Friday, August 22, 2014
7

The Unloved Dollar Standard

PALO ALTO – Since World War II’s end, the US dollar has been used to invoice most global trade, serving as the intermediary currency for clearing international payments among banks and dominating official foreign-exchange reserves. This arrangement has often been criticized, but is there any viable alternative?

The problem for post-WWII Europe, mired in depression and inflation, was that it lacked foreign reserves, which meant that trade carried a high opportunity cost. To facilitate trade without requiring payment after each transaction, the Organization for European Economic Cooperation created the European Payments Union in 1950. Supported by a dollar-denominated line of credit, the EPU’s 15 Western European member states established exact dollar exchange-rate parities as a prelude to anchoring their domestic price levels and removing all currency restrictions on intra-European trade. This formed the keystone of the hugely successful European Recovery Program (the Marshall Plan), through which the US helped to rebuild Europe’s economies.

Today, most developing economies, with the exception of a few Eastern European countries, still choose to anchor their domestic macroeconomic arrangements by stabilizing their exchange rates against the dollar, at least intermittently. Meanwhile, to avoid exchange-rate conflict, the US Federal Reserve typically stays out of the currency markets.

But the dollar’s role as international anchor is beginning to falter, as emerging markets everywhere grow increasingly frustrated by the Fed’s near-zero interest-rate policy, which has caused a flood of “hot” capital inflows from the US. That, in turn, has fueled sharp exchange-rate appreciation and a loss of international competitiveness – unless the affected central banks intervene to buy dollars.

Indeed, since late 2003, when the Fed first cut interest rates to 1%, triggering the US housing bubble, dollar reserves in emerging markets have increased six-fold, reaching $7 trillion by 2011. The resulting expansion in emerging markets’ monetary base has led to much higher inflation in these countries than in the US, and to global commodity-price bubbles, particularly for oil and staple foods.

But the US is also unhappy with the way the dollar standard is functioning. Whereas other countries can choose to intervene in order to stabilize their exchange rates with the world’s principal reserve currency, the US, in order to maintain consistency in rate setting, does not have the option to intervene, and lacks its own exchange-rate policy.

Moreover, the US protests other countries’ exchange-rate policies. Two decades ago, the US pressed the Japanese to allow the yen to strengthen against the dollar, claiming that Japan’s unfair exchange-rate policies were responsible for America’s ballooning bilateral trade deficit. Likewise, today’s “China-bashing” in the US – which has intensified as China’s contribution to America’s trade deficit has soared – is intended to force the Chinese authorities to allow faster renminbi appreciation.

Herein lies the great paradox. Although no one likes the dollar standard, governments and private market participants still consider it the best option.

In fact, US trade deficits are primarily the result of insufficient, mainly government, saving – not a misaligned exchange rate, as economists have led policymakers to believe. Large US budget deficits during Ronald Reagan’s presidency generated the famous twin fiscal and trade deficits of the 1980’s. This, not an undervalued yen, caused the bilateral deficit with Japan to widen in the 1980’s and 1990’s.

The much larger US fiscal deficits of the new millennium, courtesy of Presidents George W. Bush and Barack Obama, portend large – and indefinite – trade deficits. But American policymakers continue to blame China, claiming that the renminbi has been undervalued for the last decade.

The claim that exchange-rate appreciation will reduce a country’s trade surplus is false, because, in globally integrated economies, domestic investment falls when the exchange rate appreciates. So the ill will that China-bashing is generating is for nothing. Worse, it detracts political attention from America’s huge fiscal deficit – $1.2 trillion (7.7% of GDP) in 2012 – and thus impedes any serious effort to rein in future spending for entitlements, such as health care and pensions.

Some contend that large fiscal deficits do not matter if the US can exploit its central position under the dollar standard –& that is, if it finances its deficits by selling Treasury bonds to foreign central banks at near-zero interest rates. But America’s ongoing trade deficits with highly industrialized countries, particularly in Asia, are accelerating de-industrialization in the US, while providing fodder for American protectionists.

Indeed, America’s trade deficit in manufactures is roughly equal to its current-account deficit (the amount by which domestic investment exceeds domestic saving). So those concerned with job losses in US manufacturing should join the chorus lobbying for a much smaller fiscal deficit.

Can large US fiscal deficits and near-zero interest rates be justified because they help to revive domestic economic growth and job creation? Five years after the credit crunch of 2007-2008, it seems that they cannot. And, without even that justification, the latest wave of criticism of the US dollar standard appears set to rise further – and to stimulate the search for a “new” arrangement.

But the best new arrangement – and possibly the only feasible one – would follow an old formula: as in the 1950’s and 1960’s, the US would set moderately positive and stable interest rates, with sufficient domestic saving to generate a (small) trade surplus. The cooperation of China, now the world’s largest exporter and US creditor, is essential for easing and encouraging the transition to this nirvana. Apart from the ongoing euro crisis, a stable renminbi/dollar exchange rate is the key to renewed (dollar) exchange-rate stability throughout Asia and Latin America – as envisaged in the original 1944 Bretton Woods Agreement.

