Traveling around Southeast Asia last week, the mood was all about currency fluctuation and impact on markets. Things do look different when the Thai stock market daily turnover touches $2 billion and is higher than that of Singapore. But the headline that Thai growth slowed quarter-on-quarter but still grew 5.3 percent year on year gave rise to fears that export-driven economies in the region are beginning to slow.
The guru on the dollar relationship with the East Asian currencies has to be Stanford
professor Ronald I. McKinnon. McKinnon made his name with his first book, “Money and Capital in Economic Development” (1973), where he took forward the pioneering work of his Stanford colleague Edward S. Shaw on the phenomenon of “financial repression” ― the use of negative real interest rates as a tax to finance development. His second book, “The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy” (1993), was an influential textbook on how to get the sequencing of financial and trade reform right.
McKinnon’s second area of expertise is the international currency order, explaining the macroeconomics of the U.S. dollar and its relationship with other currencies, particularly the yen and other East Asian currencies.
The trouble was that his analysis did not “jive” with the populist policy view that “revaluing the other currency” would reduce the U.S. trade deficit. This began with the concern in the 1970s that the U.S.-Japan trade imbalance was due to the cheap yen relative to the dollar. The Plaza Accord in 1985 was the political agreement to strengthen the yen and depreciate the dollar. From 1985 to 1990, the yen appreciated from 240 yen to 120 yen per dollar, followed by a huge bubble and two lost decades of growth.
In his important new book, McKinnon explains some uncomfortable truths with regard to what he called “The Unloved Dollar Standard: From Bretton Woods to the Rise of China,” Oxford University Press. The dollar standard is unloved because of what one U.S. Treasury secretary told his foreign critics of U.S. exchange rate policy ― “our dollar, your problem.”
McKinnon argues that U.S. monetary policy has been highly insular, despite globalization making such insularity obsolete. He thinks that three macroeconomic fallacies were responsible ― the Phillips curve fallacy; the efficient market fallacy and the exchange rate and trade balance fallacy. In the 1960s, the U.S. belief in the Phillips curve ― that higher inflation generated lower unemployment ― resulted in the U.S. pushing the Europeans and the Japanese to appreciate their currencies. When they refused, Nixon broke the link with gold in 1971.
In the Greenspan era (1987-2008), there was a strong belief in efficient markets, which encouraged global foreign exchange liberalization, despite high volatility. But the most enduring fallacy is the belief that the exchange rate’s role is to correct trade imbalance, hence the Japan bashing in the 1980s and the China bashing in the 21st century in order to push for their exchange rates to appreciate in order to reduce the U.S. trade deficit.
McKinnon considers the third fallacy as the most pernicious conceptual barrier to a more internationalist and stable U.S. monetary policy. Chapter 7, which is written by his student Helen Qiao, gives a robust argument why the third fallacy is wrong. She argues that while a depreciation of an insular economy with no net foreign liability may result in improved trade balance, it is not clear whether the depreciation of the dollar with a large net global liability is to the benefit of the United States.
In the case of Japan, a rising yen since the 1970s did not “cure” the Japanese trade surplus with the U.S. Between 2005 and 2007, when the RMB appreciated, the Sino-U.S. trade surplus doubled. Helen Qiao worries that China could follow Japan’s steps into deflation and even a zero-interest rate liquidity trap if the RMB continues to appreciate.
The central thesis of this book is that the U.S. should recognize that the dollar standard is actually a global standard, with many privileges and responsibilities. Depreciating the dollar is not to the U.S. advantage, because it would only lead to future inflation. Instead, the U.S. should concentrate on improving its competitiveness and manufacturing prowess. This requires having positive real interest rates.
The logic of the McKinnon thesis is irrefutable, although his American colleagues may find the conclusions somewhat unpalatable. The logic is that whoever maintains the dominant currency standard must maintain strong self-discipline, because the benchmark standard cannot be on shifting sands. If the dollar is weak because the U.S. economy is weak, then all other currencies will be volatile, because they float around an unsteady standard.
For small open economies that maintain heavy trade with the U.S., having dollar pegs require them to keep their economies flexible and they must maintain fiscal and monetary discipline. This is the experience of the Hong Kong dollar peg.
Flexible exchange rates have not resulted in countries adjusting their overall competitiveness. What happened instead is that flexible exchange rates often allow governments to run “soft budget constraints” and try to depreciate their way out of the lack of competitiveness. It is the refusal to make structural reforms that cause overall competitiveness to decline and these economies then go into a vicious circle of over-reliance on the exchange rate to keep the economy afloat.
This is not sustainable, since if everyone tries to devalue their way out of trouble, rather than making structural adjustments, then the world will enter into a collective deflation.
The solution to this requires the U.S. and China to work cooperatively at the monetary and exchange rate levels. This makes a lot of sense, which is why perhaps Obama and Xi are meeting soon to achieve rapport.
Anyone who wants to understand currency wars must read this book. It is an honest and frank appraisal of how we need common sense to get out of the current fragile state of global currency arrangements.
By Andrew Sheng
Andrew Sheng is president of the Fung Global Institute. ― Ed.