TCS Daily

A Tale of Three Currencies

By Desmond Lachman - February 26, 2007 12:00 AM

Today's international payment system is very much out of kilter. The clearest sign that this is the case is the fact that global payment imbalances between the United States and the Asian economies are now at their widest level in the past sixty years. And these imbalances show no sign of narrowing anytime soon. This is giving rise to ever louder calls for trade protection in both Europe and the United States against China and Japan, both of which countries are charged with manipulating their currencies for competitive advantage.

Even more troubling than today's growing payment imbalances is the fact that, the IMF notwithstanding, there appear to be no rules as to what countries might do with their exchange rates. Some countries seem free to fix their exchange rates at levels that are patently undervalued, while others seem free to actively manage their floating exchange rates in a manner that maintains for them an unfair international competitive edge. In this currency free for all, currencies are simply not moving in the direction that might offer hope that today's global payment imbalances might be attenuated anytime soon.

Currency management in China and Japan, the two countries with the world's largest external current account surpluses, vividly illustrate the lack of order in the global currency market. Despite very public assurances in July 2005 that it would float its currency, China's central bank continues to intervene heavily in the foreign exchange market to prevent the Chinese currency from appreciating. It does so despite the fact that China's current account surplus has now widened to around 9 percent of its GDP and its international reserves have now surpassed the US$1 trillion mark.

As a result of this heavy foreign exchange intervention, China's exchange rate today is at very much the same level as it was eighteen months ago against a basket of its main trade partners' currencies. And this is the case despite China's ever-widening balance of payments surplus.

Whereas China effectively fixes its exchange rate, since March 2004 Japan has maintained a freely floating currency without any official intervention. Yet despite the Bank of Japan's hands-off foreign exchange policy, the Japanese yen has depreciated by almost 20 percent over the past two years as the Bank of Japan hews to its low interest rate strategy. This has taken the yen to its most depreciated level in almost twenty years at a time when Japan's external current account surplus has remained in the vicinity of US$150 billion.

The correction of today's global payment imbalance problem will require a marked reduction in the United States external deficit. It is widely recognized, however, that currency movements alone will not correct the large US balance of payments deficit even were those currency movements to be in the right direction. Rather the correction of the large US payment imbalance would also require a major increase in US household and government savings from their presently very low levels. This would be needed to make the room for the increased production of traded goods required to reduce the external deficit

In an ideal world, the United States dollar would depreciate most against the countries of those countries like China and Japan, which have the world's largest current surpluses. This would allow the US to reduce its payments imbalance without putting undue pressure on economic regions like the European Union, which has an appropriate balance of payments position and which is not part of the US balance of payments problem.

Sadly, over the past two years, exchange rate movements have been in anything but in the right direction. Instead of the Asian currencies appreciating as they should have against the US dollar, it has been the Euro that has taken most of the strain. Little wonder then that cries for trade protection are growing louder each day in European capitals.

It is against this background that one has to regret the conspicuous silence on these matters by the International Monetary Fund. For after all, the IMF was set up in 1944 as the international organization that was charged with the specific mandate of preventing any return to the economic mayhem of the 1920s and 1930s. One also has to regret that the IMF has all but given up on its proposed multi-lateral surveillance exercise, which was announced with much fanfare last year and which was supposed to have paved the way for a collaborative solution to today's payment imbalance problem.

Economic policymakers have been fortunate to date that today's very large global payment imbalances have not been tested in an economic downturn. If past experience is any guide, it would be a grave mistake for these policymakers to keep counting on their luck and to keep avoiding addressing the issue of how we are to move to a more stable international currency system.

The author is Resident Fellow, American Enterprise Institute.



currency problems
There would be no problem of currency instablility at all if the gold standard had been maintained. But governments hate that proper solution because they then could not manipulate their currencies, inflate them, etc. The gold standard imposes a discipline that no government wants to adhere to. This matter has been worked out years ago already by the austrian economists.

Coupla thoughts
I've read a lot of articles on this subject over the last few years with themes ranging from Chicken Little, to economic dark matter, to differences in rates of return on US versus foreign investment. Not sure I've ever seen daylight in this. Coupla thoughts though regarding China and Japan respectively:
1. Would a country that needs to grow at 9% a year just to maintain social stability want to keep large currency reserves to stimulate their economy should a recession occur?
2. Would a country with an aging and shrinking population want to maintain large currency reserves as a form of insurance to support its retirees?

Just asking.

1. They don't 'need to', but it is desirable in order to maintain power, rather than resorting to any other 'Tienamen massacre', as they recently did, and would do again without remorse, in orde to maintain control. They would happily give up the olympics, wealth, modernization, cell phones, etc. They would even go back to Mao times of deprivation if necessary to maintain power. If you think that is no longer the case, just ask them what their policy re Taiwan, and Tibet is.
2. Currency reserves are not exactly an insurance policy as you suggest. It would have to depend on growth, creating wealth, to be sustainable, and even that is not possible if they continue to lose population without replacement ones, like the europeans who already have their replacement population in place.


The Gold Standard? What are you thinking?...

