Why Pressuring the Chinese Is Wrongheaded

The arguments that call for a stronger Chinese currency are usually based on the notion that the policy exchange rates pursued by the Chinese and other Asian governments are the cause of t oday’s global imbalances. The idea of market adjustment behind this in turn derives from David Hume’s time-honoured price-specie flow mechanism, even though it was meant to be a model of how adjustment is supposed to have worked under the gold standard in an era long past. It describes an automatic adjustment process where countries that are running trade surpluses experience r ising prices, making their exports more expensive and imports cheaper, while deficit countries experience falling prices, making their exports cheaper and imports dearer. Thus, automatic price changes bring about an adjustment where exports (imports) tend to rise and imports (exports) fall in deficit (surplus) countries, eliminating the initial trade imbalance. If this is indeed how market adjustment works, then clearly the very persistence of trade imbalances in itself implies market interference.

However, despite its simple elegant logic, the price-specie flow mechanism is a highly misleading way of thinking about international trade imbalances. Not only for today, but even for the gold standard era, the period spanning from early 1870s to the beginning of the first world war, it was arguably a poor model of

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how adjustment actually worked. For its simplifying assumptions leave out a couple of essential features, namely, capital flows due to foreign lending and central bank policy, that had already b ecome important by the second half of the 19th century and have been even much more so since.

Hume had assumed that only gold coins circulated as money and that trade imbalances were settled in transfers of bullion, i gnoring the impact of both foreign lending and central bank policy on the money supply. But, of course, under the gold standard, convertible paper currency was the norm. By statute, central banks usually had to hold gold (along with foreign exchange) r eserves in the order of 35 to 40% of their liabilities depending on the country and use government bonds to collateralise the part of the paper currency not backed by gold, the so-called fiduciary issue. Thus, they could change within certain bounds at their d iscretion what we would today call the money multiplier by varying the ratio of gold reserves to currency, or more importantly manage their reserves (money base) by varying the interest rate at which they borrowed from other central banks. Moreover, uncertainty and pessimistic expectations could become self-fulfilling as they had the effect of lowering the money multiplier and thus causing the money supply to shrink even when gold inflow was raising the gold reserves as was the case, for instance, in Belgium and France, late 1920s on (Bernanke 1995; Eichengreen 1996). Thus, the real world gold standard allowed for a good deal of flexibility and it was far from a foregone conclusion that a deficit (surplus) country would experience a falling (rising) money supply. In fact, the system worked relatively well only when the money supply, prices and output were relatively insulated from trade imbalances and ran into trouble when they were not, as happened during times when foreign lending became skittish.

The real world gold system was mainly about central banks acting in accordance with what Keynes called, the rules of the game, whereby preserving gold reserves in the face of trade imbalances was their main priority. Their most effective tool was the interest rate policy, and thus whenever a country ran a trade deficit (surplus) its central bank’s first response would be to raise (lower) the interest rate. That in turn had two opposing effects on final demand. On the one hand, the higher discount rate in the deficit country had a contractionary effect on spending and thus tended to lower prices. But, at the same time, it attracted foreign lending which augmented reserves (domestic money base) and thus was potentially expansionary. The strength of the contractionary effect depended on how high the interest rate rose and on the interest rate elasticity of spending, while that of the expansionary effect rested on how responsive the capital inflow was to the higher interest rate and the degree to which credit supply e xpanded with the money base. Likewise, the response of the central bank of a surplus country would be to lower the interest rate, giving rise similarly to two opposing effects. The lower i nterest rate on the one hand would stimulate domestic spending, and on the other induce increased foreign lending, contracting the domestic money base. The net impact on final demand d epended on the balance of these two opposing forces.

Thus, adjustment towards balanced trade – holding onto the rest of the assumptions of the price-specie flow mechanism –

Towards an Alternative View

An alternative view draws on the implications of the dollar’s r eplacement of gold as the main monetary reserve asset throughout the world after the second world war. The story of how the severe dollar shortages of the early post-second world war era quickly turned into rising US trade deficits and accumulation of excess dollars in European central banks by the 1960s is too well known to recount here. The US deficits were initially quite welcome as they were seen as means of reserve injections into a dollarstarved Europe and beyond. However as the 1950s wore on they increasingly became a cause for concern and even alarm. By the early 1960s, the US liabilities overseas exceeded its gold reserves, and questions began to emerge about the stability of the dollar.

At the time, Robert Triffin (1960) captured the gist of the problem posed by the dollar’s reserve currency role. To avoid getting trapped in a deflationary spiral similar to what occurred during the inter-war years, the world needed an elastic money supply and thus its dollar holdings had to increase steadily to back it up. But, that required the world to run a trade surplus with the US. To put it differently, the US had to keep running ever larger trade deficits for the size of these dollar holdings overseas to expand, which however raised doubts about the dollar-gold parity, undermining confidence in the monetary standard. This was in a nutshell, Triffin’s dilemma. The world growth and the prerequisite expansion of monetary reserves it depended on undermined the monetary standard that was the backbone of these reserves. Fine tuning the US policy-mix could at best strike a balance between the opposing scales and help earn time but not solve the problem

– that is until the strong-dollar policy after the 1980s, as we shall see, gave the dollar a second lease on life.

