SANTA BARBARA, California: China's currency, the yuan weakened slightly against the dollar at the start of last week. Around the world, the immediate response panicked.
Financial markets fell, US President Donald Trump's administration formally labeled China a currency manipulator, and fears of a new currency war spread like a fire.
China still has many arrows
It therefore seems unlikely that China is in the process of declaring a complete currency war. What happened earlier this week was much more subtle – in fact, a shot over the US bow.
The yuan was already close to the symbolic level of 7 yuan per US dollar. By setting the daily reference rate for the currency to a smidgen below 7 yuan, the Chinese authorities created room for currency traders to temporarily push market rates above that mark – an effective devaluation.
Although the actual size of the devaluation was minuscule, the psychological impact was enormous. China reminded America that it still has many economic arrows.
Unfortunately, the Trump administration responded in a typically unclear manner, mistaking the modest Chinese signal for something more sinister. By immediately declaring China as a currency manipulator, the US only succeeded in hardening its positions on both sides.
READ: Who is manipulating who in this China-US currency war? A Comment
CONDITIONS CAN GET THE WORLD
To avoid losing face, Chinese leaders may now feel compelled to respond in nature. They can make good on the threat of devaluation, or pull out some of its other arrows.
For example, China could embargo the export of rare earth minerals that are so important to America's technology industry, or extend the boycott of US agricultural products.
Or it could go beyond the trade area and cause problems in the South China Sea or the Taiwan Strait. In short, the relationship between the world's two largest economies can go from bad to much worse.
A NEUTRAL ARBITER
Can further escalation be avoided? One way to avoid this outcome may be to look to a neutral judge to judge the currency issue.
The most obvious candidate is the International Monetary Fund, whose main function is to oversee the "rules of the game" in international money matters.
All members of the Fund have promised to avoid currency manipulation, and all are formally subject to "regular" monitoring of the Fund's policies. In principle, if America and China really want to avoid a monetary conflict, they can ask the IMF to step in to settle matters.
NOTE: The long, winding road back to a US-China trade agreement, a comment  In practice, however, the fund's authority is unfortunately limited. The IMF has no powers to enforce rulings. At best, just "naming and shaming" currency manipulators.
And finally, it is hard to imagine America or China kowtowing to a toothless multilateral organization. Can anyone really imagine Trump submitting to the verdict of a bunch of extraterrestrial international officials?
A GRAND BARGAIN  A slightly more realistic alternative could be a direct agreement between the US and Chinese governments – perhaps also the European Central Bank and one or two other monetary powers – to achieve some form of currency detention.
There is precedent for such an agreement. Back in 1936, after more than half a decade of uncontrolled competitive evaluations during the Great Depression, today's most important powers – the United States, the United Kingdom and France – went to an informal system for mutual exchange rate stabilization.  Jokingly called the "twenty four hour gold standard", the tripartite agreement obliged each country to give 24 hours notice of any change in the price of the currency. Despite being far from perfect, the pact managed to restore a certain look to order in monetary matters.
A similar agreement today would be more difficult to negotiate. In the 1930s, America, the United Kingdom and France were on reasonably good terms.
Today's America and China, on the other hand, are strategic opponents engaged in a trade war, and even a very limited exchange rate initiative may prove unattainable.
NOTE: During the trade war, China's pain is not necessarily the United States gain, a comment
Yet it is not out of the ordinary. Lastly, both sides can see some benefit from taking the currency conflict off the table, hoping to prevent greater harm to themselves and others.
Benjamin J Cohen, Professor of International Political Economy at the University of California, Santa Barbara, is the author of the latest of Currency Statistics: Monetary Rivalry and Geopolitical Ambition.