Thursday, June 22, 2006

A currency agreement could avert the dollar's collapse

A currency agreement could avert the dollar's collapse
By John Grieve Smith
Published: June 22 2006 03:00 | Last updated: June 22 2006 03:00
Copyright The Financial Times Limited 2006


There is growing discussion in the International Monetary Fund and elsewhere about the need to tackle global imbalances. But it is strange that, while the dollar is widely acknowledged to be overvalued, this has so far had relatively little impact on the market or central banks' willingness to hold dollar assets. There is an increasing danger that sooner or later something could spark off a dramatic fall in the dollar, leading to chaos in currency markets, a sharp fall on Wall Street and a recession in the US spreading to the rest of the world.

We urgently need an agreement among the main players - the US, China, Japan, the eurozone and the UK - for an orderly adjustment of exchange rates before it is too late. There are good precedents for such an approach in the Smithsonian and Plaza agreements, devaluing the dollar in 1971 and 1985 respectively.


The US administration appears to have tried to avoid the issue by focusing on China and pressing it to revalue. But while American industry may be particularly sensitive to Chinese competition, the Chinese balance of payments surplus is only one big contributor to the global imbalance. China had a current balance of payments surplus of a little more than $100bn (£54bn) in 2005, as against the US deficit of $800bn. Other areas with surpluses of more than $100bn were Japan, Russia and the Middle East. It is neither practical, nor rational, to try to avoid devaluing the dollar by pressing other countries to appreciate their currencies. There is, however, a case for upward revaluations by some other players as part of a concerted move to achieve better global balance. This would reduce the nominal devaluation in the dollar required.

Such exchange rate adjustments would need to be accompanied by changes in countries' monetary andfiscal policies to maintain, or achieve,a healthy rate of expansion and high employment. This is clearly the case in the US, where higher exports and lower imports as a result of devaluation would result in a considerable boost to demand and hence the need for some monetary or budgetary tightening.

We should not, however, get this the wrong way round and think that reducing the US budget deficit is on its own the way to remove the balance of payments deficit - the myth of the "twin deficits". Raising taxes or cutting public expenditure, without any adjustment in the exchange rate, would mean that only a fraction of the resulting reduction in domestic demand would be reflected in lower imports; and the resulting slack would not be made up by a corresponding increase in exports. In present conditions, this would be a recipe for recession.

Such an international agreement on adjustments in exchange rates would mean that the central banks of the countries involved would have to intervene in currency markets, at least until the markets had settled into the new pattern of rates agreed. Such an adjustment would alleviate the threat of abig international financial crisis. But we should still be subject to irrational movements in exchange rates. It is difficult for multinational companies to plan future investment or operations rationally, when variations in exchange rates can alter the relative costs of production in different countries in an unpredictable fashion. We need to move forward to an international regime where exchange rates are more stable and predictable.

The case for a system of managed exchange rates is most apparent in regional groupings with strong trading links, such as the European Union. The extreme solution is currency union, as in the eurozone. But this is only suitable for countries that have achieved a very high degree of economic integration. A more general solution is a system of agreed parities and target zones such as we had in the European exchange rate mechanism. We need, however, to learn from past experience and ensure that any new arrangements provide for more frequent changes in parities in small steps, rather than waiting for drastic changes (devaluations) in crisis conditions - such as on Black Wednesday, when sterling was forced out of the ERM in 1992.

Once a series of such regional arrangements was in place, it would be practicable to manage the rates between them on an informal or formal basis. In the meantime, there are too many different currencies to manage on a global basis; in the short term, the best we can hope for is an agreement to manage the rates between main currencies. As happens too often in economic policy, do we have to wait for a crisis before taking any policy initiative?

The writer is a fellow of RobinsonCollege, Cambridge

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