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The Case for Re-Regulating Capital Accounts

NEW YORK – Today’s debates over “currency wars” reveal two paradoxical features of the global economy. The first is that there is no mechanism linking world trade rules to exchange-rate movements. Countries spend years negotiating trade rules, but exchange-rate movements can, within days, have a greater impact on trade than those painstaking deals. Furthermore, exchange-rate movements are essentially determined by financial flows and may have no effects in terms of correcting global trade imbalances.

The second paradox is that monetary expansion may be largely ineffective in the country that undertakes it, but can generate large negative externalities on others. This is particularly true of the quantitative easing now underway in the United States, because the American dollar is the major global reserve currency.

So far during the financial crisis and ensuing recession, the US has been incapable of kick-starting credit growth, the major transmission mechanism by which monetary expansion feeds through to domestic economic activity. But it is inducing massive capital flows to emerging markets, where they are generating asset-price bubbles. If this leads to a weakening of the dollar, it would also have negative effects on trading partners. (The same can be said of recent Japanese monetary-policy decisions.)

Some proposals would resolve the first of these paradoxes by allowing countries to use the World Trade Organization’s dispute-resolution mechanism in cases of exchange-rate manipulation. But this is the wrong way to go, for it might serve only to erode one of the few effective mechanisms in place to make multilateral agreements binding.