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A V Rajwade: Dilemmas of the currency wars

Independent monetary policy, liberal capital accounts, managed exchange rates ... central banks struggle to balance competing imperatives.

A V Rajwade  |  New Delhi 

As the date of the G20 Summit nears, the rhetoric on the issue of exchange rates is occupying more and more media space. And there is agreement on only one point: trade restrictions and competitive devaluations will only damage the already fragile global economy. The apprehensions about trade restrictions and tariff and non-tariff barriers are not fanciful: apart from the enactment of a provision for the imposition of a 20 per cent duty on Chinese imports by the US Congress, recently more than half the respondents to a poll in that country voted in favour of the proposition that free trade was hurting the US (Wall Street Journal, October 5). The problem is not the desirability of free trade per se, but the exchange rate. Successive US treasury secretaries have claimed that the US has a “strong dollar” policy, without ever defining what a “strong dollar” means. But the trade numbers and declining manufacturing jobs clearly suggest an overvalued currency: is it part of a deliberate plan to ensure that the huge mass of people whose real wages have remained stagnant since the “Reagan Revolution” can increase consumption through cheap imports and a housing bubble facilitating “home equity” loans? The cost of the first is the loss of manufacturing jobs. And the cost of the second is now too well known.

The US has deficits with other countries too: Europe, Japan and so on. But the currency war, now postponed until the next month’s G20 Summit, has China as the principal opponent. The reasons are:

One, both the euro and the yen have appreciated against the dollar in recent months.

Two, the exchange rates between the euro, the dollar and the yen are, broadly speaking, market-determined and, therefore, beyond criticism. After all, how can any market-determined price be wrong?

On market-determined exchange rates, it is worth recalling that freely floating exchange rates did not come into being as a deliberate policy. The fixed exchange rate system collapsed in August 1971 because of the uncertainties following the US’ withdrawal of the gold convertibility of the dollar. The attempt to bring back fixed rates, notably the Smithsonian Agreement of December 1971, could not be sustained because of free capital movements, and the inflation differentials and global imbalances following the sharp rise in oil prices in 1973.

Many analysts and commentators both in India and abroad have attributed the recent fall of the dollar against the euro and the yen to the loose US monetary policy. This does not stand to reason — surely the Japanese monetary policy is, if anything, looser and the European Central Bank is not far behind. The theory that money supply determines exchange rates through inflation, also called the Purchasing Power Parity (PPP) theory, was first advanced in the 1970s by Rudiger Dornbusch. As Kenneth Rogoff has pointed out, however, “Whereas the over-shooting model is a landmark theoretical achievement, it is an empirical bust, at least as far as it concerns exchange rates among the United States, Japan and Europe.” The reason the Dornbusch theory did not work was simple: with liberal capital accounts, capital flows, not trade flows, became the major determinant of the exchange market’s demand-supply dynamics. According to the latest survey of the Bank for International Settlements, the global currency markets currently trade $4 trillion of currencies every day, i.e. $1,000 trillion a year. Just compare that to the global trade of $15 trillion in 2009 as per the World Trade Organisation. In short, the PPP theory, based on trade flows determining demand and supply of currencies to be exchanged, doesn’t matter any more.

Nobel laureate Robert Mundell has correctly identified the impossible trinity: an independent monetary policy, a liberal capital account and managed exchange rates. The favoured fashion of the last three decades has been to give up the third. The problem is that this has a cost that the real economy has to bear, through lost output and jobs, or consumption. On the other hand, the better off and the financial sector benefit through trading profits in volatile currency markets, and short-term capital movements chasing speculative profits.

No wonder in the US (and the UK) the manufacturing sector and jobs occupy an increasingly smaller portion of the pie, which itself is not growing very fast. No wonder, again, that though until the beginning of the 1980s, the financial sector’s share in corporate profits was around 15 per cent, it had gone up to 40 per cent just before the crisis, even as the manufacturing sector’s share in GDP has fallen sharply. And the 40 per cent share of the financial sector still does not include profits made by hedge funds, private equity, trader bonuses (which are often up to 50 per cent of trading profits) and other beneficiaries of financial sector profits outside the corporate sector.

Tailpiece: As for the US-China currency war, Martin Wolf says, “America is going to win the global currency battle” (Financial Times, October 13) while Yiping Huang says, “The US will lose a currency war” (Wall Street Journal, October 14). Toss a coin!

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First Published: Mon, October 25 2010. 00:36 IST