Bretton Woods Stress Disorder Again?

Did you hear? China is manipulating its currency to enrich itself on America’s back. Were you not aware that the Euro was actually German machinations so that it could out-compete the area’s periphery for its own gain?

There is a lot of talk out there of currencies being used as a form of weapon in the 21st century’s new form of favourite international warfare; economic warfare. Everybody seems to be guilty of partaking in this ‘non-violent’ form of confrontation. China has an undervalued currency pegged on the US dollar. To be fair, over a dozen other countries do too. Half of western African countries have pegged to the Euro as well as a few notable others. Accusations have been leveled against Germany for unduly profiting from the competitive weakness of its monetary partners since the 1992 Maastricht Treaty (and especially since the Euro crisis of 2011). Various central bankers and government officials around the World have called quantitative easing intentional currency manipulation, essentially accusing the US of cheating (the Bank of England and European Central Bank would also be guilty of this in such a framework). Essentially there has been a lot of posturing and indignation flying around focused on this one issue of currencies. I think remembering what a currency really does for an economy could help cool the air.

Some people like to say that currencies function as market mechanisms. Now nothing could be further from the truth. Just because there is a semi-unregulated currency market does not mean currencies are free market instruments. Just like a carbon market is not a liberal concept because trading is free. The collapse of the Bretton Woods system occurred because nations couldn’t compete in a relatively free trade environment. Certain nations were more competitive and the others did not have the political will to increase national competitiveness. A new system arose quite naturally whereby a floating currency did all the work of correcting competitive imbalances. As a nation comparatively slid into economic incompetitiveness its currency would be reevaluated downwards by a free currency market to insure a semblance of equilibrium of balance in trade terms. Essentially governments outsourced the responsibility of putting into place national competitiveness to the markets to avoid labour disputes and imposing fiscal rectitude to national budgets.

So when China pegs its currency to the US’s it is in fact just returning to a Bretton Woods type formula. If a trade balance exists between the two countries it is because the two governments do not share the same appreciation for macroeconomic rectitude. While the US splurges as a nation China saves. While in the US labour movements have the legal upper hand on business (see GM, Chrysler bankruptcies and Boing labour conflicts) in China pro business policies abound (sort of). In essence, the Chinese government does not shy away from imposing strict macro prudential policies on its economy, America elects Democrats instead. So the US’s complaint really resides in its political dithering with regards to economic policy. China’s currency policy is just one of limiting the risk to business of currency volatility. A policy US corporations should be in total agreement with if unclouded by nationalistic sentiment. To sum up a free floating currency is just a political tool to avoid hard decisions domestically.

Let’s remind ourselves of the cost of a free floating currency when a country is profoundly uncompetitive like Greece and even the US. When a country runs successive and deep current account deficits it means the country is chronically living above its means. A free floating currency would drop to correct this phenomenon. Increasing the price of foreign goods to impose a contraction in national living standards. So a country would in theory spend less on imported goods (food, clothing, cars and other discretionary items) to afford overspending in other goods (typically healthcare, education and other entitlements). So next time you see your native currency drop, odds are good that to afford government social programs you and all other individuals will need to buy cheaper food, flimsier cars and smaller houses. I wonder if electors aware of these dynamics would so liberally demand government services if they understood it meant less beer Friday night and less outings to the restaurant. Now some social democrats might argue it’s the price to pay for equity. Remind the next one you see that poor people are disproportionately affected by increased inflation on consumption goods. If they think value added retail taxes are regressive tell them government services induced current account deficits are more so (lost jobs, lost buying power).

So if one believes the Chinese won’t give up the peg and the Euro will survive (both highly likely outcomes) another solution is necessary. The US to take as an example, are doubly guilty of digging there own grave. The US worker remains the most productive of the World by any metric, so why does does the Chinese worker out-compete him (as demonstrated by the gaping trade deficit between the two countries). The reason is because the Americans are doubly competitive. How so? One of the US’s greatest exports with which virtually no country can compete is its government debts! No other financial instrument is more prized than the US’s Treasury Bonds. While the merchandise and trade balances can be negative the balance of payments always equals zero.

So all countries are faced with a straightforward choice; export goods and services or export financial paper (of which government is generally the largest component). Since the US issue so much debt that everybody buys the money cannot be spent on goods! If Barack Obama really wants to double exports in 5 years he can do it in a heartbeat by refusing to sign the next debt level increase legislation to hit his office. Obviously this implies hard political choices which I don’t mean to discount so caricaturally. China’s peg works by purchasing US financial assets, stop issuing them and China will not be able to buy them. The peg will then collapse without outright adoptions of the US dollar. Since China is so hell bent on controlling its internal economy, sacrificing the totality of its monetary policy sovereignty to another country is probably not in the cards.

The lesson while somewhat different for the PIIGS is essentially the same. Get competitive or get punished “à la Grecque”. Stop living above your means. Whether in a monetary union or even in a free floating currency regime, free lunches don’t exists, you’ve got to pay the piper someday. So Brazil and Canada pipe down will you, stop blaming your woes on currencies that refuse to act conveniently to your politics. To the US, ”Buy-American”, quantitative easing et al. are really cheap tricks. To any and all thinking of tariffs and quotas, please look at what happened last time that was tried. So to all China haters in the US or Germanophobes in Greece and the like, blame yourself for being ungovernable first, everybody else is just trying to do their jobs, time you started doing yours.

Cius