Currency Wars: The Making of the Next Global Crisis

by James Rickards

  The Pittsburgh G20 leaders’ summit produced a breakthrough plan for the kind of rebalancing of growth that Geithner wanted. The plan was contained in the official leaders’ statement as “A Framework for Strong, Sustainable, and Balanced Growth.” It was not immediately clear how this rebalancing was to be achieved. Like all such technical statements from large multilateral bodies, it is written in a kind of global elite-speak in which plain language is the first casualty. Buried in Section 20 of the framework, however, is this passage:Our collective response to the crisis has highlighted . . . the need for a more legitimate and effective IMF. The Fund must play a critical role in promoting global financial stability and rebalancing growth.

  There was no doubt on the part of the participants that rebalancing meant increased consumption by China and increased exports by the United States. Now the IMF was being deputized by the G20 to act as a kind of cop on the beat to see to it that G20 members lived up to any obligations they might undertake in that regard. So the international foundation was laid in Pittsburgh for President Obama’s National Export Initiative announced two months later.

  The G20’s use of the IMF as an outsourced secretariat, research department, statistical agency and policy referee suited both organizations extremely well. It gave the G20 access to enormous expertise without its having to create and build an expert staff on its own. For the IMF, it was more like a reprieve. As late as 2006 many international monetary experts seriously questioned the purpose and continued existence of the IMF. In the 1950s and 1960s, it had provided bridge loans to countries suffering temporary balance of payments difficulties to allow them to maintain their currency peg to the dollar. In the 1980s and 1990s it had assisted developing economies suffering foreign exchange crises by providing finance conditioned upon austerity measures designed to protect foreign bankers and bondholders. Yet with the elimination of gold, the rise of floating exchange rates and the piling up of huge surpluses by developing countries, the IMF entered the twenty-first century with no discernable mission. Suddenly the G20 breathed new life into the IMF by positioning it as a kind of Bank of the G20 or proto–world central bank. Its ambitious leader at the time, Dominique Strauss-Kahn, could not have been more pleased, and he eagerly set about as the global referee for whatever guidelines the G20 might set.

  Despite this heady start toward global rebalancing and President Obama’s personal buy-in, two G20 summits came and went in 2010 with no significant progress in the commitments of member nations to the Pittsburgh summit goals. The IMF did conduct extensive reviews of the practices of each country under the heading “mutual assessment” and continued allegiance to the framework was paid in the G20 communiqués, but the ambitious goals of rebalancing were essentially ignored, especially by China.

  Geithner was blunt in criticizing the Chinese for not allowing greater yuan revaluation. When asked by the Wall Street Journal in September 2010 if the Chinese had done enough, he said, “Of course not . . . they’ve done very, very little.” U.S. exports did improve in 2010, but this was mostly because of relatively high growth in emerging markets and a demand for U.S. high-tech products rather than exchange rate changes. The Chinese did allow the yuan to appreciate slightly, mostly to forestall China being branded a currency manipulator by the U.S. Treasury, which could lead to trade sanctions by the U.S. Congress. But neither of these developments came close to meeting Geithner’s demands. Even a bilateral summit in January 2011 between President Hu and President Obama, the so-called G2, produced little more than mutually cordial remarks and smiling photo ops. It seemed that if the United States wanted a cheaper dollar it would have to act on its own to get it. Reliance by the world on the G20 had so far proved a dead end.

  By June 2011, however, the United States was emerging as a winner in the currency war. Like winners in many wars throughout history, the United States had a secret weapon. That financial weapon was what went by the ungainly name “quantitative easing,” or QE, which essentially consists of increasing the money supply to inflate asset prices. As in 1971, the United States was acting unilaterally to weaken the dollar through inflation. QE was a policy bomb dropped on the global economy in 2009, and its successor, promptly dubbed QE2, was dropped in late 2010. The impact on the world monetary system was swift and effective. By using quantitative easing to generate inflation abroad, the United States was increasing the cost structure of almost every major exporting nation and fast-growing emerging economy in the world all at once.

  Quantitative easing in its simplest form is just printing money. To create money from thin air, the Federal Reserve buys Treasury debt securities from a select group of banks called primary dealers. The primary dealers have a global base of customers, ranging from sovereign wealth funds, other central banks, pension funds and institutional investors to high-net-worth individuals. The dealers act as intermediaries between the Fed and the marketplace by underwriting Treasury auctions of new debt and making a market in existing debt.

  When the Fed wants to reduce the money supply, they sell securities to the primary dealers. The securities go to the dealers and the money paid to the Fed simply disappears. Conversely, when the Fed wants to increase the money supply, they buy securities from the dealers. The Fed takes delivery of the securities and pays the dealers with freshly printed money. The money goes into the dealers’ bank accounts, where it can then support even more money creation by the banking system. This buying and selling of securities between the Fed and the primary dealers is the main form of open market operations. The usual purpose of open market operations is to control short-term interest rates, which the Fed typically does by buying or selling the shortest-maturity Treasury securities—instruments such as Treasury bills maturing in thirty days. But what happens when interest rates in the shortest maturities are already zero and the Fed wants to provide additional monetary “ease”? Instead of buying very short maturities, the Fed can buy Treasury notes with intermediate maturities of five, seven or ten years. The ten-year note in particular is the benchmark used to price mortgages and corporate debt. By buying intermediate-term debt, the Fed could provide lower interest rates for home buyers and corporate borrowers to hopefully stimulate more economic activity. At least, this was the conventional theory.

