How US creates currency wars with no winners
Andrew Sheng says academic's book delivers irrefutable home truths on US monetary policy
Travelling around Southeast Asia last week, the mood was all about currency fluctuation and its impact on markets. Things do look different when the Thai stock market's daily turnover touches US$2 billion and is higher than that of Singapore. But the headline that Thai growth slowed quarter on quarter but was still 5.3 per cent 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 McKinnon. He made his name with his first book, Money and Capital in Economic Development, where he took forward the pioneering work of his Stanford colleague, Edward Shaw, on the phenomenon of "financial repression" - the use of negative real interest rates as a tax to finance development.
McKinnon's second area of expertise is the international currency order, explaining the macroeconomics of the US dollar and its relationship with other currencies such as the yen. The trouble was that his analysis did not "jive" with the populist policy view that "revaluing the other currency" would reduce the US trade deficit.
This began with the concern in the 1970s that the US-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 to 120 per dollar; a huge bubble and two lost decades of growth followed.
In his new book, The Unloved Dollar Standard: From Bretton Woods to the Rise of China, McKinnon explains some uncomfortable truths. The dollar standard is unloved because of what one US Treasury secretary told his foreign critics of US exchange rate policy - "our dollar, your problem".
McKinnon argues that US monetary policy has been highly insular, despite globalisation making such insularity obsolete, and 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 US belief in the Phillips Curve - that higher inflation generated lower unemployment - resulted in the US pushing the Europeans and Japanese to appreciate their currencies. When they refused, Richard Nixon broke the link with gold in 1971. In the Alan Greenspan era (1987-2008), there was a strong belief in efficient markets, which encouraged global foreign exchange liberalisation, 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 now to push for their exchange rates to appreciate, to reduce the US trade deficit. McKinnon considers the third fallacy the most pernicious conceptual barrier to a more internationalist and stable US monetary policy.
The central thesis of this book is that the US should recognise that the dollar standard is actually a global standard, with privileges and responsibilities. Dollar depreciation is not to America's advantage, because it would only lead to future inflation. Instead, the US 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 US colleagues may find the conclusions unpalatable. The logic is that whoever maintains the dominant currency standard must maintain strong self-discipline; the benchmark standard cannot be on shifting sands. If the dollar is weak because the US economy is weak, then all other currencies will be volatile, because they float around an unsteady standard. For small, open economies that maintain large trade with the US, having a dollar peg requires them to keep their economies flexible and they must maintain fiscal and monetary discipline. This is Hong Kong's experience.
Flexible exchange rates have not resulted in countries adjusting their overall competitiveness. Instead, 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 causes 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; if everyone simply tries to devalue their way out of trouble, then the world will enter collective deflation.
The solution to this requires the US and China to co-operative at monetary and exchange rate levels. This makes sense, which may be why presidents Barack Obama and Xi Jinping are meeting soon to achieve a rapport.
Anyone who wants to understand currency wars must read this book. It is a frank appraisal of how we need common sense to get out of the current fragile state of global currency arrangements.
Andrew Sheng is president of the Fung Global Institute