Please. The mechanics. The Gold Standard was simply impossible to maintain. And very dangerous.

The problem with many professional economists and literally all civilian pundits is a lack of understanding regarding fundmental financial mechanisms.

The governmental disciplines you refer to are identical whether the Central Bank holds (idle) gold or interest bearing, financial instruments. In either case the government does not dare "print" money. The government must either collect tax revenues or borrow funds. The alternative is currency meltdown and that is simply not going to be allowed to happen here in America.

gold standard
Nope, you check it out. It is not in the interests of governments to have a stable gold standard because they cannot manipulate the economy as much. If you really think that they do not 'print' money then you are just profoundly naive. Study up a bit on the economists who advocate it, not just its detractors like the Keynsians and the marxists.

There is no "tsunami of dollars" out there...

The Governments of those nations enjoying a balance of payments surplus are not necessarily building up an unhealthy budget surplus. To get their hands on our money they must tax their own GDP or borrow in the open market just as we do. Of course, their Central Banks must hold reserves and they might go into the foreign exchange market (FOREX) with such funds to support their own currencies. But FOREX does $1.9 trillion a day. Vastly more than any underlying economic activity. And no government is going to manipulate anything out there for very long in the face of those numbers.

The governments of China and India are spending much of their new wealth (taxes and bonds) building infrastructure, and the same sorts of defense and social service programs we invest in.

The European currencies strengthened as their economies came to life in the last five years. Our currency has stayed about where it was (our inflation has been modest) and the Chinese are not yet ready to start importing consumer goods so they have left the yuan pegged to the dollar. When they want more of our stuff, just watch what they do to the yuan.

We already enjoy a global economy. Our hard currencies are completely interchangable and far and away most of that exchange involves electronic balances converted from one such denomination into another at the FOREX market rate. When this happens the one currency balance simply ceases to exist and another is created.

Yes, there is a lot of liquidity out there in the global arena. But it literally does not matter if those funds are dollars, euros, yen or pounds. Won, yuan, real or pesos. There is certainly no mountain of dollars sitting anywhere ready to buy everything in America. Our deficits denominated in dollars are converted into something else and those dollars are gone.

Please describe the mechanism (related to our balance of payments) that is projected to destroy our economy in the event of a recession. How is it that such a cataclysm did not crush us all 5 years ago?

I think we understand what a real estate meltdown might look like or the possibility that our offshore suppliers might eventually launch their own competitive operations (since we put them into the global market making our products). If they are converting raw commodities into commodity consumer goods, however, there is not much margin in this so no one is getting very rich doing that.

But how is the money itself going to kill us?

Banks create money but governments must borrow what they do not generate out of their tax base. One would be naive to think that governments have not already learned this lesson.

The government manipulates the economy through banking policies. Gold or interest bearing financial instruments held by the Central Bank as reserves impact the solvency of the Central Bank rather than the behavior of the economy. Of course, if a currency goes soft because the Central Bank has questionable (insufficient) reserves or the Treasury is printing money for the government to make payroll, then the economy suffers.

This would not be called manipulation. This would be called political self abuse. It makes the government go blind.

That means you bought into their bill of goods; just want they want. Do you call yourself a Keynsian, or marxist economist, or what other kind of economics that likes 'fiat' money. Here are some comments about Greenspan's view of it:
"Gold and economic freedom are inseparable.
Statists are all united in their hatred, terror, and rants against gold.
Gold acts to protect property rights, which is something that the State hates.
So, how do we account for Greenspan now? Rothbard answers:
Favors the gold standard, but only at a high philosophical level.
Never has he ever done anything to promote the gold standard."
Of course he wouldn't since he was part of the special interest group that benefited from the fractional reserve system. I like austrian economics.

More gold...

Gold is a shiny lump of stone. It just sits there. Gold is not working capital. It is completely idle.

On the other hand, interest-bearing Treasury instruments constitute funds borrowed by the government to invest in goods or services that constitute economic activity (part of the GDP). Gold bullion is a commodity extracted from another commodity (crushed rock). Only when gold goes on to become a raw component for some more profitable manufacturing process does it become very interesting in terms of the creation of wealth.

If gold at a fixed value were substituted for US Treasuries as the underlying financial reserves at Central Banks then those economies would be fundamentally restricted in terms of exchange rate flexibility and exposed in terms of solvency. There is simply not enough gold to underwrite global financial capitalism.

Besides, why would we want to do all that work mining gold just to have it sit in vaults doing nothing? Money has always been an abstract store of value. Specie changes nothing in that regard.

Dietmar, my friend, you like just about everything Austrian, don't you?

See, I was right. Your comments show that you have never ready anything about the case for the gold standard, but only against. But aren't Greenspan's comments then troubling for you? Don't they encourage you to study the issue? It also show that you don't know why gold is different than any old stone, always has been, in almost all cultures of the world. BTW, I do like almost everything austrian, particularly the work of their economists who worked all this stuff out already in the 20s and 30s. But of course modern politicians who are statists don't like it because it prevents them from having as much power and wealth as they like to have.

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