The world economy is poorly served by the current system of exchange rates. That system has contributed to today’s global financial imbalances, which are widely viewed as posing significant economic risk. These imbalances have also created political tensions between countries over how to adjust them, and within countries over job losses. Exchange rates matter more than ever under globalization, which means the world needs a better system.
Today’s global imbalances concern the US trade deficit, which has spiraled out of control after years of dollar over-valuation. This problem is particularly acute with China. A few years back the problem of over-valued exchange rates afflicted Latin America, and to a lesser degree East Asia. Now, with the dollar weakening, the burden of over-valuation is shifting on to the euro.
This pattern of rolling exchange rate misalignment is bad for the global economy. Such misalignments often end in costly economic crises, and they also cause inefficiency by distorting trade. That is because rather than competing on productivity, too often countries compete through under-valued currencies that confer an exchange rate subsidy.
These costs have been obscured by the debt-financed boom of the last few years. In the US, the costs of manufacturing job loss have been camouflaged by a house price bubble. Other countries have dismissed the US trade deficit problem because it has created matching trade surpluses that have spurred export-led growth. But this picture is vulnerable to credit retrenchment and reversal of the dollar’s over-valuation. History repeatedly shows that conditions look artificially rosy when wracking up debt, and the hangover only sets in when the financial punch bowl is removed.
The current global exchange rate system is a sub-optimal arrangement. There are many theoretical reasons explaining why foreign exchange markets are prone to mis-pricing, and the empirical evidence shows exchange rates persistently depart from their warranted fundamental levels. Moreover, the system permits strategic manipulation so that some countries (particularly in East Asia) actively intervene to under-value their currencies. That has made for a lop-sided world in which half play by free market rules and half are neo-mercantilist, creating threatening tensions.
It is possible to do better than the current system. The immediate need is for a coordinated global re-alignment of exchange rates that begins to smoothly unwind existing imbalances. The 1985 Plaza currency accord provides a model of how this can be done. China’s participation is key as it has large trade surpluses with both the U.S. and Europe. Moreover, other East Asian countries with trade surpluses will resist revaluing unless China revalues for fear they will become uncompetitive. Finally, markets must believe this realignment it will hold. Absent that, business will not make the changes to production and investment patterns needed to restore equilibrium.
Beyond such realignment, there is need for systemic reform to avoid recurring misalignments. That suggests a system of managed exchange rates for major currencies in which countries cooperatively set exchange rates.
Such a system needs rules of intervention. Historically, the onus of defense has fallen on the country whose exchange rate is weakening, which requires it to sell foreign exchange reserves. That is a fundamentally flawed arrangement because countries have limited reserves and the market knows it. Speculators therefore have an incentive to try and “break the bank†by shorting the weak currency, and they have a good shot at success given the scale of low cost leverage financial markets can muster.
Instead, the onus of intervention must be placed on the strong currency country. Its central bank has unlimited amounts of its own currency for sale so it can never be beaten by the market. Consequently, if this intervention rule is credibly adopted, speculators will back off, making the target exchange rate viable.
Intervening in this way will also give an expansionary tilt to the global economy. When weak countries defend exchange rates they often use high interest rates to make their currency attractive, which imparts a deflationary global bias. If strong surplus countries do the intervening, they may lower their interest rates and impart an expansionary bias.
A sensible managed exchange rate system can increase the benefits from trade, diminish exchange rate induced distortions, and reduce country conflict over trade deficits. The means are at hand, but so far the politics have lagged.
In the U.S., discussion of exchange rate policy is still blocked by simplistic free market nostrums. It is also blocked by mistaken fears that a managed system would surrender sovereignty and control. Yet, that is implicitly what has been happening. By absenting itself from the market, the U.S. has de facto allowed other countries to set the exchange rate, and that means the U.S. has been letting itself be strategically out-gamed.
Impetus for change has also been reduced because other countries have been beneficiaries of the over-valued dollar. However, many are now starting to suffer from the dollar’s weakness.
Putting the pieces together, increasing awareness of the dangers of global imbalances and uncertainty about the dollar has created space for change. The still missing ingredient is political leadership that recognizes there is a better way.
Copyright Thomas I. Palley
I agree with your article could fiscal policy be used to control the economy instead of monetary policy. I have disliked the idea of inflation targeting for a long time as it is obviously going to create huge levels of private debt.
“The immediate need is for a coordinated global re-alignment of exchange rates that begins to smoothly unwind existing imbalances. . . China’s participation is key as it has large trade surpluses with both the U.S. and Europe. . . Finally, markets must believe this realignment it will hold.”
Huge compromises will surely be needed if the world’s politicians are to agree a common set of values that somehow redirect the market. An indication of the gulf in thinking between East and West was apparent yesterday in the World Economic Forum’s report on global competitiveness. The United States was ranked best in the world, according to a formula devised at a university in the US. Many were surprised.
The London Times reports:
– The top rank for the US came despite nagging concerns over America’s huge budget and trade deficits and the faltering dollar. The [WEF] said that the status of the US as a global economic leader was bolstered by the efficiency of its markets, the sophistication of its business community and the “impressive capacity for technological innovation that exists within a first-rate system of universities and research centresâ€.
The FT reports:
– For all the awe that their economies create, China and India rank 34th and 48th respectively in the World Economic Forum’s global competitiveness index. Their low ranking reflects the need for these economies to improve many aspects of their markets and average living standards before they can be compared with advanced economies.
– China needs to improve its higher education, financial markets and training, while India, falling slightly down this year’s league, is plagued by macroeconomic instability, poor health and education systems and low labour market efficiency.
It seems that many Asian countries decided after the 1997-98 currency crisis that going to the IMF was something they must never do again, as IMF bailouts required forfeiting sovereignty over economic decisions. I’m thinking here of the IMF forcing Korea to break the government-industry link behind the Chaebols as a condition of getting a loan. Thus, the lesson was that if you want to have an economic policy different from that which the US would approve of, then you must stockpile reserves so that you will never again have to beg. So stockpiling reserves–and the undervalued currency that creates the stockpile–then became the key to economic sovereignty. Thus, while I like your argument very much, it seems that the world is actually moving in a different direction–the impetus is not toward rectifying imbalances, but rather the lesson learned from recent history is that imbalance (I’m thinking the Asian surpluses) is essential.
how about something simpler than a “managed” regime. How about flexible exchange rates and letting the amrket work instead of the US subsiding foreign mercantilism. Yeas some of this stuff is actually doesn;t need the ten page spreadsheet to solve the obvious. models are great in the abstract as is economics. So I guess the bottom line here is that now we have no choice but to make a bad tradeoff given we have offshored our industrial base. Looks like that financial services advanatage is not so much…it was abstract 18th century economic theories that got us here. why don;t we start with some new thinking…instead of retrograde solutions that did nothing but compound the problem.