10/06/2010 02:03 pm ET | Updated May 25, 2011

How "Free Trade" Led to Currency War

This post originally appeared at Campaign for America's Future (CAF) at their Blog for OurFuture as part of the Making It In America project. I am a Fellow with CAF.

Lyndon Johnson is said to have commented that the press is like birds sitting on a telephone line. When one flies away, they all fly away. This week they are all flying around squawking "currency war!" But the world has been in a currency/trade war for some time, with only one side fighting and the rest losing. Now the world, on the edge of defeat in that war, sees that China is not "trading", they are taking. So, how to fight back, without (further) blowing up the world's economy?

The world can't get to full recovery from this terrible recession without more balanced trade. That is a huge part of the equation. Our trade deficits started with Reagan when "free trade" was used to force concessions from labor by threatening to move the factories to non-democracies, away from the wage and environmental protections that We, the People fought so hard to achieve. The wage squeeze resulted in unprecedented concentration of wealth -- and loss of buying power for the rest of the population.

Under George W. Bush, Wall Street used China for short-term profits and bonuses and China used the power that brought to buy advantage around the world. So now the rest of us are living with the long-term consequences of race-to-the-bottom policies. Namely, the bottom.

That loss of buying power -- lack of demand -- is holding back recovery. To lift the economy we need to lift wages. We can't get there without challenging current arrangements with China.

Yves Smith sums up this "full boil," in Currency War Threats Escalating, at Naked Capitalism,

Last week, the simmering threat of trade disputes erupted into a full boil when Brazil's finance minister Guido Mantega said that national governments around the world were weakening their currencies in an "international currency war" to gain competitive advantage. Mantega stressed that Brazil was prepared to back his words with action to lower the value of the Brazilian real. Yesterday, IMF chief Dominique Struass-Kahn warned that countries were beginning to use their currencies as "a policy weapon" in a Financial Times interview.

So does the world now go into a full-on, chaotic currency/trade war? Martin Wolf weighs in at the Financial Times, How to fight the currency wars with stubborn China, (Click through to see the charts)

Has the time for a currency war with China arrived? The answer looks increasingly to be yes. The politics and economics of an assault on Chinese exchange rate policy are increasingly convincing. The idea is, of course, deeply disturbing. But I no longer believe there is an alternative.

Wolf runs down the issues.

Currency manipulation? "If a decision to invest half a country's gross domestic product in currency reserves is not exchange rate manipulation, what is?"

Does it matter? "By keeping its real exchange rate down, China subsidises production of its exports and import substitutes. Since China is now the world's biggest exporter, this has to be a significant distortion of world trade."

What might China reasonably be asked to do? Stop the manipulation and increase domestic demand. "[T]he menu of possible options for the Chinese authorities could include a cap on the intervention, an end to sterilisation of the monetary consequences and targets for real domestic demand, household consumption and the current account."

Can other countries shift China's policies, with limited collateral damage?

Negotiation remains a hope. The rest of Group of 20 leading countries should unite in calling for these changes. But if negotiation continues to fail, alternatives must be considered. Import surcharges are one possibility. ... countervailing currency intervention ... affected countries could prevent other countries from purchasing their financial instruments, unless the latter offered reciprocal access to their financial markets.

OK, about that "without (further) blowing up the world's economy" I mentioned at the top. Instead of tariffs and other trade sanctions Wolf suggests currency-rate counter-policies,

"I find ideas for intervention in capital markets far more attractive than those involving action against trade. ... A trade war would be very dangerous. Insisting that China stop purchasing the liabilities of other countries so long as it operates tight controls on capital inflows is, instead, direct and proportionate and, above all, moves the world towards market opening."

Will China retaliate by ceasing to buy US bonds? If they do, that would be a good thing.

Some fear that a cessation of Chinese purchases of US government bonds would lead to a collapse. Nothing is less likely, given the massive financial surpluses of the private sectors of the world and the continuing role of the dollar. If it weakened the dollar, however, that would be helpful, not damaging.

Yves Smith weighs in on Wolf's recommendations,

Yves here. I see the odds of things going Wolf's way as close to zero. China has no intention of "opening" its markets to investment bankers; it is not about to have its capital markets colonized, and it lacks the domestic finance skills to cope. China has made a close study of the errors Japan made in its peak years, in the 1980s, and one was the overly rapid deregulation of its financial response to US pressure.

Similarly, the impetus to put pressure on China IS coming from the trade front, due to high unemployment. Action on the trade/tariff front looks like a more direct remedy, even if, as Auerback points out, the lags in trade are long. And with more economists lining up behind the crowd-pleasing idea of getting tough with China, the pressures and the intellectual cover, are in place.

Even though no one wants a trade war with China, it is not beyond the real of possibility that we wind up there. ... he odds of miscalculation have to be magnified when operating across a large cultural divide.

I wrote the other day, and want to repeat: There are always winners and losers. Right now in China there are currently winners and losers from the manipulated currency rate. If rates adjust to where they should be China might lose some jobs, but Chinese workers will immediately be higher-paid relative to the world than they had been, and Chinese consumers will also be more able to buy things made elsewhere.

Right now those in control of industries that are moving to China are winners and those in China who want higher pay and want to import are losers. And as is the way of the world, the winners in China are fighting to keep their advantages, while the losers want change to occur. And outside of China the winners are fighting to keep their advantages, while the losers want change to occur.

But if China starts bringing its currency to market rates the world's winners and losers will be the winners and losers for the right reasons. It is time for China to move on from currency manipulation.

Sign up here for the CAF daily summary.

Follow Dave Johnson on TwitterFollow CAF on Twitter