Potentially, the reserve shortage and convertibility problems could simultaneously be fixed by raising the dollar price of gold while maintaining other currencies’ peg to the dollar. That would have simply amounted to devaluing all currencies together against gold which would raise the size of reserves by increasing the value of gold in them. In fact, the Bretton Woods’ Articles of Agreement had a provision for a universal reduction in par values that could have been used to that effect. But, such a measure was politically unattractive to the US because it would have rewarded countries who cashed in their dollars and penalised those who held onto them, and in addition would have benefited the Soviet Union and South Africa (Mundell 1995). Thus, the US instead supported the idea of developing a synthetic substitute for gold and that was how International Monetary Fund (IMF) Special Drawing Rights (SDRs) were initially born.3 But, for a host of reasons – striking a deal among G-10 countries proved hard and slow – that did not go far either and the system simply broke down. Inflation accomplished with a vengeance what concerted action failed to do. International (especially European central bank) reserves that were already inflated by the US deficits of the 1960s exploded during the 1970s.4 Rising inflation and the explosive rise in international reserves fixed international attention on the problem of confidence in the dollar. The US’ reluctance to rein in spending to improve its balance of payment situation eventually gave rise to successive runs on the dollar, finally triggering a regime change in the US by the end of that decade.

Reconstitution of the Dollar Standard

It is possible to read the monetary history since the breakdown of Bretton Woods as a story of the protracted process of reconstituting the dollar standard without the gold anchor rather than the usual emphasis on the transition from fixed to floating exchange rates. The key to this revisionist reading is the focus on how the strong dollar policy became a viable option in terms of dealing with Triffin’s dilemma when it could not be before. In the Bretton Woods era, the strong dollar was associated with reserve shortages abroad since it implied US trade surpluses. But that radically changed under the altered conditions of the 1980s when the strong dollar went hand in hand with ballooning US current

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a ccount deficits. What made this change possible was first and foremost the political and monetary regime shift in the US.

A dollar standard without a gold anchor was successfully negotiated in the Smithsonian Conference in Washington DC right a fter the Nixon administration terminated the dollar’s convertibility to gold in July 1971, only to crumble within a couple of years. Two general themes are often emphasised as to why it failed. One is the idea of incompatibility of fixed exchange rates with international capital flows that were becoming increasingly free at a time when many of the earlier capital controls were b eing dismantled,5 while the other is the Europeans’ frustration at having to accommodate the turns and twists in US macroeconomic policy and their complaint about the inflationary impact of the weak dollar. The common European currency, it is often remarked, to a large degree owes its very inception to this sense of frustration on the part of the Europeans. Be that as it may, the real source of the problem with inflation as it turned out was not so much the US macroeconomic profligacy as the political strength of labour that gave rise to the wage-price spiral throughout the advanced capitalist countries. The lesson was not lost on the world in the aftermath of Bretton Woods that it was next to impossible to discipline a superpower such as the US, let alone do it by anchoring the dollar to gold. The threat of inflation could be much better contained if the US led Europe in abrogating the post-second world war social compact that made it hard to discipline labour.

The monetary tightening that started under Fed Chairman Paul Volcker was soon joined with a large dose of fiscal stimulus under the Reagan administration, and the result was higher real interest rates, a much stronger dollar and ballooning trade deficits – just as the Mundell-Flemming model predicted. But, this time around, US trade deficits were no longer a source of chagrin for confidence in the dollar. The political reconfiguration that broke the back of labour unions provided all the necessary backing the dollar needed as the increased threat of unemployment proved a much more convincing anchor than gold for wealth owners around the world. It still took about a decade for the pure dollar standard to come to its own as marked gyrations in major exchange rates and the domestic political backlash against the strong dollar in the US continued to pose a threat to the emergent monetary regime. However, by the 1990s, advancing globalisation and the triumphalism that ensued after the fall of the Berlin Wall clinched the trend the changing political climate had set in motion earlier. As the strong dollar and trade deficits returned with a vengeance in the mid1990s, it became abundantly clear that there was no going back.