  In a globalized world, however, exchange rates act like a water-slide to move the effect of interest rates around quickly. Quantitative easing could be used by the Fed not just to ease financial conditions in the United States but also in China. It was the perfect currency war weapon and the Fed knew it. Quantitative easing worked because of the yuan-dollar peg maintained by the People’s Bank of China. As the Fed printed more money in its QE programs, much of that money found its way to China in the form of trade surpluses or hot money inflows looking for higher profits than were available in the United States. Once the dollars got to China, they were soaked up by the central bank in exchange for newly printed yuan. The more money the Fed printed, the more money China had to print to maintain the peg. China’s policy of pegging the yuan to the dollar was based on the mistaken belief and misplaced hope that the Fed would not abuse its money printing privileges. Now the Fed was printing with a vengeance.

  There was one important difference between the United States and China. The United States was a slack economy with little chance of inflation in the short run. China was a booming economy and had bounced back nicely from the Panic of 2008. There was less excess capacity in China to absorb the new money without causing inflation. The money printing in China quickly led to higher prices there. China was now importing inflation from the United States through the exchange rate peg after previously having exported its deflation to the United States the same way.

  While yuan revaluation was going slowly in late 2010 and early 2011, inflation in China took off and quickly passed 5 percent on an annualized basis. By refusing to revalue, China was getting inflation instead. The United States was happy either way, because revaluation and inflation both increased the costs of Chines
e exports and made the United States more competitive. From June 2010 through January 2011, yuan revaluation had moved at about a 4 percent annualized rate and Chinese inflation was moving at a 5 percent annualized rate so the total increase in the Chinese cost structure by adding revaluation and inflation was 9 percent. Projected over several years, this meant that the dollar would decline over 20 percent relative to the yuan in terms of export prices. This was exactly what Senator Chuck Schumer and other critics in the United States had been calling for. China now had no good options. If it maintained the currency peg, the Fed would keep printing and inflation in China would get out of control. If China revalued, it might keep a lid on inflation, but its cost structure would go up when measured in other currencies. The Fed and the United States would win either way.

  While revaluation and inflation might be economic equivalents when it came to increasing costs, there was one important difference. Revaluation could be controlled to some extent since the Chinese could direct the timing of each change in the pegged rate even if the Fed was forcing the overall direction. Inflation, on the other hand, was essentially uncontrolled. It could emerge in one sector such as food or fuel and quickly spread through supply chains in unpredictable ways. Inflation could have huge behavioral impacts and start to feed on itself in a self-fulfilling cycle as merchants and wholesalers raised prices in anticipation of price increases by others.

  Inflation was one of the catalysts of the June 1989 Tiananmen Square protests, which ended in massacre. Conservative Chinese counted on a steady relationship between their currency and the dollar and a steady value for their massive holdings of U.S. Treasury debt, exactly as Europe had enjoyed in the early days of Bretton Woods. Now they were betrayed—the Fed was forcing their hand. Given the choice between uncontrolled inflation with unforeseen consequences and a controlled revaluation of the yuan, the Chinese moved steadily in the direction of revaluation beginning in June 2010, increasing dramatically by mid-2011.

  The United States had won round one of the currency wars. Like a heavyweight boxing match between the United States and China, it was round one of what promised to be a fifteen-round fight. Both boxers were still standing; the United States had won the round on points, not with a knockout. The Fed was planted in the U.S. corner like a cut man ready to fix any damage. China had help in its corner too—from QE victims around the world. Soon the bell would toll to start round two.

  When the principal combatants use their weapons in any war, noncombatants soon suffer collateral damage, and a currency war is no different. The inflation the United States had desperately sought not only found its way to China but also to emerging markets generally. Through a combination of trade surpluses and hot money flows seeking higher investment returns, inflation caused by U.S. money printing soon emerged in South Korea, Brazil, Indonesia, Thailand, Vietnam and elsewhere. Fed chairman Bernanke blithely adopted a “blame the victim” approach, saying that those countries had no one to blame but themselves because they’d refused to appreciate their currencies against the dollar in order to reduce their surpluses and slow down the hot money. In the anodyne language of central bankers, Bernanke said:Policy makers in the emerging markets have a range of powerful . . . tools that they can use to manage their economies and prevent overheating, including exchange rate adjustment.... Resurgent demand in the emerging markets has contributed significantly to the sharp recent run-up in global commodity prices. More generally, the maintenance of undervalued currencies by some countries has contributed to a pattern of global spending that is unbalanced and unsustainable.

