Thomas Pallley on Managed Exchange Rates

I managed to miss this very good post, “Exchange Rates: There is a Better Way,” by Thomas Palley last week (it was also picked up by the Guardian) but since it does not appear to have been discussed in the usual suspect economics blogs, I though I would call readers’ attention to it.

Before you groan that managed exchange rates are outre, it’s worth noting that a lot of exchange rates are managed, so basing policy on the pretense that we live in a world of floating exchange rates is naive. Palley stresses that the system we have is producing sub-optimal results and better alternatives exist.

For US readers, a key element of his argument comes late in the piece:

In the U.S., discussion of exchange rate policy is still blocked by simplistic free market nostrums. It is also blocked by mistaken fears that a managed system would surrender sovereignty and control. Yet, that is implicitly what has been happening. By absenting itself from the market, the U.S. has de facto allowed other countries to set the exchange rate, and that means the U.S. has been letting itself be strategically out-gamed.

From Palley:

The world economy is poorly served by the current system of exchange rates. That system has contributed to today’s global financial imbalances, which are widely viewed as posing significant economic risk. These imbalances have also created political tensions between countries over how to adjust them, and within countries over job losses. Exchange rates matter more than ever under globalization, which means the world needs a better system.

Today’s global imbalances concern the US trade deficit, which has spiraled out of control after years of dollar over-valuation. This problem is particularly acute with China. A few years back the problem of over-valued exchange rates afflicted Latin America, and to a lesser degree East Asia. Now, with the dollar weakening, the burden of over-valuation is shifting on to the euro.

This pattern of rolling exchange rate misalignment is bad for the global economy. Such misalignments often end in costly economic crises, and they also cause inefficiency by distorting trade. That is because rather than competing on productivity, too often countries compete through under-valued currencies that confer an exchange rate subsidy.

These costs have been obscured by the debt-financed boom of the last few years. In the US, the costs of manufacturing job loss have been camouflaged by a house price bubble. Other countries have dismissed the US trade deficit problem because it has created matching trade surpluses that have spurred export-led growth. But this picture is vulnerable to credit retrenchment and reversal of the dollar’s over-valuation. History repeatedly shows that conditions look artificially rosy when wracking up debt, and the hangover only sets in when the financial punch bowl is removed.

The current global exchange rate system is a sub-optimal arrangement. There are many theoretical reasons explaining why foreign exchange markets are prone to mis-pricing, and the empirical evidence shows exchange rates persistently depart from their warranted fundamental levels. Moreover, the system permits strategic manipulation so that some countries (particularly in East Asia) actively intervene to under-value their currencies. That has made for a lop-sided world in which half play by free market rules and half are neo-mercantilist, creating threatening tensions.

It is possible to do better than the current system. The immediate need is for a coordinated global re-alignment of exchange rates that begins to smoothly unwind existing imbalances. The 1985 Plaza currency accord provides a model of how this can be done. China’s participation is key as it has large trade surpluses with both the U.S. and Europe. Moreover, other East Asian countries with trade surpluses will resist revaluing unless China revalues for fear they will become uncompetitive. Finally, markets must believe this realignment it will hold. Absent that, business will not make the changes to production and investment patterns needed to restore equilibrium.

Beyond such realignment, there is need for systemic reform to avoid recurring misalignments. That suggests a system of managed exchange rates for major currencies in which countries cooperatively set exchange rates.

Such a system needs rules of intervention. Historically, the onus of defense has fallen on the country whose exchange rate is weakening, which requires it to sell foreign exchange reserves. That is a fundamentally flawed arrangement because countries have limited reserves and the market knows it. Speculators therefore have an incentive to try and “break the bank” by shorting the weak currency, and they have a good shot at success given the scale of low cost leverage financial markets can muster.

Instead, the onus of intervention must be placed on the strong currency country. Its central bank has unlimited amounts of its own currency for sale so it can never be beaten by the market. Consequently, if this intervention rule is credibly adopted, speculators will back off, making the target exchange rate viable.

Intervening in this way will also give an expansionary tilt to the global economy. When weak countries defend exchange rates they often use high interest rates to make their currency attractive, which imparts a deflationary global bias. If strong surplus countries do the intervening, they may lower their interest rates and impart an expansionary bias.

A sensible managed exchange rate system can increase the benefits from trade, diminish exchange rate induced distortions, and reduce country conflict over trade deficits. The means are at hand, but so far the politics have lagged.

In the U.S., discussion of exchange rate policy is still blocked by simplistic free market nostrums. It is also blocked by mistaken fears that a managed system would surrender sovereignty and control. Yet, that is implicitly what has been happening. By absenting itself from the market, the U.S. has de facto allowed other countries to set the exchange rate, and that means the U.S. has been letting itself be strategically out-gamed.

Impetus for change has also been reduced because other countries have been beneficiaries of the over-valued dollar. However, many are now starting to suffer from the dollar’s weakness.

Putting the pieces together, increasing awareness of the dangers of global imbalances and uncertainty about the dollar has created space for change. The still missing ingredient is political leadership that recognizes there is a better way.