US trade deficits were once again the key to world growth. But, now, reserves accumulated in the hands of a few successful e xport promoters only – first Japan and Germany, then increasingly China and the oil exporters among a few others – who ran increasing trade surpluses with the US, which were then recycled to the rest of the world through the US financial system. The fact that exports became the sole safe source of demand stimulus helped contain the exchange rate volatility of the earlier decade. The appreciation of any currency against the dollar became selflimiting as any country whose currency appreciated was liable to experience falling exports and succumb to economic stagnation, which then curtailed the demand for its currency

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Also, the trade imbalances were no longer deflationary for the deficit countries that could attract capital. De facto, less successful exporters in the periphery were given a choice between deflation and making themselves hospitable to foreign capital, and more often than not the hope of expansion on borrowed money won over deflation. It was as though a privatised version of Keynes’ old International Clearing House idea was put into effect in the sense that the trade surpluses were now being effectively recycled. In fact, more than merely recycled, they were being multiplied at an increasing rate within the US financial system as they were in part absorbed in the US and in part passed onto the rest of the world. On the one hand, with Bank of Japan monetising US debt at an increasing rate, an endogenous mechanism of speculative demandled global money supply came into being (D’Arista 2004; Schnabl and Hoffman 2008). On the other, getting rid of the last vestiges of financial regulation in the US gave impetus to a market-based credit system that eclipsed traditional banking (D’Arista 2002; Erturk and Ozgur 2009). New financial instruments proliferated and were absorbed with rapidly increasing levels of leverage, raising the financial system’s capacity to finance ever larger quantities of long-term illiquid assets with short-term liabilities (Crotty 2008; Kregel 2008). Soon, the world was awash in liquidity.

The main recipients of these funds were the countries that could compete better than the rest in attracting capital. While some hardly received any, others were drenched, and the latter had to cope with the strongly procyclical nature of the capital i nflow with limited success at best. Thus, the threat of deflation and exchange rate volatility was replaced by capital flow volatility, leading to capital-account driven boom and bust cycles that culminated in one currency crisis after another in the emerging economies throughout the 1990s.

The main point about the increased prevalence of sudden stops and abrupt capital flow reversals is that international adjustment in this period became capital account driven and increasingly dysfunctional in the sense of accentuating existing trade imbalances. The explosive expansion of financial liberalisation in emerging economies in the 1990s made variable-price financial instruments the main conduits of capital flows in contrast to the originally non-negotiable fixed-price bank loans of the 1980s. As a result, speculative asset price expectations became an important driver of portfolio dynamics, seldom giving rise to erratic capital flows (Erturk 2005). The primacy of the capital inflow was such that even countries that ran sizeable trade deficits quite often experienced rising real exchange rates and a booming credit supply, culminating in even larger deficits – that is, until they were hit by a crisis.

The Asian crisis marked an important turning point. The “ savings glut” US Federal Reserve Chairman Ben Bernanke talked about was real, caused by the collapse of investment in Asia and beyond, which was in part the result of growing competition from China (Erturk 2001-02) and in part the crisis itself. Foreign exchange reserves of emerging economies steadily increased as many of them began to run large current account surpluses. C ontagion made it harder to finance consumption booms and even those that continued to run deficits began to accumulate r eserves as net spending remained below the capital inflow. With

What Should Be the Focus of Crisis Management?

Until just recently it was believed that the crisis would end when investors returned to the stock market and recapitalised banks. But investors lacked confidence that they would not be throwing good money after bad. The dubious assets still buried deep in bank balance sheets had to be cleansed and yet trying to sell them off would push down their market value further, compounding banks’ losses. Thus, the bottom could not be reached until the investors returned, but they would stay on the sidelines until asset prices have hit bottom. Former Treasury Secretary Henry Paulson’s initial rescue package was aimed at addressing this dilemma by trying to provide a floor to falling asset prices. It was meant to work like the kiss of the beautiful princess, restoring the frog of bad assets to their true market value, and the hope was financial markets would go on functioning normally there after. But, the Paulson Plan failed to transform investors’ expectations. It failed to persuade financial markets that it could p rovide the bottom the market would not.

It has by now become clear that this is no ordinary recession. As economic contraction gained momentum in the US and the rest of the world, the focus of crisis management has shifted in quick succession from restoring the liquidity of the credit system to mitigating credit contraction by direct intervention in banks, if need be. Also, in the US and beyond, there now appears to be considerable agreement across a wide spectrum that a massive fiscal stimulus is indispensable to prevent the current slump from getting even worse. As a result, a hefty package of public spending and tax cuts in the US is now on its way. Leaving aside the new European emphasis on regulation, the only real criticism is that it might not be big enough (Feldstein 2009).

While the emphasis on resuscitating the banks and injection of public spending are both important, the trouble is that neither addresses directly the main source of global deflation, which is that the global imbalances are no longer being recycled effectively. The fundamental issue comes down to this: because both its households and banks are now bankrupt, the US has lost much of its capacity to either absorb or recycle trade surpluses elsewhere. That in a nutshell is the driving force behind the global deflationary trend. Substituting en masse public spending for p rivate consumption and putting banks on life support are at best stop-gap measures, but it is unlikely that they will ever bring back the old system that recycled trade surpluses. Even under the best case scenario where the confidence in the dollar holds up, the broken machinery that produced the world credit supply will not be put back together for the simple reason that too many borrowers and intermediaries are insolvent. There is no easy way to make the debt overhang go away, and thus tax cuts or other measures will not bring about a lasting increase in private consumption. If,

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References

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