Global Currency Relations, Macroeconomic Recovery, and Long Term Financial Stability

Prominent both during and after the discussions held at last week's G20 meeting in Seoul was the relation between the US dollar on the one hand, and the currencies of some of the US's major trading partners -- notably China -- on the other. The Americans sought, unsuccessfully as it turned out, support from other nations in encouraging China in particular, though not China alone, to allow its currency to rise more rapidly in value relative to the dollar. China's not doing so, the argument ran, impedes US macroeconomic recovery and, with it, global recovery as well. For insofar as China and other nations hold the dollar 'unnaturally' high through massive purchases of dollar-denominated assets on global markets, advocates of this position maintain, they render US exports more globally expensive than they must become if the US is to begin to restore international payments balance and, in so doing, partly export its way toward macroeconomic recovery. And until it recovers, the argument concludes, the US, as the world's largest consumer market, cannot assist the world to recovery. Now, there can be no doubt that US trade imbalances are unsustainable and, over time, a continuing source of global financial instability. Long term trade deficits are macroeconomically equivalent to domestic disinvestment. They accordingly render it all the more difficult to maintain full employment at home, which in turn renders it all the more difficult for the Fed simultaneously to satisfy its employment-maintenance mandate on the one hand, and its price-stability-maintenance mandate on the other. For the Fed is forced, in the name of employment-maintenance, to keep credit and money loose simply in order to maintain demand for domestically produced products. (There is the most innocent explanation -- which is far from the only explanation -- for 'QEII.') And loose credit, as we have only recently come to see yet again, is inimical to price stability. It has a nasty way of fueling asset price bubbles. While all of this explains the sense of urgency increasingly on display among US policy-makers seeking to readjust relative currency values, it does not justify the disturbing tendency to cast blame uniquely upon -- and in some cases even to begin to demonize -- US trading partners. For as it happens, there are perfectly innocent, understandable reasons for hesitancy among some of our trading partners about ceasing their interventions on foreign exchange markets to prop up the dollar. Two are particularly salient right now. The first such reason is rooted in what I'll call a 'self-insurance' motive. A number of East Asian nations were badly burned during the so-called 'Asian Financial Crisis' of the late 1990s. Governments and firms in the region, which owed substantial dollar-denominated development debt to foreign investors in those fateful days, found themselves suddenly bankrupted by speculative attacks upon their currencies in global markets. For the drops in their currency values relative to the dollar effectively rendered their dollar-denominated debts unpayable. Loans from the International Monetary Fund (

) might have been hoped to help; but alas, these came with strings attached -- strings which all too often sounded in requirements that borrowers adopt slump-worsening austerity measures. Affected nations learned from this ugly experience: Amass larger foreign exchange holdings -- especially dollar holdings -- in future, in order that you might either pay your debts in dollars, or defend your currency against speculative attack by purchasing that currency on global markets with your foreign exchange. Much in the way of current dollar holdings by our trading partners can presumably be explained at least partly by reference to this painful lesson learned only a decade ago. The second reason for 'dollar hoarding' by non-American central banks right now is to prevent a precipitous rise, not simply in the dollar cost of non-American goods, but in the rates of return offered on non-American financial assets. Dollar inflation turns investors away from dollar-denominated assets toward these other assets, and East Asian nations in particular currently fear a flood of higher-returns-seeking foreign capital into domestic markets, such as might trigger the development and growth of asset bubbles fully as ominous as those which developed in the US from the late 1990s to about 2007. Purchasing dollars massively enables these nations to 'sterilize' what would otherwise be highly inflationary capital inflows. And worry about such inflows can hardly be called morbid or unjustified right now, especially after the Fed's announced intention to commence 'QEII.' All of this said, however, the fact remains that long term trade imbalances between the US and other nations must be reversed, and reversed soon, for all of the reasons noted above. Continuing imbalance will stall both US and global macroeconomic recovery, and in future will render financial stability virtually impossible to maintain. Indeed, US trade deficits' growth over the late 1990s and during the first decade of the new millennium played a critical role in prompting loose monetary policy during the period, which latter in turn fueled the US megabubble. What, then, are we to do? It will be helpful at this point to recall that the world faced a similar question in 1944, at the Bretton Woods conference that brought us the IMF and the World Bank. 'Beggar thy neighbor' style competitive currency devaluations over the 1930s were thought by participants to have inhibited global macroeconomic recovery and ultimately issued both in domestic political dysfunction and in international strife. World leaders were determined to prevent a recurrence. One plan for what became the IMF offered at Bretton Woods -- J. M. Keynes' 'International Clearing Union' Plan submitted on behalf of the UK Treasury -- would have offered 'automatic' but gradual currency adjustments over time when trade imbalances between nations persisted. The plan also provided for a true international reserve currency -- rather than relying on one dominant nation's currency to play that unsustainable role, as the dollar has problematically done since Bretton Woods -- to be issued by what amounted to a global central bank to national central banks, which would stand to the new institution much as domestic banks do to their central banks. All cross-border financial and monetary transactions would have been channeled through this institution. In effect, all nations would thereby have been spared the need either to 'self-insure' by hoarding foreign exchange, or to 'sterilize' potentially inflationary cross-border capital flows by the same means. And, of course, long term trade imbalances would simply have been stopped in their tracks by automatic adjustment. As it happened, the US, which in 1944 was by far the world's largest creditor, was by far the world's largest manufacturer (accounting for about half of world GDP), and looked likely to retain that position well into the future, took a line at Bretton Woods not unlike that taken by many of the US's trading partners in surplus -- in particular, Germany -- today, or that taken by the IMF vis a vis East Asian nations in crisis ten years ago: the Keynes plan, the Americans maintained, erred in not placing the full burden of adjustment on the deficit-running nation. And since the US held most of the cards, it got its way; the IMF we got was a pale shadow of the Clearing Union. The original Clearing Union plan would not be workable, unmodified, in today's global capital markets, which are more teched-up, free-flowing and high-volume by many orders of magnitude than were those of the 1940s. But the original plan can be adapted; the US is apt to be more friendly to such a plan now than it was in 1944; and the renewed interest we are now witnessing in East Asia today in capital controls and even financial transaction ('Tobin') taxes suggests that the markets themselves might be rendered more amenable to a latterday Clearing Union plan. I'll sketch what a plan of the sort might look like in a future column. In the meanwhile, we can say at least this much right now: First, trading partners in persistent surplus with the US will be foolish to insist on debtor adjustment alone as the US itself did in 1944 and the IMF did in the late 1990s, for in the present state of the world that is synonymous with 'global slump.' But second, the US for its part will be at least as foolish to view the present impasse as no more than the product of self-aggrandizement on the part of its trading partners, who as I've noted have very good reason to hesitate over dollar-disinvestment and dollar-devaluation in a world where capital flows freely and speculatively across borders and self-insurance is the only insurance there is. Our only long term answer is a truly global currency; a truly cooperatively owned and operated global 'bank' that manages, in the name of all nations, global credit supplies denominated in that currency; and procedurally regular, automatic adjustment mechanisms that revalue national currencies in relation to one another to prevent sustained cross-border surpluses and deficits. But more of that soon. Robert Hockett is Professor of Law at Cornell Law School, where he teaches and writes in the areas of domestic and international financial law and economics.