A War Over Exchange Rates Could Undermine Recovery

By Sebastian Mallaby
Sunday, May 17, 2009

Those who are ignorant of history will be condemned to repeat it, as a teacher no doubt told you long ago. But the urgent question today is actually the opposite one: Can a team that is positively steeped in history -- particularly the history of the 1930s -- avoid the mistakes of that era and engineer a quick recovery from a Depression-size shock? Christina Romer, the chair of the White House Council of Economic Advisers and an authority on the 1930s, recently gave a hopeful answer to this question at the Council on Foreign Relations. But there was one gap in her argument, and therein lies a threat to the "green shoots" of recovery.

Romer has a right to optimism. Managed adroitly, crashes need not take a catastrophic toll. A year or two after the 1929 panic on Wall Street, there was no inevitability about calamity, as Philip Zelikow of the University of Virginia recalled recently. There were signs of an economic rebound; Germany's democratic government was holding together; Japan remained a responsible player in the international system. It took the policy errors of the early 1930s to change all that. Those errors need not be repeated now.

What errors? In 1930, the United States imposed the notorious Smoot-Hawley tariff, setting up a pattern of retaliation that exacerbated the downturn and splintered the world. This time, by contrast, there has been surprisingly little backlash against open trade. In 1931, the U.S. Federal Reserve hiked interest rates aggressively. This time the Fed, led by another scholarly expert on the 1930s, is forcing down interest rates by printing money. In 1932, the U.S. government tightened fiscal policy. Again, the lesson of that error has been absorbed aggressively -- witness the enormous fiscal stimulus.

But there is one less comforting part of the 1930s comparison. The international tensions of the 1930s were not just about trade; they were also about exchange rates. To get a leg up on each other, countries devalued their currencies, and each devaluation triggered the next one. In 1930, New Zealand secured a cost advantage for its butter exports by devaluing its money. The next year Denmark, its main butter rival, responded with its own devaluation. The two nations proceeded to chase each other downward.

Today, nothing quite so damaging seems likely. But whereas the world is blessed by a rules-based trading system that staves off protectionism, there is no similar architecture governing exchange rates. Countries can keep their money cheap to boost exports, even if they risk exporting trouble at the same time. Indeed, this is a fair description of China's behavior over much of this decade. Whereas Romer can confidently say that economic policy is better now than in the 1930s with respect to trade, interest rates and stimulus, it is hard to be so confident with respect to exchange rates.

This chink in Romer's comparison with the Depression clouds her sunny outlook for U.S. economic growth. In her Council on Foreign Relations speech, Romer acknowledged that the traditional engine of the economy -- U.S. consumers -- will be sputtering for the near future: U.S. households lost about a quarter of their wealth during the 2007-08 chaos and must now save. She also acknowledged that the new engine of growth -- spending by the U.S. government -- will have to slow down, too: The federal deficit will have to shrink once this stimulus is done. So Romer pinned her hopes for sustained recovery on export growth plus higher rates of business investment, with the investment presumably dependent on expanding markets abroad.

Will that export growth prove possible? The trouble is that other major economies harbor the same hope. Angela Merkel, the German chancellor, has stated categorically that Germany likes its export-led growth model and has no plans to change. Japan, to its credit, has passed a hefty stimulus, allowing government spending to replace exports, but it cannot sustain this policy because its national debt is astronomical. That leaves one other big economy -- China. Some Chinese leaders want to shift toward domestic consumption rather than exports, which is why the government's stimulus package includes money for health care. But the Chinese also want to boost growth urgently, and the surest way to do that is to spend money on the things that they are used to spending money on -- ports, roads and other infrastructure that winds up stoking China's export engine.

If the United States, Germany, Japan and China all aim to boost exports, we are in for trouble. It is impossible for all the big economies to improve their trade positions simultaneously; a jockeying for advantage, through the manipulation of exchange rates or through other measures, is certainly conceivable. Just as in the Depression, we have no rules for governing the disputes that may arise out of such conflict. It is too early to congratulate the scholar-statesmen for banishing all whiff of 1930s-style tensions.


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