Competitive Depreciation: Modern Economic Warfare

Today, China has too much savings. The U.S. has too little. In the long-run such savings imbalances cannot continue. As with all excesses, they come to an end.

Yuan Climbs To Strongest Since 1993 As Obama Criticizes China

Chinese renminbi bank notes are arranged for a photograph in Beijing, China, on Tuesday, Sept. 21, 2010. The yuan climbed to the strongest level since 1993 after U.S. President Barack Obama criticized China for not letting its currency strengthen. Photographer: Nelson Ching/Bloomberg

Nelson Ching/Bloomberg

Guido Mantega, Brazil’s Finance Minister put it succinctly; we are in the midst of an international currency war. I won’t even bother putting the term currency war in quotation marks because it is not a euphemistic description of what is happening, but rather a disturbing reality.

My readers are probably bored with reading my blogs about the problems the poorly constructed

Eurozone is putting on the U.S., and the rest of the world. To add to the mess, the Japanese, who have not intervened in the foreign currency markets for years, did so recently, sending chills down the spines of many. China is moving its currency upwards, but at such a slow pace, one might call it “Chinese water torture.” First, it won’t solve China’s fundamental problem, which is that the country saves far too much money for its own good. And second, it is making it more difficult for the rest of the world to adjust to the saving imbalances seen in the Chinese case.

Your first reaction might be that savings is always a good thing. However, the word “savings” means different things in different contexts. In this case, savings isn’t the money people put in their local bank accounts for a rainy day. Rather, it is economic savings, a quite different animal.

Basically economic savings is everything that is not consumed. If something is not consumed there are two ways it is “spent:” 1) it is spent investing in real goods such as building factories or machines; or, 2) if there aren’t enough opportunities to spend the excess savings at home, it is lent abroad to finance someone else’s consumption and/or investment.

Although the two do not coincide precisely, a rough estimate of a country’s excess or deficient savings is its current account balance. If there is a surplus, the country has too much savings. If there is a deficit, it lacks adequate savings. Historically, developing countries such as China had to import foreign savings to finance development. This time around, developing or emerging countries such as China appear to be sending their savings to finance consumption in the advanced industrial countries, in particular the U.S. Outside wartime, we haven’t seen something like this since the days of the Roman Empire when rich Rome sapped the savings of its provinces.

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China has had a huge current account surplus since the mid-1990s when it unified its foreign currency exchange rates (equivalent to a large devaluation). The U.S. has been running large current account deficits since the mid-1980s when supply side economics first came into vogue.

Today, China has too much savings. The U.S. has too little. In the long-run such imbalances cannot continue. As with all excesses, they come to an end. The only question is how. Is the end gradual and orderly, or is it sudden and disorderly?

During the last financial crisis, the U.S. current account deficit fell by about half in a short period of time. That was not an orderly decline. This caused problems around the world as the surplus countries needed to adjust suddenly to the loss of an important part of their lucrative U.S. markets.

At the same time, given the problems this dislocation caused, we saw that some European countries fell into a sudden fiscal and financial crisis. The problem was exacerbated when many of these countries found it difficult to respond as they had historically because they had only recently lost their monetary freedom upon entering the Eurozone. This chaotic environment caused the euro to fall sharply against the U.S. dollar and Japanese yen making U.S. and Japanese goods less competitive. This loss of competitiveness caused U.S. and Japanese growth to slow as investment and inventory restocking slowed while euro bloc countries such as Germany and France gained.

China reacted at first by spending lots of money domestically – a good idea. The problem is that these funds were primarily being spent on infrastructure, something that would improve China’s competitiveness in the medium-term, but make matters worse for the rest of the world in the long-run.

The reaction we are seeing is that other East Asian countries have joined the competitive devaluation/depreciation bandwagon. It wouldn’t be surprising if it soon spreads to Latin America where already capital control measures are being put in place to stem the tidal wave of hot money coming to their shores.

If left unchecked, competitive devaluations and/or depreciations can cause the world to slip back into recession. At the same time, no matter what, the savings/investment rebalancing in the US and China will continue. We need statesmen and stateswomen, not nationalists. Also, keeping in mind some basic economics would certainly help.

Vincent J. Truglia, Managing Director of Global Economic Research at Granite Springs Asset Management LLC, worked for 15 years at Moody’s Corporation where he headed the Sovereign Risk Unit.

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