The knives behind the smiles

INTERNATIONAL ECONOMIC cooperation has given way to a currency war as the leaders of the Group of 20 (G20) leading economies meet in South Korea--and the U.S. is expanding the conflict by taking aim at China.

The stakes in this battle are high. The U.S. is not only pursuing short-term relief for its weak economy, but it's struggling to contain the influence of China, India and other newly industrializing countries that have shifted the global balance of economic power. So whatever the official outcome of the summit, economic rivalries will intensify, wrapped in nationalism, trade protectionism and, in the U.S., endless China-bashing.

Thus, in Seoul, the raging currency war overshadowed diplomacy. By undertaking what's known as competitive devaluations of their currencies, the world's major economic powers are trying to make their own exports cheaper relative to their rivals. The motivation: A huge overhang of excess capacity across the whole world economy.

In the U.S., capacity utilization rate for total industry in September was just 74.7 percent, a rate 5.9 percentage points below the average from 1972 to 2009. According to one estimate made earlier this year, "the global economic downturn has brought nations like the U.S., Canada, Germany and Japan back to pre-2003 industrial production levels. In other countries, the situation is worse. Industrial production in Britain, France and Italy is currently the lowest since the early 1990s."

In this environment, countries are worried that major companies and even whole industries could be wiped out by intensifying international competition. By trying to make their own currencies cheaper, they hope to protect their own corporations at the expense of their rivals--which is why this policy, used during the Great Depression of the 1930s, is also known as "beggar thy neighbor."

The currency war, therefore, is but a prelude to a wider trade war. "Not all economies can have a net export improvement," wrote economist Nouriel Roubini. "This zero-sum game in currencies and net exports means one country's gain is some other country's loss, and a competitive devaluation war has ensued."

FOR THE U.S., the world's biggest importer, the aim is to devalue the dollar to make imports more expensive and U.S. exports cheaper, thereby driving down the trade deficit, which reached $695.9 billion in 2008 before dropping to $380.7 billion in 2009 because of the economic crisis.

The trade deficit is growing again, which has sapped the strength of the economic recovery in the U.S. China, which accounts for the biggest share of that deficit, is of course the main target of U.S. complaints, and was the subject of campaign ads from both Republican and Democratic candidates in the recent elections.

This finger-pointing, backstabbing and blame-shifting at the G20 is a big change from the group's meetings at the start of the crisis, in late 2008 in Washington and a few months later in London. Then, the leaders of the world's biggest economies coordinated actions that, according to the Bank of England, injected at least $14 trillion of stimulus into the world economy--a figure equivalent to the annual economic output of the U.S.

Thus, with the world economy at the precipice after the financial crash of October 2008 that followed the collapse of Lehman Brothers, state spending propped up the world economy by bailing out the banks amid a plunge in trade and industrial production. The total world stimulus was estimated at around $20 trillion.

Nearly two years later, the abyss has been avoided, but the global economy remains in deep trouble. The economic expansion of 2002-2007 led to a buildup of excess capacity worldwide in everything from factories to office buildings to houses. That excess capacity contributed to the collapse of 2008--and it still exists. Now the question is which countries will have to absorb the cost of writing down the value of those assets.

Economist Walter Molano summed up the mainstream view:

With the two-year anniversary of the Lehman collapse moving into the background, policymakers are coming to grips with the reality that the measures taken during the past two years amounted to nothing more than an enormous transfer of wealth to the financial sector.

However, the fundamental economic problems persist across most of the developed world, and there is not much more that can be done other than to embark on a lengthy period of gradual restructuring, depreciation and deflation. In other words, the medium- to long-term outlook for the core developed economies is extremely weak. The question is whether the developing world can successfully decouple?

THE WAY out of this crisis, according to economists, is a "rebalancing" of the world economy. That means countries with big trade surpluses--principally, China--should stimulate their own domestic economies to boost imports and strengthen their currencies, while deficit countries, especially the U.S., should devalue its currency, cut domestic consumption and boost exports.

