Central bankers are huddling in search of a magic elixir to ward off deflation

Finance ministers, central bankers and big-deal financiers have arrived in Washington for the annual Oktoberfest of economic policy-making, and in case you couldn’t tell from the headlines over the past few days, they’re plenty worried that the global recovery is about to lose steam.

Central bankers, having pushed overnight interest rates to zero, are contemplating creative new ways to increase the supply of money and credit and prevent a deflationary dynamic from taking hold. The Bank of Japan took the first step by announcing it would pump the equivalent of $60 billion into the economy by buying not only government bonds but also short-term IOUs from banks and corporations and packages of securitized real estate loans. The European Central Bank is scooping up the bonds of some of its most debt-soaked member countries. And Federal Reserve Chairman Ben Bernanke seems to have convinced his colleagues that it’s time to print up another trillion or two to buy Treasury notes and bonds with longer maturities.

At this point, the risks of central banks doing nothing (deflation, continued high unemployment) are greater than the risks of cranking up the monetary printing press (future inflation). But nobody should expect it will prove a magic elixir for the economy. A number of economic modelers estimate that the unemployment rate would remain above 9 percent whether the Fed expanded its balance sheet by $500 million or $2 trillion.

The reason is that the normal channels through which monetary easing works are pretty worn out. Interest rates are already so low that pushing them lower won’t induce more borrowing. Households are of a mind to pay down debt, not add to it, and businesses have plenty of cash and don’t foresee the growth in sales that would justify an expansion of capacity or product lines.

The one channel that is working is the financial market. In recent weeks, prices of stocks and bonds have moved higher in anticipation of the flood of central bank money; those higher prices, in turn, should help bolster confidence among business executives and wealthy consumers. The lower rates also will boost the profits of banks, too many of which are hanging on by a thread and desperate to offset the yet-unacknowledged losses they face from commercial real estate loans.

Re-inflating financial bubbles isn’t generally considered a worthy goal for monetary policy, but it speaks to the growing desperation of Fed policymakers that they feel they have no choice but to resort to it.

The more urgent issue on this weekend’s agenda concerns exchange rates and the threat that countries will start competing to devalue their exchange rates to bolster their economies. On this, too, Japan has taken the first step, intervening in currency markets to drive down the value of the yen against the dollar. Japan’s primary aim, however, wasn’t to protect its export sales to the United States – it was to stem the loss of global market share to competitors in China, Taiwan and other Southeast Asian powerhouses that peg their currencies in some fashion to the dollar.

Japan is hardly the only country anxious about a rise in its currency and its effect on exports. South Korea and Brazil also have taken steps to blunt the impact of a rising currency, and European exporters have begun to grumble about the recent spike in the value of the euro. The fear now is that countries will embark on a series of competitive devaluations that will lead to an outright trade war and destabilize the global financial system.

At the core of this problem is China’s stubborn refusal to allows its currency, the yuan, to gradually appreciate against the dollar to reflect the dramatic increase in China’s wealth and productivity. Allowing the yuan to float is a necessary first step in rebalancing a global economy that has become dependent on the United States consuming much more than it produces and China producing more than it consumes. That imbalance was the root cause of the recent credit bubble, and as long as it persists it will make it difficult for the United States to bring the unemployment rate down to an acceptable level.

For years, China has been playing rope-a-dope on the currency issue, promising to move toward a market-based floating currency whenever tensions got too high but never quite getting around to doing it. And for years, top U.S. officials in various administrations have said that patience and persistence would work better than imposing the kind of retaliatory tariffs urged on them by angry members of Congress.

But this week, Treasury Secretary Timothy F. Geithner effectively acknowledged that the strategy of all-carrot-and-no-stick had failed, and he began to turn up the heat on China. The secretary made clear that the United States would no longer support China’s efforts to gain a leading role in organizations such as the World Bank and the International Monetary Fund as long as it continued to undervalue its currency and pursue other mercantilist policies. Geithner also hinted that the U.S. would pursue international sanctions against China if it continued to run large trade surpluses, favoring exports over domestic consumption.

The response from Chinese officials, and their running dogs in the U.S. business community, has been predictable. On the one hand, they say that the yuan is not all that underpriced and, in any case, that raising its value wouldn’t significantly affect the trade balance. Then in the next breath, they say that raising the exchange rate would force the closure of so many Chinese factories and, in the words of Premier Wen Jiabao, “bring disaster to China and the world.”

That may be the kind of logic that sways opinion down at the central committee, but it hardly inspires confidence that China is ready to take its rightful place in global economic leadership.