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Exchange Rates: There is a Better Way
Copyright Thomas I. Palley
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. (read more).
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.
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