence of the 2007 depression and whose dimensions and consequences are just now coming into focus.
No one denies the importance of other major currencies in the global financial system, including Japanese yen, UK pounds sterling, Swiss francs, and those of the remaining BRICs: Brazilian real, Russian ruble, Indian rupee and South African rand. These currencies derive their importance from the size of the economies that issue them and the volume of trade and financial transactions in which those countries engage. By these measures, the indigenous dollars issued by Australia, New Zealand, Canada, Singapore, Hong Kong and Taiwan, as well as the Norwegian krone, South Korean won and UAE dirham, all have pride of place. But the combined GDP of the United States, European Union and China—almost 60 percent of global GDP—creates a center of gravity to which all other economies and currencies are peripheral in some way.
Every war has its main fronts and its romantic and often bloody sideshows. World War II was the greatest and most expansive military conflict in history. The U.S. perspective on World War II is neatly divided into Europe and the Pacific, while a Japanese perspective would encompass an imperial empire stretching from Burma to an overextended attack at Pearl Harbor. The English, it seems, fought everywhere at once.
So it is with currency wars. The main battle lines being drawn are a dollar-yuan theater across the Pacific, a dollar-euro theater across the Atlantic and a euro-yuan theater in the Eurasian landmass. These battles are real but the geographic designations are metaphorical. The fact is, currency wars are fought globally in all major financial centers at once, twenty-four hours per day, by bankers, traders, politicians and automated systems—and the fate of economies and their affected citizens hang in the balance.
Participation in currency wars today is no longer confined to the national issuers of currency and their central banks. Involvement extends to multilateral and global institutions such as the IMF, World Bank, Bank for International Settlements and United Nations, as well as private entities such as hedge funds, global corporations and private family offices of the superrich. Whether as speculators, hedgers or manipulators these private institutions have as much influence over the fate of currencies as the nations that issue them. To see that the battle lines are global, not neatly confined to nation-states, one need only consider the oft-told story of the hedge fund run by George Soros that “broke the Bank of England” in 1992 on a massive currency bet. Today there are many more hedge funds with many more trillions of dollars in leverage than Soros would have imagined twenty years ago.
Battles in the Pacific, Atlantic and Eurasian theaters of Currency War III have commenced with important sideshows playing out in Brazil, Russia, the Middle East and throughout Asia. CWIII will not be fought over the fate of the real or the ruble, however; it will be fought over the relative values of the euro, the dollar and the yuan, and this will affect the destinies of the countries that issue them as well as their trading partners.
The world is now entering its third currency war in less than one hundred years. Whether it ends tragically as in CWI or is managed to a soft landing as in CWII remains to be seen. What is clear is that—considering the growth since the 1980s of national economies, money printing and leverage through derivatives—this currency war will be truly global and fought on a more massive scale than ever. Currency War III will include both official and private players. This expansion in size, geography and participation exponentially increases the risk of collapse. Today the risk is not just of devaluation of one currency against another or a rise in the price of gold. Today the risk is the collapse of the monetary system itself—a loss of confidence in paper currencies and a massive flight to hard assets. Given these risks of catastrophic failure, Currency War III may be the last currency war—or, to paraphrase Woodrow Wilson, the war to end all currency wars.
The Pacific Theater
The struggle between China and the United States, between the yuan and the dollar, is the centerpiece of global finance today and the main front in Currency War III. The evolution of this struggle begins with the emergence of China from a quarter century of economic isolation, social chaos and the doctrinaire suppression of free markets by the communist regime.
The modern Chinese economic miracle began in January 1975 with the Four Modernizations plan announced by Premier Zhou Enlai, which affected agriculture, industry, defense and technology. Implementation was delayed, however, due to disruptions caused by Zhou’s death in January 1976, followed by the death of Communist Party chairman Mao Zedong in September of that year and the arrest one month later of the radical Gang of Four, including Madame Mao, after a brief reign.
