Eichengreen and Irwin say aggressive domestic monetary policy is the key to avoiding a trade war:
How to Prevent a Currency War, by Barry Eichengreen and Douglas Irwin, Commentary, Vox EU: Three years into the financial crisis, one might think that the world could put Great Depression analogies behind it. But they are back, and with more force than ever. Now the fear is that currency warfare, leading to tariffs and retaliation, could cause disruptions to the international trading system as serious as those of the 1930’s.
There’s good reason to worry, for the experience of the 1930’s suggests that exchange-rate disputes can be even more dangerous than deep slumps in terms of generating protectionist pressures. ...
In the 1930’s, the countries that raised their tariffs and tightened their quotas the most were those with the least ability to manage their exchange rates – namely, countries that remained on the gold standard. ... But trade restrictions were a poor substitute for domestic reflationary measures, as they did little to arrest the downward spiral of output and prices. They did nothing to stabilize rickety banking systems. By contrast, countries that loosened monetary policies and reflated not only stabilized their financial systems more effectively and recovered faster, but also avoided the toxic protectionism of the day.
Today, the United States is in the position of the gold-standard countries in the 1930’s. It can’t unilaterally adjust the level of the dollar against the Chinese renminbi. Employment growth continues to disappoint, and fears of deflation will not go away. Lacking other instruments with which to address these problems, the pressure for a protectionist response is growing.
So what can be done to address the situation without getting into a beggar-thy-neighbor, retaliatory free-for-all? In the deflationary 1930’s, the most important way that countries could subdue protectionist pressure was to use monetary policy actively to push up the price level and stimulate economic recovery. The same is true today. If fears of deflation were to recede, and if output and employment were to grow more vigorously, the pressure for a protectionist response would dissipate.
The villain..., then, is not China, but the US Federal Reserve Board, which has been reluctant to use all the tools at its disposal...
Of course, with China pegging the renminbi to the dollar, the Fed would, in effect, be reflating not just the US but also the Chinese economy. ... China might not be happy with the result. Inflation there is already too high for comfort. Fortunately, the Chinese government has a ready solution to this problem: that’s right, it can let its currency appreciate.