Dollar war heats up

October 8, 2010, 6:44 PM UTC

Global tensions are rising, and the weapon of choice is currency.

Brazil’s finance minister has spoken flatly of an “international currency war.” U.S. Treasury Secretary Tim Geithner was less inflammatory but warned in a speech this week that countries acting to make their currencies cheaper could lead to a “damaging dynamic.”

Do loose currencies sink ships?

Everybody wants export powerhouse China to let the yuan rise, but Premier Wen Jiabao lashed out this week, saying a rapid increase could cause a destabilizing “crisis in the Chinese economy.”

At issue are sluggish economies worldwide. Countries want to keep their currencies weak to raise their exports. Japan, for example, recently intervened in markets to weaken the yen for the first time in six years. Other nations, from Colombia to South Korea, have taken similar actions.

The United States isn’t so direct, but the Federal Reserve’s likely policy of buying more Treasury bonds stands to send an already sinking dollar down even further. That helps exporters here but punishes others — particularly the currencies of smaller, faster-growing nations such as Brazil, which lack the financial firepower China has used to keep the value of its currency.

Officially, you’ll find few buyers for the idea of an outright war. International Monetary Fund chief Dominique Strauss Kahn said this week the war talk is “maybe too military.”

But an IMF meeting of global finance representatives is under way in Washington D.C. this weekend, and trade policy is high on the agenda. Even with all the usual back-and-forth among the U.S., China and Europe, the dynamics bear watching.

“If there’s an unanticipated development, it’s Brazil,” said Derek Scissors, a trade expert at the Heritage Foundation in Washington. “It’s probably just posturing, but a group could have an impact, as it would be able to point fingers at both China and the U.S. (for undermining the dollar).”

At the same time, it’s worth remembering that currency values are just one obvious manifestation of national economic policies.

So while Geithner and others are right to push for China to shift toward a domestic consumption economy from one driven by exports, the U.S. has hardly made a dent in the incentives here that for so long have emphasized consumption over investment. Thus the housing bubble and other horrors of recent years.

“The imbalances cut both ways,” said Frank Warnock, a business professor at the Darden School at the University of Virginia. “I don’t think anyone believes berating the Chinese is going to work. There’s going to have to be some sort of a quid pro quo.”

Warnock warns that if not addressed in some fashion, escalating currency wars could feed a new wave of protectionism that would further hamper the economic recovery by crimping trade. But that’s hardly the only risk.

He also warns of global inflation, as endlessly expanding liquidity swirls round the world, and asset bubbles, as seen in the U.S. stock and housing markets following a decade of easy money policies in Japan and then here. Geithner noted similar concerns in his speech this week.

And though developing economies such as China and Brazil are growing at a smart clip, it’s worth recalling they are still dwarfed by the resources available here – which means policy mistakes can feed big problems that will be costly to clean up later.

“When a huge amount of money sloshes out of the U.S.,” Warnock said, “it turns out the rest of the world is pretty small.”