Mao’s designated successor, Hua Guofeng, carried forward Zhou’s vision and made a definitive break with the Maoist past at a National Party Congress in December 1978. Hua was aided in this by the recently rehabilitated and soon to be dominant Deng Xiaoping. Real change began the next year, followed by a period of experimentation and pilot programs aimed at increasi
ng autonomy in decision making on farms and in factories. In 1979, China took the landmark decision to create four special economic zones offering favorable work rules, reduced regulation and tax benefits designed to attract foreign investment, especially in manufacturing, assembly and textile industries. They were the precursors of a much larger program of economic development zones launched in 1984 involving most of the large coastal cities in eastern China. Although China grew rapidly in percentage terms in the mid-1980s, it was working from a low base and neither its currency nor its bilateral trade relations with major countries such as the United States and Germany gave much cause for concern.
Today’s currency war is marked by claims of Chinese undervaluation, yet as late as 1983 the yuan was massively overvalued at a rate of 2.8 yuan to one dollar. However, this was at a time when exports were a relatively small part of Chinese GDP and the leadership was more focused on cheap imports to develop infrastructure. As the export sector grew, China engaged in a series of six devaluations over ten years so that, by 1993, the yuan had been cheapened to a level of 5.32 yuan to the dollar. Then, on January 1, 1994, China announced a reformed system of foreign exchange and massively devalued the yuan to 8.7 to the dollar. That shock caused the U.S. Treasury to label China a currency “manipulator” pursuant to the 1988 Trade Act, which requires the Treasury to single out countries that are using exchange rates to gain unfair advantage in international trade. That was the last time Treasury used the manipulator label against China despite veiled threats to do so ever since. A series of mild revaluations followed in response so that, by 1997, the yuan was pegged at 8.28 to the dollar, where it remained practically unchanged until 2004.
In the late 1980s, China suffered a significant bout of inflation, which prompted popular discontent and a conservative backlash led by old-guard communists against the economic reform and opening programs of Deng. Separately, a liberal protest movement, led by students and intellectuals seeking democratic reform, also contributed to political upheaval. These conservative and liberal movements collided violently and tragically in the Tiananmen Square massacre of June 4, 1989, when People’s Liberation Army troops, acting on orders from the Communist Party leadership, used live fire and tanks to clear human rights and prodemocracy protestors from the square in the center of Beijing adjacent to the old imperial Forbidden City. Hundreds were killed. There was a slowdown of the Chinese economy after 1989, partly as a result of efforts to curb inflation and partly as a foreign reaction to the Tiananmen Square massacre. This pause proved temporary, however.
In the 1990s, China finally broke the “iron rice bowl,” the welfare policy that had previously guaranteed the Chinese people food and some social services at the cost of slow growth and inefficiency. Something resembling a market economy began to appear, which meant that Chinese workers had the opportunity to do better for themselves but had no guaranteed support if they failed. The key to this new social contract was the steady creation of millions of jobs for the new job seekers. With memories of Tiananmen fresh in their minds and the historical memory of over a century of chaos, the leadership knew the survival of the Communist Party and the continuation of political stability depended on job creation; everything else in Chinese policy would be subordinate to that goal. The surest way to rapid, massive job creation was to become an export powerhouse. The currency peg was the means to this end. For the Communist Party of China, the dollar-yuan peg was an economic bulwark against another Tiananmen Square.
By 1992, reactionary elements in China opposed to reform again began to push for a dismantling of Deng’s special economic zones and other programs. In response, a visibly ailing and officially retired Deng Xiaoping made his famous New Year’s Southern Tour, a personal visit to major industrial cities, including Shanghai, which generated support for continued economic development and which politically disarmed the reactionaries. The 1992 Southern Tour marked a second-stage takeoff in Chinese economic growth, with real GDP more than doubling from 1992 to 2000. However, the effect of this spectacular growth in the 1990s on U.S.-China economic relations was muted by the continuing U.S response to the Tiananmen Square massacre, which included economic sanctions and a general cooling of direct foreign investment by U.S. firms in China. A series of blunders and miscalculations, including the firing of a NATO cruise missile at the Chinese embassy in Belgrade in 1999, served to increase tensions. Economic relations were kept in an adversarial state by the April 2001 collision of a Chinese jet fighter with a U.S. reconnaissance plane, killing the Chinese pilot and causing the emergency landing of the U.S. plane on Chinese territory and temporary imprisonment of the crew.
