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.

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    Maybe I am being facile, but where have “simplistic free market nostrums” gone wrong?

    Asian neomercantilism has created the current reality of export-addicted, artificially undervalued Chinese and Japanese currencies, whereas free-floating currencies have been artificially overvalued.

    But whenever the trade deficit stabilizes, and it appears to be doing so fairly rapidly already, it is always the mercantilists who suffer. An analogous situation was in 1927 when the United States tried to maintain overheated circumstances by propping up its peg to the sterling. When it all blew to pieces, the UK suffered pretty badly, but it was nothing compared to what happened to the United States.

    The Chinese have consistently refused to revalue the yuan, because millions would be thrown into unemployment as low-margin businesses would be forced to close. It is a shortsighted political decision that will perpetuate the global trade imbalance.

    Bernanke, I believe, is devaluing the dollar to bring the trade imbalances issue to a head. America will suffer inflation from a falling dollar, but China’s artificially cheap peg is causing them to massively oversterilize and thus inflict raging inflation upon their economy.

    This has caused more and more Chinese savers to take their money out of savings deposits in banks and dump it in the Chinese stock markets, because the real interest rate is negative three percent according to *official* CPI, which does not reflect a broad array of unsustainable price caps which have been in place since September–and which were lifted the very day of the Fed’s October meeting.

    You should read Michael Pettis’s blog (piao hao report) for more details on that.

    But the Chinese are playing a game of currency chicken and everybody knows it. When two Chinese drivers fight over a highway lane, the MO is to not look as you merge, and one person always eventually blinks. But Western banks don’t need to look to see what a mess the Chinese have made of their economy, regardless of what the headline statistics say.

  2. Yves Smith

    I am not wedded to Palley’s point of view; I am featuring it because I think it is solid enough to be worth considering. Anything that forces people to sharpen their thinking and analysis is to my mind an advance.

    But to your point, if the analogy that the current situation brings to your mind is 1927, I think that proves Palley’s point. Even though the train wreck of the Depression damaged the US severely, it took a toll on other countries as well. It wasn’t a win/lose, but a lose/lose, with the US taking the worst hit.

    The practice of central banking around the world is fixated on avoiding a recurrence of the Depression. Bernake’s academic claim to fame is that he is an expert in it. That’s why I don’t think that Bernanke wants to drive down the dollar. I see him as hostage to domestic interests and pressures (witness the Wall Street Journal front page story of roughly ten days ago that depicted him as being heavily dependent on the Street for advice).

    Remember, the FT’s Martin Wolf has pointed out that another game of chicken is at work; the financial institutions versus the central bankers. And he has concluded that the central bankers will always swerve.

    In fact an op-ed piece in today’s FT by former Treasury Secretary George Shultz argues that the decline in housing investment (meaning not the fall of the dollar) is what has led to the improvement in the US balance of payments (although one can argue these stats a lot of different ways).


    I think 1927 is a decent analogy, but with a crucial difference: China, the savvy currency manipulator, is in the position of the United States in 1927 (and the US is in Britain’s position). China has set itself up for extreme problems precisely because it has been too unsimplistic for its own good.

    Just my two depreciating cents.

  4. Yves Smith


    I don’t disagree. We have the very real possibility of a world-class mess here, and too many people are taking false comfort in the fact that the real economy so far hasn’t taken a hit (that is, of course, if you believe the bogus GDP and job creation stats).

    Advanced economies run on credit. If the financial infrastructure sustains too much damage due to the greed and stupidity of its business managers, the combination of reduced lending capacity plus fear to take on too much risk among those who are relatively unscathed can easily tank the real economy.

  5. minka

    “But whenever the trade deficit stabilizes, and it appears to be doing so fairly rapidly already, it is always the mercantilists who suffer.”

    A strong statement, which is utterly unsupported by current circumstances.

    It is the BRIC countries which are leading in growth, led by China.

    To assert that this situation will end ‘like’ 1927 is forecasting an argument by analogy – very weak.

  6. James

    I think this is why some believe the dollar could rally if the world begins to slow and head into a recession. What was thought of as a safe haven (EM’s BRICS) would be a death sentence.

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