Exchange Rate Clubs and the Monetary Approach

There is a long comment by Ronald McKinnon on the link between exchange rates and international adjustment at Martin Wolf's blog at the Financial Times. This is a shortened version, just a part of the section at the end -- there's quite a bit more at the (open) link given above:

Exchange Rate Clubs and the Monetary Approach Specialists in exchange rate economics fall into two distinct clubs: A and B. Members of Club A, by far the larger group, have been brought up since they were undergraduates on the elasticities model of the balance of trade. Besides being algebraically tractable, the microeconomics of this model seem intuitively plausible. With nominal export prices 'sticky' in each country’s currency in the short run, the relative price effects of a depreciation in the nominal exchange rate seem to go in the right direction for reducing a trade deficit. The depreciating country’s exports become cheaper in world markets and it sells more, and its imports become more expensive in the domestic currency so it buys less, so the trade balance allegedly improves. Members of Club A focus on this link between the real, i.e., inflation - adjusted, exchange rate and the real trade balance. ...

True, Club A’s more sophisticated members also worry about saving-investment imbalances across countries; but these don’t easily fit into the elasticities model, which dominates their thinking. They still see a devaluation of the real exchange rate to be useful for easing the adjustment process if, say, a country with large trade and fiscal deficits reforms itself by phasing out the fiscal deficit so that its real international balance of trade can improve. ... Martin Wolf is a member of Club A in very high standing.

Club B is much smaller, and is mainly made up of monetary economists (excluding monetary cranks, of course!). Characteristically, members of Club B emphasize the linkages between national monetary policies and nominal exchange rates in financially open economies. Causality goes in both directions. A floating nominal exchange rate today is determined by what forward-looking investors think the national monetary policy will be relative to that in other countries into the future. Conversely, official action taken today to peg an exchange rate into the indefinite future -- or negotiate some major change such as a devaluation or appreciation -- requires that relative national monetary policies must (eventually) be changed to support it. Otherwise, the officially assigned path for the nominal exchange rate cannot be sustained. Countries that agree (perhaps by some Plaza - type negotiation) to having their currencies appreciate are also agreeing to follow a deflationary future monetary policy relative to greater inflation in the depreciating country.

I am sorry to report that membership in Club B is quite exclusionary. It won’t admit economists who believe that governments can manipulate real exchange rates on a sustainable basis - let alone those who believe that exchange rate changes can compensate for saving-investment imbalances across countries. As narrow-minded monetary economists, members of Club B believe that central banks should aim only to stabilize the national price level. They are most fearful of having to alter the national monetary policy to support either an exchange rate appreciation or depreciation that the Ministry of Finance negotiates (mistakenly in their view) to 'correct' a trade imbalance with some foreign country.

Being monetary economists, Club B’s members can easily understand international currency asymmetry: why it is convenient, and even necessary, for one currency such as the dollar to dominate international finance as a vehicle and invoice currency. They understand the logic of an intervention system where other countries use the dollar as their key intervention currency, and the United States (as center country) does not intervene in order to minimize potential conflicts.

On occasion, a central banker in good standing in Club B may opt to peg (stabilize) his country’s nominal exchange rate to the dollar in order to better anchor his country’s price level - as many countries in Asia now do. Unfortunately, members of Club A may see this as a mercantilist plot for stimulating exports by keeping its real exchange rate undervalued. But, with a fixed nominal exchange rate, Club B members know any such 'undervaluation' would be washed away by inflation after which the domestic price level would stabilize as long as the dollar itself was stable.

What is truly dismaying for members of Club B is when so many members of Club A are opting for a massive dollar devaluation on the incorrect assumption that it would reduce the U.S. trade deficit. Club B members know that such a great monetary shock from nominal depreciation would eventually result in inflation in the United States or (relative) deflation in countries on its monetary periphery. Nobody would know how this division between inflation and deflation would play out. ... However, the end result would be to wipe out any sustained change in the dollar’s real exchange rate, although its nominal exchange rate remains depreciated.

True, following a nominal devaluation, there are lags before prices begin to rise at home or fall abroad. But even in this short run of price 'stickiness', the balance of trade of the depreciating country is unlikely to improve.

First, for imports already contracted for and invoiced in a foreign currency like the euro, the U.S. importer would have to pay more (depreciated) dollars for the European goods he had agreed to buy. Economists call this the 'J' curve effect.

Second, with a temporarily real depreciation of the dollar, international investors would see a window of opportunity for a year or two to undertake physical investments at lower cost in the United States. Conversely, they would see countries with appreciated currencies to be more expensive. As a consequence, an investment-led spending boom in the United States would increase imports and a slump abroad would reduce imports of American goods. The upshot is that the net effect on the U.S. trade balance in this intermediate term of two years or so would be ambiguous - even though the foreign currency prices of American exports in world markets had been (temporarily) reduced.

However, the really big incidental negative from a deep nominal devaluation of the dollar is the monetary upheaval associated with debasing the key currency of the international monetary system.

Such an event did occur in August 1971 when President Nixon imposed import tariffs in order to force all the other industrial countries to appreciate against the dollar. Because this 'Nixon Shock' was so well telegraphed in advance, the huge flight from dollar assets into foreign monies led to a loss of monetary control both in the United States as well as in Europe and Japan. Foreign governments had to intervene to resist having their currencies appreciate by more than what was agreed on with President Nixon, and their massive buildup of dollar exchange reserves led them to issue too much base money.

In the United States, the flight from dollar assets greatly reduced the demand for U.S. base money, and the Fed, not realizing this, continued to increase the supply of base money. The result was the disastrous worldwide inflation of the 1970s into the 1980s. However, the inflation was greater in the United States, which had depreciated, than in Germany and Japan, who had been forced into appreciating. But growth in real income and productivity declined everywhere. (Ironically, the net U.S. trade balance did not improve!)

Members of Club B lie awake at night wondering if such a calamitous event might happen again.

[Thanks to Rybinski.eu for the head's up.]