Ironically, it was the al-Qaeda attacks on September 11, 2001, and China’s resulting firm support for the U.S.-led global war on terror that finally broke the ice and helped U.S.-China relations get back on track. Despite almost twenty-five years of significant economic progress by China, beginning in 1976, it was only in 2002 that U.S.-China bilateral trade and investment codependence kicked into high gear.
That year, 2002, also marked the beginning of Fed chairman Alan Greenspan’s experiment with sustained ultralow interest rates. Greenspan had started to cut rates in the summer of 2000 following the tech bubble collapse. The resulting decline of over 4.75 percent in the fed funds rate from July 2000 to July 2002 could be viewed as a normal cyclical easing designed to help the economy out of a rut. What happened next was an extraordinary period of over two additional years during which the effective fed funds rate never rose above 1.8 percent and dropped below 1.0 percent in December 2003. As late as October 2004, the effective fed funds rate was 1.76 percent, almost exactly where it had been in July 2002.
This low rate policy was justified initially as a response to the challenges of the 2000 tech bubble collapse, the 2001 recession, the 9/11 attacks and Greenspan’s fears of deflation. Yet it was primarily fear of deflation that caused Greenspan to keep rates low for far longer than would ordinarily be justified by a mild recession. China was now exporting its deflation to the world, partly through a steady supply of cheap labor. Greenspan’s low rate policy, partly intended to offset the effects of Chinese deflation in the United States, sowed the seeds of the full-scale currency war that emerged later in the decade.
Greenspan’s low rates were not only a policy response to potential deflation; they were also a kind of intravenous drug to Wall Street. The Federal Open Market Committee, the body that sets the fed funds target rate, was now acting like a meth lab for hyperactive deal junkies on the Street. Lower rates meant that all types of dubious or risky deals could begin to look attractive, because marginal borrowers would ostensibly be able to afford the financing costs. Low rates also set off a search for yield by institutional investors who needed higher returns than were being offered in risk-free government securities or highly rated bonds. The subprime residential loan market and the commercial real estate market both exploded in terms of loan originations, deal flow, securitizations and underlying asset prices due to Greenspan’s low rate policies. The great real estate bubble of 2002 to 2007 was under way.
In September 2002, just as the low rate policy was taking off, Greenspan gained an ally, Ben Bernanke, appointed as a new member of the Fed Board of Governors. Bernanke’s deeply rooted fear of deflation was even greater than Greenspan’s. Bernanke would quickly establish his deflation-fighting credentials with a speech to the National Economists Club in Washington, D.C., just two months after being sworn in as a Fed governor. The speech, entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” was widely noted at the time for its reference to Milton Friedman’s idea of dropping freshly printed money from helicopters to prevent deflation if necessary, and earned Bernanke the sobriquet “Helicopter Ben.”
Bernanke’s 2002 speech was the blueprint for the 2008 bailouts and the 2009 policy of quantitative easing. Bernanke spoke plainly about how the Fed could print money to monetize government deficits, whether they arose from tax cuts or spending increases,
saying:A broad-based tax cut . . . accommodated by a program of open market purchases . . . would almost certainly be an effective stimulant to consumption.... A money-financed tax cut is essentially equivalent to Milton Friedman’s famous “helicopter drop” of money....
Of course . . . the government could . . . even acquire existing real or financial assets. If . . . the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open market operations in private assets.
Bernanke was explaining how the Treasury could issue debt to buy private stock and the Fed could finance that debt by printing money. This is essentially what happened when the Treasury took over AIG, GM and Citibank and bailed out Goldman Sachs, among others. It had all been spelled out by Bernanke years earlier.
With Bernanke on the board, Greenspan had the perfect soul mate, and in time the perfect successor, in his antideflationary crusade. The Greenspan-Bernanke fear of deflation is the one constant of the entire 2002–2011 period. In their view, deflation was the enemy and China, because of low wages and its low production costs—from ignoring safety and pollution—was an important source.
Currency Wars: The Making of the Next Global Crisis Page 12
