Economic Nationalism Is Complicating the Crisis

We are in a race between economic recovery and economic nationalism. At last week's G20 summit, leading nations agreed to roughly $1 trillion of additional lending, mostly through the International Monetary Fund, to end the worldwide slump. But beneath the veil of consensus, countries are maneuvering to protect their economies and blame someone else for the crisis. Will the world economic order overcome these stresses or give way to a global free-for-all, characterized by rampant protectionism, nationalistic subsidies and preferences?

Emblematic of the tension is a recent proposal by Zhou Xiaochuan, governor of the People's Bank of China (PBOC), to replace the dollar as the world's major international currency. In a paper posted on the PBOC's Web site, Zhou argued that the present crisis reflects "the inherent vulnerabilities and systemic risks" of the dollar-based global economy. The PBOC is China's Federal Reserve, meaning that Zhou is no obscure bureaucrat or renegade academic. His critique is a significant event.

It may surprise Americans that, up to a point, his analysis is correct. The dollarized world economy developed huge potential instabilities—vast trade imbalances (American deficits, Asian surpluses) and massive, offsetting international money flows. But what Zhou omits from his analysis is revealing. To wit: China and others are implicated in the dollar system's failings. By keeping their currencies artificially depressed—a way to aid exports—they abetted the very imbalances that they now criticize.

The Chinese denounce American profligacy after promoting it and profiting from it. Low prices of imported consumer goods (shoes, computers, TVs) encouraged overconsumption. From 2000 to 2008, the U.S. trade deficit with China ballooned from $84 billion to $266 billion. China's foreign-exchange reserves are now an astounding $2 trillion. The reserves are not an accident; they are the consequence of conscious policies.

It's not just that exchange rates were (and are) misaligned. American economists have argued that a flood tide of Chinese money, earned from those bulging trade surpluses, depressed interest rates on U.S. Treasury securities and sent investors searching for higher yields elsewhere. That expanded the demand for riskier securities, including subprime mortgages, and pumped up the real-estate bubble. So China's policies contributed to the original financial crisis (though they were not the only cause) as well as to Americans' excess spending.

For decades, dollars have lubricated global prosperity. They're used to price major commodities—oil, wheat, copper—and to conduct most trade. Countries such as Thailand and South Korea deal in dollars for more than 80 percent of their exports, notes economist Linda Goldberg of the Federal Reserve Bank of New York. The dollar also serves as the major currency for cross-border investments by governments and the private sector. Indeed, governments hold almost two thirds of their $6.7 trillion in foreign-exchange reserves in dollars.

But overreliance on the dollar can also backfire, as it now has. Not only have countries suffered declines in exports to a slumping U.S. economy. They've also lost dollar loans needed to finance trade with third countries. "When the crisis hit, U.S. banks cut back on dollar credit lines to foreign borrowers," says David Hu of the International Investment Group. The additional IMF loans endorsed at last week's summit aim to offset these losses.

Given the dollar's drawbacks, why not switch to something else, as Zhou suggests? The trouble, as even he concedes, is that there's no obvious replacement. The attraction of an international currency depends on its presumed stability, what it will buy and how easy it is to invest. The euro (27 percent of government reserves) and the yen (3 percent) don't yet rival the dollar. As for China, it hasn't even made its currency (the renminbi, or RMB) freely convertible for Chinese investments. Zhou mentions relying more on "special drawing rights" (SDRs). But SDRs are not a real currency. They're synthetic money issued by the IMF that can be converted into a mix of dollars, euros, yen and pounds.

We are stuck with the dollar standard for many years. To work, it requires that countries with huge trade surpluses reduce the export-led growth that fed the system's instabilities. The Chinese increasingly recognize this. "They're very aware of the need to promote [domestic] consumer spending," says economist Pieter Bottelier of Johns Hopkins University. In November, China announced a "stimulus" of 4 trillion RMB ($586 billion). In addition, says Bottelier, the government is expanding health and pension benefits to dampen households' need for high savings.

But China also has a default position: promote exports. It has increased export rebates; it has engaged in RMB currency "swaps" with trading partners (the latest: $10 billion with Argentina) that seem designed to stimulate demand for Chinese goods; it has stopped a slow appreciation of the RMB. China seems comfortable advancing its economy at other countries' expense. The significance of Zhou's pronouncement is political. It rationalizes this sort of predatory behavior: if we are innocent victims of U.S. economic mismanagement, then we're entitled to do whatever's necessary to insulate ourselves from the fallout.

Down this path lies continued instability and growing mistrust. The global economy is suspended between the lofty rhetoric of last week's summit and the gritty realities of domestic politics. We've already seen more protectionism. A World Bank study found that 17 countries in the G20 had recently adopted policies that discriminate against imports or favor domestic production. Though mostly modest in themselves, they "open the door for a lot of other opportunistic measures," says Gary Hufbauer of the Peterson Institute. Precisely. The deeper the recession goes—and the longer recovery is delayed—the greater the danger of economic strife.