Is the dollar to blame?

Ronald McKinnon’s book, The Unloved Dollar Standard, is the story of monetary disillusionment. The system – or, rather, the non-system – which emerged after the collapse of the so-called Bretton Woods rules in 1971 was supposed to ensure global monetary stability with as its backbone a US dollar freed from its convertibility into gold. At least, that’s what the author, a naive young economist, thought at the start of his career in the 1960s.

Forty years later, McKinnon blames successive American administrations for the repeated failures of the international monetary system. The latter have, almost systematically, criticized countries which maintained supposedly undervalued exchange rates with the dollar. American authorities should, McKinnon thinks, have recognized that global imbalances came from their own monetary and budgetary inadequacies, and not from others. This argument relates to the forty years that the book covers.

Before getting to the heart of the argument, it is useful to recall that Ronald McKinnon, professor of international economics at Stanford University, has a reputation as an iconoclast among economists interested in monetary issues. Very liberal in obedience (which corresponds to the general position of the economics department at Stanford), it is distinguished by its support for a system of fixed, or quasi-fixed, exchange rates, and by a certain hostility to free movements capital.

Forty years of dollar domination

The story he tells unfolds from the 1970s to the present day. Despite all the upheavals that the world economy has experienced over the last forty years, from the oil shocks to the emergence of China, one aspect seems to stubbornly remain: the domination of the dollar as the main currency in international trade and as an asset reserve. The first chapter explains this state of affairs: if there were no dominant currency, each international exchange would have to be carried out between two minor currencies. There would therefore be a money market for each pair of countries, that is, if there were 100 independent currencies, 99×100 different markets and exchange rates to coordinate. As markets preferred simplicity, it was simpler to select an intermediate currency against which all others exchanged. The Second World War was the historical accident which allowed the dollar to definitively replace the English pound in this role. The Bretton Woods system had engraved this domination in stone by making the dollar the only currency convertible into gold. Twenty-five years later, this convertibility proved untenable, and Richard Nixon decided to make the dollar a floating currency, which, depending on the countries’ choices, could remain an anchor for other currencies.

With power comes responsibility

The heart of McKinnon’s argument is this: given the dominance of the dollar, domestic economic policy errors in the United States have global consequences. McKinnon sees, for example, in what we call the first oil shock, not a problem specifically linked to raw materials, but an overly lax monetary policy of the American Federal Bank (Fed), which fueled global inflation, whose prices raw materials. It is a total reinterpretation of the global inflationary episodes of the 1970s. A weakening dollar generates, like currents of air, unstable capital flows rushing into countries that maintain high interest rates: Germany and Japan in the 1970s, and the major emerging countries today. These countries, faced with upward pressure on their exchange rates, intervene in the markets and buy dollars, thus increasing the supply of domestic money, and therefore inflation. The ultimate consequence is found in episodes of global inflation, whether in 1973, 1979, or in the great global commodity inflation of 2007-2008.

Why would the American monetary and budgetary authorities have failed to play their role as guardian of global monetary health? ? Why have the Americans repeatedly sought to devalue the dollar, either by directly intervening in the currency markets or by putting pressure, through diplomatic channels, to force their partners to reassess their exchange rate? ?

Are we wrong about the role of exchange rates? ?

McKinnon’s main answer is that economists and economic policy makers simply have a flawed understanding of how exchange rates work. They are victims, he writes, of the illusion according to which a monetary devaluation makes it possible to adjust a deficit trade balance (and symmetrically that a country with a surplus can be forced to return to balance by forcing it to appreciate its currency ). This illusion comes, according to him, from the confusion between two accounting identities. Most economists think that the trade balance is the result of trade flows: devalue your currency and your goods will be cheaper than others, you will sell more, and you will therefore obtain an export surplus. McKinnon sees the second equation: the trade balance is the result of saving and investment decisions. Invest more than you save, and you will have to borrow the difference, and therefore import more goods and services than you export. However, there is no reason to think that the exchange rate affects national savings or investment: this is what interest rates and a series of other variables (demographic, fiscal or technological, among others).

In our contemporary world where the main global imbalance is between China and the United States, such an approach has three major political consequences, which are in total contradiction with the common analysis: because interest rate differentials are the main reason for capital flows, the United States can only reduce its trade deficit by sharply increasing its interest rates, currently at zero. Then, the undervaluation of the Chinese currency (the Renminbi) is not of great importance: stability is a quality that the Chinese authorities must maintain and they must resist repeated calls from the Americans to appreciate and float the renminbi. Finally, since the adjustment must be real and not nominal, the American authorities should reduce their spending (and therefore the public deficit) while the Chinese should do the opposite and stimulate more spending.

Is the dominance of the dollar under threat? ?

You don’t have to be a convinced Keynesian to worry about such recommendations. Such a shock would kill the little recovery that the American economy is currently experiencing. Furthermore, while it is true that emerging countries suffer from the expansive monetary policies of developed countries, they have several tools at their disposal to cope, such as capital controls.

Let’s focus on the case of China. The country undoubtedly benefited initially from its fixity with the dollar which allowed it to radically reduce rampant inflation (which was between 10 and 20% in the years 1985-1995), as well as from the undervaluation of the currency which was a major component of its development strategy from 1995. But the trade surplus only became truly problematic in 2005-2008. The Chinese currency, the renminbi, began its appreciation in the summer of 2005, and its consequences were clear with a temporary lag (the time to adapt to the new prices): the surplus was indeed reduced.

McKinnon’s theory that exchange rates have no impact on the trade balance has actually long been discredited, most elegantly in a 1987 article by Richard Baldwin and Paul Krugman. there are indeed two equations of different nature, but they imply the same adjustment process: a country which maintains a current deficit must spend less and save more, but more fundamentally, the country must spend less abroad. This means that the reduction in spending must be accompanied by a depreciation — that is, a reduction in domestic prices, which will allow spending to be directed at domestic producers. It is also possible to restore its trade balance without the support of exchange movements, but it is much more difficult, since everything must go through the adjustment of quantities. To take an example close to us, one of the causes of the seriousness of the euro zone crisis comes from the impossibility of adjusting prices (exchange rates) to restore balance between countries of the north and the south: Adjustment by quantities implies for deficit countries to carry out massive austerity and accept high unemployment.

Finally, to return to the Chinese case, in a sense, McKinnon does not go far enough. His main recommendation is to keep the dollar at the center of the system, simply more stable than before. He is so disappointed by the dollar experience that he fails to see the way out of it: the emergence of the renminbi as the dominant currency could be much faster than expected. The steps already taken by the Chinese authorities are impressive: partial opening of markets to international investors, existence of a market offshore of the renminbi in Hong Kong, establishment of mutual credit lines between central banks to exchange in renminbi in the event of financial disruption in dollars. Thus, the dollar standard could give rise to the renminbi standard more quickly than we think.