The greatest challenge for the G20 summit next month in Seoul is to tackle global imbalances.
The G20 can help break vicious cycle
At next month's summit of the Group of 20 leading economies and emerging markets (G20), the South Korean hosts had hoped to revive their fledgling recovery and put the global economy on sounder footing. This included a desire to discuss wide-ranging reforms of the global financial system and re-orientate policy towards investment-led growth that underpinned South Korea's post-1945 economic miracle.
But instead of a new Bretton Woods system, the looming currency and trade war between debtor and creditor countries, chief of all the US and China, will dominate the agenda. That, coupled with new trouble in the financial sector, could plunge much of the world economy back into recession.
Last week's annual meeting of the IMF was a disaster. By failing to make any progress on Sino-US tensions over the undervalued Chinese currency, the IMF made it more difficult for the G20 to agree on how to rebalance the global economic system. Such an agreement must include not only measures to reduce trade imbalances but also policies aimed at reconnecting finance to the real economy - thereby stimulating investment, consumption and growth.
As the global recovery loses steam, lower growth and higher unemployment are hurting both developed countries and emerging markets. To maintain Chinese exports and sustain economic expansion, Beijing has continued to hold down the value of the yuan.
In retaliation, Washington has decided to impose trade barriers to protect its markets from cheap imports and boost US exports. Earlier this month, the US House of Representatives passed legislation enabling US companies to apply for duties to be levied on imports from countries manipulating their currencies, though it is yet to be voted on in the Senate. The Federal Reserve's decision to pump more money into the US economy via asset purchases - or quantitative easing - may be far more important. It has already weakened the value of the US dollar relative to the yen and the euro. As such, both China and the US are manipulating their currencies and distorting free trade.
All this could lead to a round of devaluation and protectionism, as both developed countries and emerging markets intervene to gain a competitive advantage. In economic speak, this policy is known as "beggar-my-neighbour". Widely used following the Great Depression of 1929-32, such policies stalled recovery by delaying international monetary and financial reform and failing to address imbalances between surplus and deficit countries - precisely our present predicament.
Currency manipulation and trade tariffs shift the necessary adjustment onto countries that attract capital inflows and are unable or unwilling to manipulate their own currency on a sufficient scale. The most prominent examples include emerging markets like Brazil and the countries of the Gulf Cooperation Council, as well as developed economies such as the eurozone member-states. The longer the covert currency and trade war between the US and China goes on, the bigger the collateral damage will be for the countries caught in the crossfire.
Crucially, current dynamics exacerbate the global imbalances that trap much of the world in conditions of stagnation or debt-deflation. Manipulated exchange rates and new tariffs reduce global trade upon which virtually all economies depend for a sustained recovery. Sluggish growth and rising unemployment reduce private investment and consumption while increasing budget deficits and debt.
That, in turn, limits the ability of states to boost demand through public investment and tax cuts. Deficient demand, coupled with a lack of confidence, stops businesses from investing and creating jobs. Without stronger growth, neither the public nor the private sector will be able to service their debts.
In a report released earlier this month, the IMF states that "nearly $4 trillion of bank debt will need to be rolled over in the next 24 months". If financial institutions can't raise the funds to refinance their existing debt, they will once more require a government bail-out - inflating public deficits and public debt. Thus, the sovereign debt crisis is entirely of a piece with the banking crisis.
As such, the greatest challenge for the G20 summit next month in Seoul is to tackle global imbalances. Since January 2009, China has accumulated almost $600 billion - 40 per cent of new global currency reserves. Chinese holdings of dollars now stand at $2.45 trillion, more than half of the country's overall national output. With US debt at unprecedented levels, Washington relies on Chinese purchases of US Treasury bonds.
To break this vicious cycle, the US needs to reduce its structural deficit and boost investment. America simply can't afford the trillion-dollar wars in Afghanistan and Iraq. It needs to get the bailed-out banks on Wall Street to lend far more to cash-strapped businesses and households on Main Street.
Likewise, China must stimulate domestic demand for foreign goods and services by raising wages in line with labour productivity and gradually opening up internal markets. If Beijing continues to promote high-tech investment, the production of cheaper consumer goods will shift to other emerging markets such as Vietnam and Indonesia.
The G20 can assist these structural transformations by agreeing a framework to coordinate exchange rate movements and charting a way towards a world currency composed of a basket of national currencies. By mitigating tensions over currency and trade, it can help provide a much-needed boost of confidence.
Adrian Pabst is a lecturer in politics at the University of Kent, UK, and a visiting professor at the Institut d'Etudes Politiques de Lille (Sciences Po), France.