Last week, Japanese Finance Minister Naoto Kan pointedly told reporters that if any of the delegates at the Group of Seven meeting next month in Iqaluit, Canada, brought up the issue of the undervaluation of the yuan, he would 'listen carefully and express opinions if necessary'. Only a week earlier, he had backed off his call for a weaker yen, but his opinions about relative currency valuations were quite clear. Ironically, it was not so long ago that Japan had argued stubbornly against foreign complaints about the yen, claiming that currency undervaluation was not the reason for Japan's apparent trading prowess. Earlier in the week, Canadian Finance Minister Jim Flaherty said the G7 meeting would likely discuss a lack of 'movement' in Asian currencies, with the very clear implication that the yuan would be at the centre of this discussion. The week before, French President Nicolas Sarkozy blasted what he called the disorderly currency markets. His greatest ire was reserved for the role of the yuan in preventing major currencies from realigning in a non-disruptive way. What trade pessimists have been predicting for nearly two years seems inexorably to be happening. As unemployment rises around the world, the trade imbalances that were considered over the past decade as economically problematic but not politically controversial are now also being seen as unacceptable. Unless we see a dramatic, and extremely unlikely, reversal of unemployment growth in the next year or two in the world's major economies, the debate will intensify, and hardliners on both sides will increasingly call the shots. The consequence? International trade will decline as countries that can fight for market share with currency undervaluation will face off against countries that cannot and who will consequently use tariffs and import quotas to regain market share. This will slow the global recovery, stunt manufacturing growth and ultimately put most of the cost of the adjustment on the trade surplus countries, whose share of global manufacturing output is greater than their share of global gross domestic product. This is looking to be a rigid replay of the collapse in trade in the early 1930s. Surplus countries such as the US, it turned out, were not dealing from positions of relative strength when global demand collapses but rather from positions of weakness. The other important lesson from the 1930s was why countries chose to raise tariffs or implement import quotas. It turns out that countries that could resort to currency manipulation did so. Countries that could not, like the US and the gold bloc of Europe for example, retaliated with tariffs and import quotas. The fact nobody wanted trade to collapse and nearly everyone understood it would slow the global recovery made no difference. Once currency and trade policy becomes a primary arena of conflict, every country must behave in a way that undermines the overall trading system or else it will be forced to bear a disproportionate share of the burden. If policymakers don't move now to halt the conflict, it will be too difficult for them to do so later. The major participants in the currency debates and the global imbalances must resolve their differences as soon as possible - but they probably won't. Michael Pettis is a professor of finance at the Guanghua School of Peking University and a senior associate at the Carnegie Endowment