Read more from our "Currency War Drums" Focal Point.

Hide Comments Hide Comments Read Comments (7)

Please login or register to post a comment

  1. CommentedParrain Boursorama

    And while the initial Kibbutz movement lost its force and vigor as the country became westernized, the safe and prosperous future of Israel necessitates the return to a similar close, family-like national unity, mutual cooperation and understanding.

  2. CommentedChee-Heong Quah

    Now I understand.

    In sum, government intervention disrupts the mechanics of the natural price mechanism in the interbank market. The act of Federal Reserves bidding up prices of bills and bonds, pushed down the short-term interest rates which do not represent the natural price of capital that would have been without Fed's intervention.

    Since the Fed set the minimum price, banks and lenders find it not profitable to lend at the new low price. But what about the "black market"? Can market prices prevail in the "black market"?

  3. CommentedJohn Monroe

    This argument loses all credibility the second it hones in on entitlement spending, rather than spending, as a root problem. How is it defense spending eludes Dr. Mckinnon's radar? -- one detects ideology intruding on thought. At least there are obvious returns for not permitting a flood of money into luxury spending (healthcare) to beggar the lower and middle classes -- at least, if one concedes that nothing will be done to rein in costs. There may be returns on defense spending but no one seems eager to mention them in public.

    Incidentally, it is not necessary to conclude from "China's exchange rate policy is not to blame for our trade deficit" that China's currency is therefore not undervalued. It is undervalued. It has been for the last fifteen years, at least. And yet it is not responsible for our trade deficit.

  4. CommentedCarol Maczinsky

    I think sinophilism and sinophobia are equally wrong. We know that the Chinese economy is on shaky grounds.

  5. CommentedMark Pitts

    The author is quite correct in pointing out that excessively low rates engineered by the Fed was a significant reason for the housing bubble. Then, as now, low rates lead investors into riskier assets, and lead even low-income borrows to believe they can come out ahead by betting on housing.
    A recent study from the Erasmus Institute also shows how excessive world saving fed into the mix.
    A greedy population that didn’t want to miss out on a “sure thing” is also to blame. Shiller explains this effect in housing and the stock market in his excellent book.
    Of course, many unthinking people want to blame the banks. However, they have yet to explain how banks could have anticipated the problem when international agencies such as the IMF could not, and the even Fed mere days before the crisis saw no problem in housing.

      CommentedJose araujo

      How many time do the Austrians have to be proven wrong for people to stop using the same arguments.

      Look at the situation right now, if low interest rates had anything to do with housing bubles wouldn't we be living in this situations right now?

      Deregulation and the spread of securization has much more to do with the housing bubbles then low interest rates. The problem wasn't the cost of risk, the problem was the wrong perception and valuation of the risk

  6. CommentedJose araujo

    Wouldn't it be much easier if you inverted the causal nexus.

    Its the over appreciation of a currency that causes fiscal deficits and not the opposite. We all know it, its empirical verifiable and it makes sense.

    We actually have evidence in many countries that its the fixed exchange rates that require a country to have huge fiscal deficits.

  7. CommentedJose araujo

    Is McKinnon proposing a new economic theory, or has he just gone mad?

    "Fed first cut interest rates to 1%, triggering the US housing bubble,..." so it was the Fed that triggered the house bubble!!!!

    "...dollar reserves in emerging markets have increased six-fold, reaching $7 trillion by 2011" now cutting interest rates leads to capital inflow, another amazing statement

    "..trade deficits are primarily the result of insufficient, mainly government, saving – not a misaligned exchange rate,..." trade deficits are now the consequence of public deficits!!!! Amazing theory..

    "Large US budget deficits during Ronald Reagan’s presidency generated the famous twin fiscal and trade deficits of the 1980’s. This, not an undervalued yen, caused the bilateral deficit with Japan to widen in the 1980’s and 1990’s." Clearly that was what caused the deficits..


    "The claim that exchange-rate appreciation will reduce a country’s trade surplus is false, because, in globally integrated economies, domestic investment falls when the exchange rate appreciates." Yes, yes, I start to understand now, up is down and down is up for Professor McKinnon


    "Indeed, America’s trade deficit in manufactures is roughly equal to its current-account deficit (the amount by which domestic investment exceeds domestic saving)" last time I checked that is the definition of the capital account, and yes capital account is the mirror of the current account, but not for Mckinnon...

    "Can large US fiscal deficits and near-zero interest rates be justified because they help to revive domestic economic growth and job creation? Five years after the credit crunch of 2007-2008, it seems that they cannot" Yes yes, for sure reducing spending and increasing interest rates is the answer to our problems...

    This must be an article from the wrong McKinnon, we must be in the presence of the GREAT Magician McKinnon, that can solve the competitive problems of the economy with his magic wand, generating trade surplus while appreciating the dollar, and growing the economy while cutting the defict

Featured