In a recent article (October 19, 2009), Financial Times quoted Tim Adams, former under secretary for International Affairs at the US Treasury, as saying: “The exchange rate is the tail on the dog. If you get the fundamentals right, the exchange rate will follow over time.” Three conclusions are possible:
His definition of “over time” is flexible enough to extend to decades.
That fundamentals determine the exchange rates of G-3 currencies (the dollar, the euro, the yen) is a myth. Over the last couple of years, the dollar alone has moved against the euro from $1.60 in April ’08 to a high of $1.25 in March ’09 to $1.49 now, even as Europe has a surplus on the external trade, the US has a deficit and interest rates in both are as low as ever. Growth? The dollar strengthened during the crisis and has weakened with the economy showing signs of growth — a few years ago, the accepted wisdom was that the dollar strengthens with economic growth!
At one time, it was thought that the G3 exchange rates were volatile because of differing monetary policies. Rudiger Dornbusch proved this with an elegant thesis on “overshooting”. But, in practice, the model was a bust. To quote Kenneth Rogoff, former economic counsellor and director of IMF’s Research Department, from Finance and Development, June 2002: “…monetary policy in the G-3 is far more stable today than it was in the mid-1970s after the first oil crisis… Yet the volatility of G-3 exchange rates has dropped only marginally since the 1970s. More serious empirical work… decisively confirms the empirical failure of the overshooting model, at least in explaining short- and medium-run fluctuations.”
C Fred Bergsten, director of the Institute of International Economics, had argued some time ago that G7 currency gyrations in recent years have far exceeded any conceivable shifts in economic fundamentals. George Soros gives another perspective: That just as expectations (rational or otherwise) influence outcomes, the reverse is equally true, that outcomes affect expectations. For example, the high price of the dollar, instead of reducing demand, may well increase it by attracting “momentum” players, taking the price still higher, neatly reversing the causation. Soros believes that the markets always distort, they always present reality in a biased manner and that the bias shown by the markets has a way of affecting the real economy (interview in The Indian Express, June 8, 2009). Clearly, investors exchanging one currency for another to reflect changing fundamentals, is a myth.
Bergsten went on to argue in favour of fluctuation bands for the major currencies, namely, the yen, the dollar and the euro (so does John Williamson). He suggests that the range could even be +/- 15 per cent initially, to be narrowed gradually over time. Academics like Peter Bofinger of Wurzburg University argue that (volatile) exchange rates are the main cause of instability in the international economy. Indeed, he favours a return to Bretton Woods-style fixed exchange rates. Ronald McKinnon of Stanford University also criticises “untethered exchange rates”. Among major economists concerned with the impact of volatility of exchange rates on the real, as distinct from financial economy, are Nobel laureates Robert Mundell (the intellectual father of the euro), James Tobin and Jeffrey Sachs of Harvard University. A study by the National Bureau of Economic Research (NBER) in the United States, published in early 2002, came to the conclusion that reduced exchange rate volatility significantly increases trade and that sharing a common currency has an even more potent effect: Nations with the same currency trade three times as much with each other as they would with different currencies. Clearly, those who believe in the benefits of cross-border trade in goods, services and investments should support managed and stable exchange rates.
Recently, the president of the Asian Development Bank strongly advised China, Japan and other east-Asian countries to begin serious negotiations on co-operation to prevent violent fluctuations in the exchange rates in regional currencies — the reference clearly is to the sharp appreciation of the yen, and other east-Asian currencies, in relation to the Chinese yuan which is pegged to the dollar.
To me, while the exchange rates in G3 currencies seem reasonable right now, what is clearly misaligned is the dollar : renminbi exchange rate. Pressures from the US and Europe to upvalue the currency have not worked. But there may be a better chance of China agreeing if its revaluation is a part of fluctuation bands for the G4 exchange rates — the alternative of a chaotic dollar slump is obviously not in its interest given its huge exposure to dollar assets.
The present may be a good time for such a Bretton Woods II initiative. Market efficiency and rationality have lost credibility; the spectre of a dollar crash is frightening; global imbalances do need to be corrected, and floating currencies can no longer take the strain of a weaker dollar.
avrajwade@gmail.com
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