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Central bankers around the world have lined up to criticize the recent quantitative easing by the U.S. Federal Reserve. Many economists have done the same. Comments range from "owes us some explanation on the decision" and "international confidence…might be hurt" to "debasing the currency" and "uncontrolled printing of money which will lead to high inflation and another global crisis down the road".



While these are valid concerns, what is most disconcerting is that the strategy of the U.S. government and the Federal Reserve is now slowly becoming apparent. And this may create problems and uncontrolled currency devaluations that may destabilize world trade and economic growth.

While Federal Reserve Chairman Ben Bernanke is a student of the great depression and knows very well that policy mistakes at the time led to the most severe economic decline of the century, his policies may lead to similar policy mistakes, by raising antagonism among nations and protectionist feelings around the globe. These were two of the key factors, instigated by policy mistakes, which turned a bad recession of the 1930s to a severe depression.

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Recent events are part of an implicit U.S. strategy to get at China's refusal to play ball. China has refused to take steps to strengthen its currency. This has led to large trade surpluses with U.S. and made China a holder of huge amount of US debt in its reserves.

How has the U.S. decided to deal with these problems and encourage China to listen? The U.S. has implicitly decided to pursue a more subtle way of getting to Chinese as opposed to direct trade wars. First, the U.S. has depreciated its own currency by printing lots of money. This not only has had the effect of depreciating the U.S. dollar and making its imports from China more expensive, but has also reduced the value of the U.S. debt that China holds. It is ingenious!

Additionally, since oil and commodities are priced in U.S. dollars, their values rise as the value of the U.S. dollar declines. The U.S. has an incentive to keep the price of oil high; it makes transportation of Chinese goods more expensive and many times prohibitive. There is a double whammy effect to quantitative easing and printing money, which may eventually induce the Chinese to co-operate. Cooperation will create more balanced economic growth and prolong the longevity of the U.S. and global recoveries and put economies around the world on a steadier path.

Risks

But there are risks in both the short run and long run. The G20 summit meeting this week in Seoul may turn ugly. In the short run, as the true intentions of U.S. policy and the second round of quantitative easing may now become more apparent, the meeting may turn to calls for full blown protectionism and currency devaluations of the "beggar thy neighbour" variety of the 1930s that led to the Great Depression with dire effects for the global economy, pushing weak economies, including the US, over the precipice.

The other risk is that of inflation down the road. Money supply and inflation are connected in the long run. And money supply has been rising fast over the last decade. Keeping interest rates artificially low also creates the risk of bubbles and volatility in commodities and financial assets. While this is not obvious as yet in the U.S., it is quite apparent in emerging economies where inflation caused by U.S. actions is running amok. But in the long run, the U.S. will not avoid the inflation problem either, with severe consequences for economic stability and sustainability. The high and rising gold prices are a reflection of this fear.

We live in interesting times. Unlike the old days when countries went to war to settle outstanding issues, globalization has managed to avert such wars, but it has replaced them by economic wars. Whereas before countries went to war to force others to submission and secure needed resources (i.e., after the British-Dutch and U.S. ban on oil and iron ore exports, Japan decided to go to war against the U.S. as the price to achieve "economic security"), nowadays countries use economic might, implicit or explicit, to force other countries to submit to their demands, or obtain the needed resources by buying control of companies that produce the necessary commodities. China has been doing this for more than a decade.

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Greece and many Eastern European countries have handed economic control of their countries to IMF and European Union politicians. Foreign countries do not need to go to war anymore to occupy others; economic power does the occupation. This will prompt calls for more nationalistic policies and protectionism around the world. Canada's response to BHP's hostile acquisition attempt of Potash Corp. of Saskatchewan may be an early sign of such calls.

And while in the old days undervaluation of currencies supported by governments led to retaliatory trade measures by other governments and further devaluations, it is now covert devaluation, such as the actions taken by the U.S., that involve not the government but rather the central bank. We may soon see the repercussions of this.



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