Global controversy mounted over the Federal Reserve's decision to pump billions of dollars into the U.S. economy, with President Barack Obama defending the move as China, Russia and the euro zone added to a chorus of criticism.
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The G-20 summit that begins Wednesday night in Seoul is shaping up as a showdown between exporting powers, such as Germany and China, and nations such as the U.S. that are struggling to emerge from recession and high unemployment.
The G-20 summit that begins Wednesday night in Seoul is shaping up as a showdown between exporting powers, such as Germany and China, and nations such as the U.S. that are struggling to emerge from recession and high unemployment.
Several other countries have voiced their concern, largely about the increase of foreign inflows, which drive up the value of their respective currencies, hurting their exports and thereby lowering growth.
So -- let's ask a basic question: what exactly is currency manipulation? And more importantly, how do you separate it from a central bank's interest rate policy? For example, central banks lower interest rates to get countries out of a recession; that's central banking 101. But lowering rates also lowers the value of the country's currency, making their exports more attractive in other countries. Other countries view this negatively, because now their products are less competitive relative to the now devalued currency. However, the lowering of currency values is to be expected and is a by-product of the action; it's also a central element of a free floating currency system.
In addition, in a free-floating currency system, the values of the respective currencies should theoretically reflect the state of the underlying economy. For example, when a country starts to recover, international investors will want to put more money into that country. This drives up the value of the currency. So -- as the economy improves, the currency's value rises, which acts as a natural brake on the economy. The converse is true of a country in a recession; it's currency becomes less attractive and valuable, making its exports more attractive, which in turn helps the country get out of the recession.
That, of course, assumes the system is not rigged somehow. Now we return to the original point: what is currency manipulation? First, I would reject the notion that central bank interest rate policy is currency manipulation and should be treated as such. While interest rate policy has an impact on currency values, it is not the central purpose of the policy, which instead is used to spur economic growth or "tap on the breaks" to slow inflationary pressures.
As for QEII, or similar programs, we move into somewhat murkier territory, although it's also important to remember the economic backdrop against which these policies are implemented. The Fed's program is occurring at a time of slow growth and high unemployment; it's extremely doubtful they would engage in this policy in a 4% GDP growth and 5% unemployment environment. As such, this is primarily an economic program, not a currency manipulation program.
But that doesn't mean the currency dimension should not be considered at all. The big problem with the dollar is it happens to be one of the world's reserve currencies. In addition, all commodities are priced in dollars, adding further complications. This is, I think, at the core of at least part of the concern regarding QEII: a dollar devaluation is naturally inflationary because commodities are priced in dollars.
In reality, I believe the real question being asked is this: do we need a new international commodity price/currency system, where commodities are priced against a basket of primary currencies rather than just the dollar? I would answer yes, that would be an extremely good idea.