But what appears to be a tidy solution in economic textbooks is being ferociously resisted in the real world. While the U.S. and China are the central front in the currency war, battle lines are being drawn all over. According to one study, G20 members have imposed 111 protectionist measures just since their last meeting in June.

Furthermore, research by the Organization for Economic Cooperation and Development, the club of rich nations, and the UN Committee on Trade and Development found that governments are continuing to prop up financial institutions worldwide. Germany, for example, has programs that direct banks to lend to manufacturing firms to help them weather the crisis, and the U.S. government still owns General Motors, at least until its shares can be sold off.

For the U.S., the biggest pressure point is a familiar one: China. The U.S. had hoped to use the G20 summit to gang up on China for its policies that keep its currency, the renminbi, pegged to the dollar at levels the U.S. claims are "artificially" low.

This, according to Obama administration officials, is the real reason that China accounted for more than 80 percent of the U.S. trade deficit with China in 2009. Moreover, the decline in both the value of the dollar and the renminbi has hit other industrializing countries such as Brazil and South Africa, which find themselves contending with cheaper Chinese imports.

These developing countries are also receiving an influx of "hot money"--investors looking for higher interest rates, higher profits and stronger currencies. Those capital flows tend to: one, push up the value of a country's currency, making its exports less competitive; and two, destabilize its financial system by making it vulnerable to a sudden outflow of funds. In response, Brazil imposed capital controls, with its finance minister declaring what had become increasingly obvious--that the world is in the midst of a currency war.

So with Brazil and other countries suffering collateral damage in the U.S.-China battle, U.S. Treasury Secretary Tim Geithner apparently thought he could direct these tensions against China in the run-up to the G20 summit. Instead, however, the U.S.'s own currency manipulation became the subject of ire at the G20 summit--low interest rates plus a new injection of $600 billion into the economy by the Federal Reserve.

The measure, known in economists' jargon as "quantitative easing," is the modern equivalent of printing more money. The more dollars in circulation, the less they are worth relative to other currencies. This is the latest in a series of efforts by the U.S. government to drive down the value of the dollar relative to the euro, the Japanese yen and other major currencies as part of President Barack Obama's plan to double U.S. exports in five years.

German Finance Minister Wolfgang Schäuble told Der Spiegel magazine that "the American growth model...is stuck in a deep crisis," adding, "It doesn't add up when the Americans accuse the Chinese of currency manipulation and then, with the help of their central bank's printing presses, artificially lower the value of the dollar."

What unites Germany and China is the fact that both are what economists call "surplus" countries--that is, they export far more than they import. To rebalance the world economy, they would have to stimulate their domestic economies by raising wages and increasing demand, and make their exports more expensive.

But Germany is resisting this course for fear that it would cost the country its competitive advantage on the world market. At the same time, Germany is also driving the austerity programs being pushed across Europe, both to defend the euro as a viable currency and to ensure that its banks recover as much debt as possible from highly indebted countries like Greece, Ireland, Italy, Portugal and Spain.

For its part, China has moved to stimulate its internal market--but far too slowly to have the impact the U.S. wants to see. Moreover, the Chinese economy is heavily geared to exporting to the U.S. and other countries, and investment is still mainly concentrated in industry and infrastructure, rather than consumer goods. And China's rulers aren't eager to surrender their advantage in labor costs, which is already under pressure from rivals like Vietnam.

Chinese policymakers worry--correctly--that the U.S. is out to repeat the Plaza Accord of 1985, in which the U.S. successfully pressured Japan to allow its currency, the yen, to appreciate sharply against the dollar. The aim of the operation was to curb Japanese imports to the U.S., but the side effect was a financial bubble in Japan, followed by a decade of economic stagnation when the bubble burst. But while Japan's economy drifted, the Chinese economy surged ahead, surpassing it this year to become the world's second largest economy after the U.S.

CHINA'S RISE makes it far more difficult for the U.S. to strong-arm the country's leaders the way it did to Japanese politicians 25 years ago.

That's partly because of China's control of an estimated $1 trillion in U.S. government and agency bonds, which makes China the major creditor of the U.S. government. But the real complication for U.S. policymakers is that the U.S. and Chinese economies are closely intertwined as the result of U.S. multinational corporations' successful efforts to use China as a low-cost export platform to compete with Japan since the 1990s.

