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How to prevent a disruptive currency war

by Barry Eichengreen and Douglas Irwin

BERKELEY, Calif. — Three years into the financial crisis, one might think that the world could put Great Depression analogies behind it. But they are back with more force than ever. Now the fear is that currency warfare, leading to tariffs and retaliation, could cause disruptions to the international trading system as serious as those of the 1930s.

There’s good reason to worry, for the experience of the 1930s suggests that exchange-rate disputes can be even more dangerous than deep slumps in terms of generating protectionist pressures.

In fact, it was not countries’ experiencing the worst economic downturns and the highest unemployment rates that raised tariffs and tightened quotas most dramatically in the 1930s.

A comparison of countries shows there was no relationship between either the depth and duration of the output collapse and the increase in levels of protection (or the magnitude of the rise in unemployment) and the extent of protectionism.

The reason why countries hit harder in the 1930s were not more inclined to respond by protecting industry from foreign competition is straightforward. The onset of the Great Depression saw a collapse of demand, which in turn led to a sharp fall in imports. As a result, levels of import penetration actually fell, quite sharply, in virtually every country. Producers had problems, to be sure, but import competition was the least of them.

The same thing happened this time: When the crisis went global in 2008-2009, imports fell faster than output. With the decline in trade, foreign competition became less of a problem for import- sensitive sectors. As a result, there was only limited resort to protectionism. The World Bank estimates that only 2 percent of the decline in trade during the crisis was due to increased protectionism. In the 1930s, by contrast, roughly half of the decline in world trade was due to protectionism. What’s different today?

The answer is currency disputes. In the 1930s, the countries that raised their tariffs and tightened their quotas the most were those with the least ability to manage their exchange rates — namely, countries that remained on the gold standard. In 1931, after Britain and some two dozen other countries suspended gold convertibility and allowed their currencies to depreciate, countries that stuck to the gold standard found themselves in a deflationary vice.

In a desperate effort to do something — anything — to defend their economies, they turned to protectionism, imposing “exchange-rate dumping” duties, and import quotas to offset the loss of competitiveness caused by their own increasingly overvalued currencies.

But trade restrictions were a poor substitute for domestic reflationary measures, as they did little to arrest the downward spiral of output and prices. They did nothing to stabilize rickety banking systems. By contrast, countries that loosened monetary policies and reflated not only stabilized their financial systems more effectively and recovered faster, but also avoided the toxic protectionism of the day.

Today, the United States is in the position of the gold-standard countries in the 1930s. It can’t unilaterally adjust the level of the dollar against the Chinese renminbi. Employment growth continues to disappoint, and fears of deflation will not go away. Lacking other instruments with which to address these problems, the pressure for a protectionist response is growing. So what can be done to address the situation without getting into a beggar-thy-neighbor, retaliatory free-for-all?

In the deflationary 1930s, the most important way that countries could subdue protectionist pressure was to use monetary policy actively to push up the price level and stimulate economic recovery. The same is true today. If fears of deflation were to recede and if output and employment were to grow more vigorously, the pressure for a protectionist response would dissipate.

The villain of the piece, then, is not China, but the U.S. Federal Reserve Board, which has been reluctant to use all the tools at its disposal to vanquish deflation and jump-start employment growth. Doing so would help to relieve the pressure in Congress to blame someone, anyone — in this case China — for America’s jobless recovery.

Where the Bank of Japan has now led, the Fed should follow.

Of course, with China pegging the renminbi to the dollar, the Fed would, in effect, be reflating not just the U.S. but also the Chinese economy. But this is within its capacity. China’s economy is still only a fraction of the size of America’s, and the Fed’s ability to expand its balance sheet is effectively unlimited.

China might not be happy with the result. Inflation there is already too high for comfort. Fortunately, the Chinese government has a ready solution to this problem: That’s right, it can let its currency appreciate.

Barry Eichengreen is professor of economics at the University of California, Berkeley. Douglas Irwin is professor of economics at Dartmouth College. © 2010 Project Syndicate (www.project-syndicate.org)