Wednesday, October 13, 2010

Fighting the Currency War

There is a lot of debate about how to fight the impending currency war. The problems are more from the US point of view rather than elsewhere. Let me explain.

US cannot unilaterally set its exchange rate. 
There are two ways of modifying exchange rate.  One ways is to clearly set the exchange rate and defend it using central bank intervention. This tool is available to smaller economies who peg their exchange rates to the dollar. But it is not available to the US as the economies of other countries depend on the US consumer. Its only way out is to convince other countries, those whose domestic jobs and economies depend on US consumer, to ease the exchange rate. US tried to convince China with the same intent. However, it is not China alone that poses a problem. The entire set of countries that use this export-dependent strategy should revalue their currencies simultaneously. Since these countries are adamantly defending the relative exchange rates, US seems to be in a state of crisis.

The other more fundamental way is to indicate to the world that the stock of money has gone up disproportionately as compared to GDP.  US has tried to print money. But it has not caused any effect. The printed money simply flows out of US into global equities, commodities and other asset classes. Further, if I get more US Dollars I can park them with other economies and wait for exchange rate reset to give me substantial gains. The more exchange rates are suppressed, the more I have to gain.

This conundrum, obscene as it is, is due to the fact that USD is also an international currency. To have a credible effect, the volume of printing must be in relation to global GDP and not simply US GDP. At USD 15 trillion, US GDP is about a third of global GDP. So you need three times more printing. Further, if US currency devalues erratically then the entire burden of currency will fall on US domestic economy. Herein lies the dilemma. It is a lose-lose proposition.

But there may be another way 
I think US may be better served by front-ending its borrowing program. The US can initiate a borrowing program equivalent of 10 years of borrowing. This program should be completed within a year. Only a part of this program will be successful. However, it will pull the global liquidity towards US while money printing is pushing liquidity out of US. It will force other banks to print and buy US bonds or let their exchange rates appreciate. Usually, governments are wary of failed bond auctions. In the case of US, this is not an option for the other countries. They need the US consumer more than US needs them. US can also set trade limits based on amount of USD reserves held. In other words, let other countries put a price on each job they are defending.

However, US needs to have a credible plan to invest this high liquidity that will flow into the country. Using this liquidity, US should get out of the recession.

Then, we must consider unintended consequences. A front-ending of borrowing may upset lenders like China. How China will react to such a policy is unclear. But it is reasonable to assume it won't be pleasant. In effect we will face a lot of unpleasantness. But then it is a war, isn't it?