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It is quite common to blame the spendthrift ways of Americans for the huge deficit in the U.S. balance of trade and, in turn, growing risk of a collapse in the U.S. dollar. A gradual decline might help address the chronic trade imbalance but if it came all at once in a precipitous plunge, economic trauma would likely spread around the globe.
Accordingly, a standard recommendation is for U.S. policymakers to dial down the settings on monetary and fiscal polices so that the debt-propelled spending of its citizenry moderates. Indeed, say some, what the U.S. needs right now is a recession. Let a downturn curtail consumption and, by extension, imports. And let exports rise as the competitiveness of the economy is bolstered by investing a larger pool of domestic savings into industrial plants and capital equipment.
But isn’t the problem also related to the way emerging countries like China and India have fixed their currencies to the U.S. dollar in order to boost the competitiveness of their exports? This not only contributes directly to the U.S. trade deficit but also to over-stimulation of the U.S. economy, which, in turn, contributes to over-spending.
How does it contribute to over-stimulation? The suppression of exchange rates requires emerging countries to print up large amounts of their own currency to buy the U.S. dollar and keep its value high. But this market manipulation results in the accumulation of huge reserves of U.S. dollars. Emerging countries have plowed these reserves into U.S. government bonds, bidding up their prices and lowering the yield on the stream of income derived from the bonds. In short, currency suppression by emerging countries keeps U.S. interest rates low, which promotes higher spending and lower saving in the U.S.
Thus, what the U.S. and other developed countries need is not so much a recession to temper their profligate ways, but for developing countries to ease up on suppression of their currencies. In other words, what the world needs is for the Bretton Woods II scheme now in place to make some currency adjustments in a coordinated manner before further drift triggers an economic calamity.
The logic of events surely points in this direction. Most parties in the informal Bretton Woods II arrangement are wrestling with serious and ever-worsening economic problems. Annual inflation rates in China and India have accelerated to 8% and developed countries, notably the U.S., are on the verge of major recessions even as inflation is picking up — i.e. the old stagflation curse.
The status quo truly isn’t tenable. Suppression of currencies requires the central banks of emerging countries to keep on printing money to buy up U.S. dollars, with the result that there is more and more money chasing a limited supply of goods and services in their economies. Maintaining a non-inflationary growth path increasingly is a challenge.
As for the U.S., the risk of a run on its currency has rarely been more elevated as it is now. Indeed, U.S. monetary policy is now being set with an eye on the U.S. dollar despite the near-term risk of a recession: as mentioned in speeches by Chairman Ben Bernanke, the Federal Reserve does not intend to lower rates at this stage for fear of sparking a run on the U.S. dollar.
I have confidence that world policymakers will eventually adopt solutions that avert global Armageddon. At least that would seem to be the lesson of the financial history of the past half-century. Several times the situation appeared to be dire but policymakers somehow came through (albeit not without a period of stress).
So it would not be a surprise to see central bankers get together and sign a multilateral accord on needed currency adjustments and other necessary steps. A notable precedent was the Plaza Accord of 1985, which helped bring down the overvalued U.S. dollar of that era.
Perhaps an agreement will come after China is finished hosting the summer Olympics. Taking measures to help alleviate global imbalances — which would include not only letting a currency float upward but also raising domestic interest rates and deregulating subsidized oil prices — may not be popular and could lead to social unrest that could detract from the Olympic showcase.
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