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Who Caused the Currency Wars?

WASHINGTON, DC – The world is on the brink of a nasty confrontation over exchange rates – now spilling over to affect trade policy (America’s flirtation with protectionism), attitudes towards capital flows (new restrictions in Brazil, Thailand, and South Korea), and public support for economic globalization (rising anti-foreigner sentiment almost everywhere). Who is to blame for this situation getting so out of control, and what is likely to happen next?

The issue is usually framed in terms of whether some countries are “cheating” by holding their exchange rates at an undervalued rate, thus boosting their exports and limiting imports relative to what would happen if their central banks floated the local currency freely.

The main culprit in this conventional view is China, although the International Monetary Fund is a close second. But, considered more broadly, the seriousness of today’s situation is primarily due to Europe’s refusal to reform global economic governance, compounded by years of political mismanagement and self-deception in the United States.

China certainly bears some responsibility. Partly by design and partly by chance, about a decade ago China found itself consistently accumulating large amounts of foreign reserves by running a trade surplus and intervening to buy up the dollars that this generated. In most countries, such intervention would tend to push up inflation, because the central bank issues local currency in return for dollars. But, because the Chinese financial system remains tightly controlled and the options for investors are very limited, the usual inflationary consequences have not followed.