  This ignored the fact that many of the commodities that residents of those countries were purchasing, such as wheat, corn, oil, soybeans, lumber, coffee and sugar, are priced on world, not local, markets. As consumers in specific markets bid up prices in response to Fed money printing, prices rose not only in those local markets but also worldwide.

  Soon the effects of Fed money printing were felt not only in the relatively successful emerging markets of East Asia and Latin America, but also in the much poorer parts of Africa and the Middle East. When a factory worker lives on $12,000 per year, rising food prices are an inconvenience. When a peasant lives on $3,000 per year, rising food prices are the difference between eating and starving, between life and death. The civil unrest, riots and insurrection that erupted in Tunisia in early 2011 and quickly spread to Egypt, Jordan, Yemen, Morocco, Libya and beyond were as much a reaction to rising food and energy prices and lower standards of living as they were to dictatorships and lack of democracy. Countries in the Middle East strained their budgets to subsidize staples such as bread to mitigate the worst effects of this inflation. This converted the inflation problem into a fiscal problem, especially in Egypt, where tax collection became chaotic and revenues from tourism dried up in the aftermath of the Arab Spring revolutions. The situation become so dire that the G8, meeting in Deauville, France, in May 2011, hastily arranged a $20 billion pledge of new financial support to Egypt and Tunisia. Bernanke was already out of touch with the travails of average Americans; now he was increasingly out of touch with the world.

  It remained to be seen whether the G20 could divert the United States from its runaway fiscal and monetary policies, which were flooding the world with dollars and causing global inflation in food and energy prices. For its part, the United States sought allies inside the G20 such as France and Brazil to apply pressure on the Chinese to revalue. The U.S. view was that everyone—Europe, North America and Latin America—would gain exports and growth if China revalued the yuan and increased domestic consumption. This may have been true in theory, but the U.S. strategy of flooding the world with dollars seemed to be causing great harm in the meantime. China and the United States were engaged in a global game of chicken, with China sticking to its export model and the United States trying to inflate away China’s export cost advantage. But inflation was not confined to China, and the whole world grew alarmed at the damage. The G20 was supposed to provide a forum to coordinate global economic policies, but it was starting to look more like a playground with two bullies daring everyone else to chose sides.

  In the run-up to the G20 leaders’ summit in Seoul in November 2010, Geithner tried to paint China into a corner by articulating a percentage test for when trade surpluses became excessive and unsustainable from a global perspective. In general, any annual trade surplus in excess of 4 percent of GDP would be treated as a sign that the currency of the surplus country needed to be revalued in order to tilt the terms of trade away from the surplus country and toward deficit countries like the United States. This was something that used to happen automatically under the classical gold standard but now required central bank currency manipulation.

  Geithner’s idea went nowhere. He had wanted to target China, yet, unfortunately for his thesis, Germany also became a target, because the German trade surplus was about as large as China’s when expressed as a percentage of GDP. By Geithner’s own metrics, the Germany currency, the euro, would also have to be revalued upward. This was the last thing Germany and the rest of Europe wanted, given the precarious nature of their economic recoveries, the structural weakness of their banking system and the importance of German exports to Europe’s job situation. Finding support in neither Europe nor Asia, Geithner quietly dropped the idea.

  Instead of setting firm targets, the Seoul G20 leaders’ summit suggested the idea of “indicative guidelines” for determining when trade surpluses might be at unsustainable levels. The exact nature of these guidelines was left to a subsequent meeting of the finance ministers and central bank governors to work out. In February 2011, the ministers and governors met in Paris and agreed in principle on what factors might be included as “indicators,” but they did not yet agree on exactly what level of each indicator might be tolerated, or not, within the indicative guidelines. That quantification process was left for a subsequent meeting in April and the entire process was left up to the final approval of the G20 leaders themselve
s at the annual meeting, in Cannes in November 2011.

  Meanwhile, the empowerment of the IMF as the watchdog of the G20 continued apace. In a March 2011 conference in Nanjing, China, attended by experts and economists, G20 president Nicolas Sarkozy said, with regard to balance of payments, “Greater supervision by the IMF appears indispensible.”

  Saying that the G20 process moves forward at a glacial pace seems kind. Yet with twenty sovereign leaders and as many different agendas, it was not clear what the alternative would be if a global solution was to be achieved. This is the downside of Geithner’s theory of convening power. The absence of governance can be efficient if the people in the room are like-minded or if one party in the room has the ability to coerce the others, as had been true when the Fed confronted the fourteen families at the time of the LTCM bailout. When the assembled parties have widely divergent goals and different views on how to achieve those goals, the absence of leadership means that minute incremental change is the best that can be hoped for. By 2011 it appeared that the changes were so minute and so slow as to be no change at all.

  The G20 was far from perfect as an institution, but it was all the world had. The G7 model seemed dead and the United Nations offered nothing comparable. The IMF was capable of good technical analysis; it was useful as a referee of whatever policies the G20 could agree on. But IMF governance was heavily weighted to the old trilateral model of North America, Japan and Western Europe, and its influence was resented in the emerging markets powerhouses such as China, India, Brazil and Indonesia. The IMF was useful; however, change would also be needed there to conform to new global realities.