For example, Chinese companies such as Foxcom produce computer gear for U.S. companies like Apple and Dell, which gain the lion's share of the profits. But by insisting that U.S. firms create joint ventures with Chinese companies and share their technology, China has been able to move into more advanced industries, including autos, commercial aviation, information technology and more. These companies--often owned in part by the Chinese state--now increasingly confront multinational corporations from the U.S., Europe and Japan on the world stage.

This wasn't achieved through the magic of the free market, but through planning. The Chinese government, following the example of South Korea and other industrializing countries, has targeted key industries and markets, and directed banks to finance companies that operate within them.

In effect, China has shifted from the bureaucratic state capitalism that characterized its economy during the rule of Chinese Communist Party leader Mao Zedong to an export-oriented state capitalism. As the Economist magazine observed, China's model is proving attractive to industrializing countries:

Not so long ago, government-controlled companies were regarded as half-formed creatures destined for full privatization. But a combination of factors--huge savings in the emerging world, oil wealth and a loss of confidence in the free-market model--has led to a resurgence of state capitalism. About a fifth of global stock market value now sits in such firms, more than twice the level of 10 years ago.

Indeed, the Chinese model has delivered while the U.S. and Western economies have grown far more slowly and proven far more vulnerable to the financial crash. As the Organization for Economic Cooperation and Development noted:

The last 20 years have seen China double its share of the world's manufacturing value-added, triple its share of steel production, and almost quadruple its share of gross domestic product. China now holds more than one-tenth of the world's currency reserves and receives nearly one-tenth of the remittances sent home from migrants working abroad. Chinese residents today hold nearly one in three of the world's trademarks and account for one in six of its patent applications.

China's growth has led to a broader shift in the world economy. According to measures of gross domestic product that take into account the purchasing power in different countries, developing and emerging economies accounted for nearly three-quarters of world economic growth between 2005 and 2009. In the current recovery, developing countries are even more central to growth.

China's growth doesn't make it immune from the crisis, however. On the contrary, the country's return to the pre-crisis rates of growth of around 10 percent have only added to the problems of overcapacity in manufacturing. Investments in Chinese fixed assets--factories and infrastructure--increased a staggering 400 percent between 2005 and 2010. In response, the government ordered the closure of steel mills built before 2005 in a bid to eliminate excess capacity. More recently, the government ordered the closure of 2,000 inefficient factories.

By using the state's authority to get rid of uncompetitive companies rather than wait for market pressures to do the job, China's rulers are attempting to keep their economy competitive to withstand pressures from the U.S. and other advanced countries. China is also flexing its muscles over one of its key strategic exports--rare earth minerals used in everything from computers and cell phones to advanced U.S. military weapons.

For it's part, the U.S. is attempting to encircle China--economically, politically and militarily--in a bid to extract concessions.

Thus, Barack Obama made a high-profile visit to India, where he acted as the deal-closer for a $5.8 billion sale of Boeing military transport planes and proposed closer U.S.-Indian economic cooperation that, he promised, would create jobs in the U.S.

The real agenda, however, was for the U.S. to boost India as a strategic rival to China in Asia and tighten links between U.S. and Indian companies. The motivation was similar for Obama's effort to expand the U.S.-South Korean free trade agreement, though the deal fell through. The U.S. is trying to create an economic axis in Asia that can counter China's rise.

And if dollars aren't enough for the U.S. to get its way in Asia, ships, planes and troops are there to further Washington's aims. With its growing ties to India, the occupation of Afghanistan, the U.S.-backed buildup of Japanese military capabilities, and America's active naval presence, the U.S. is determined to check China's ambitions to become the dominant power in the region.

All this adds up to a more dangerous and unstable world as the lingering effects of the crash of 2008 continue to shape world politics. The big question is how the working class, East and West, will respond. The strikes in both France and China in recent months highlight the potential for resistance. International solidarity that links such struggles is needed to counter the drift towards nationalism, austerity and militarism.