When the United States declared China a currency manipulator last week, long-building trade tensions between the world’s two largest economies spread to the combustible realm of currencies — with potentially huge consequences for the global financial system should the escalation continue.
Did China allow the value of the yuan to fall against the dollar simply to allow it to better match the nation’s economic situation, as the country’s leaders and many international economists argue? Or was it, as President Donald Trump contends, an effort to give Chinese exporters an unfair advantage in trade?
That clash reflects Trump’s rejection of the consensus of global economic policymakers. That consensus says countries should be free to set monetary policies aimed at generating sustained growth, even if that causes their currency to depreciate. And they should be free to manage their exchange rates so long as they keep those rates broadly in line with their economic fundamentals.
The conflict also reflects the president’s singular focus on reducing trade deficits, which he has argued make the United States a loser in the global trade system. But waging a currency war could come at a big cost.
“I worry it further undermines the international framework that has supported decades of faster growth,” said Kristin Forbes, an economist at MIT and a former official of the U.S. Treasury and the Bank of England. “Exchange rates are the shock absorber in the global economy.”
There have been international strains over currency valuations for years, all the more so in a world in which all the major economies are coping with sluggish growth. But the newest currency frictions are different.
Up until now, countries have been focused on stimulating their domestic economies. In particular, central banks have cut interest rates and taken other steps to pump money into their financial systems. That tends to lower the value of their currency. After all, investing in a currency with lower interest rates is less attractive, all else equal, than in one with higher rates.
But the conventional wisdom among international economists is that this doesn’t count as currency manipulation. It’s not a game in which one country’s win means another’s loss. Lower interest rates should generate more economic activity, which makes the whole world better off.
The Trump administration has introduced a zero-sum approach to global currency policy — envisioning a loser for every winner — that violates the spirit of those rules.
In that sense, the latest moves risk upsetting a relatively stable order, creating unpredictable ripple effects. When currencies swing wildly, they can pull along the economies of some of the most powerful nations, such as by crushing entire sectors of the economy that find themselves uncompetitive after a swing in global exchange rates.
And it could undermine the central role the United States has played in the international financial system, especially if the accusations of manipulation are followed up with concrete retaliation to try to artificially depress the value of the dollar.
“The dollar being the primary global currency has enormous benefits for the U.S., but with the side effect that when the U.S. tries to depreciate, there are limits on how much it can do that,” said Adam Posen, president of the Peterson Institute for International Economics. “But if the U.S. abuses its privilege too much by bullying, there will eventually be a switch.”
The decision to name China a currency manipulator does not, in and of itself, do much. But it could be followed up with pressure on the International Monetary Fund and other nations to make similar findings and lean on the Chinese to adjust their policies. Or it could lead to direct intervention in foreign exchange markets by the U.S. Treasury.
There is also a paradox for Trump. Because of the dollar’s unique role as the global reserve currency, when panic sets in overseas, money tends to flow into U.S. Treasury bonds, which are viewed as the safest assets on earth. But that movement tends to prop up the value of the dollar and push overseas currencies lower.
In other words, the more chaos he injects into the global economy by trying to pressure China, Europe and others to depreciate their currencies, the more upward pressure there will be on the dollar, undermining those efforts.
“It’s dangerous to start a currency war because you don’t know where it will end,” said Eric Winograd, chief U.S. economist at AllianceBernstein. “We’ve seen with the trade war that it started in one place, and ended up much broader. There’s every risk a currency war will do the same.”