Wednesday, March 21, 2007

The Debate Continues

Desmond Lachman's latest response:

Dear Mr. Calhoun,

Thank you for your e-mail.

You raise several interesting questions, which I will try to answer in turn and which you should feel free to post if you choose:

Government Intervention: My idea is certainly not to have government intervention in currency markets in the normal sense of the term. Rather, it is to have a rules-based system in much the same way as we do in every US financial market, where there are very clear rules distinguishing between permissible and non-permissible behavior. (For instance we have an SEC that prohibits practices likel insider trading etc., to make markets work better). The basic rule that we would want in a freely floating international currency system is that countries are not permitted to engage in currency intervention other than for strictly “smoothing purposes”. This is the sort of rule that the International Monetary Fund is supposed to be applying in the exercise of its exchange rate surveillance functions but sadly it is not discharging its mandate in the way it is supposed to be doing.

China and Inflation You are certainly right in asserting that China’s maintenance of an artificially depreciated exchange rate does result in both goods price and asset price inflation that is harmful to China’s long-term prosperity. China tries to “sterilize” its foreign exchange rate intervention by mopping up liquidity through increased bond placements in its domestic market. However, China is far from successful in doing so. In the end, inflation will bring China’s real exchange rate back into line with where it should be to have a more balanced trade position. However, this process can take a very long time and it also gives China an unfair trading advantage in the interim. It would be both in China’s long-term interest as well as that of the global economy if China were to move in the direction of allowing much greater flexibility in its exchange rate. China pays lip service to this objective but in practice does not allow its currency to fluctuate very much as it feels that it must keep a very-undervalued exchange rate in order to keep its export machine humming.

Japan and interest rates Over the past few quarters, Japan’s economy has shown signs of recovery and deflation shows signs of abating. Yet the Bank of Japan, under political pressure from the government chooses not to increase interest rates from their abnormally low levels. Maintenance of low interest rates has encouraged “the carry trade”, which has led to a considerable weakening of the yen over the past year despite Japan’s very strong balance of payments position. The danger to Japan and to the global economy is that the carry trade unwinds in an abrupt manner at some point, which could cause large unanticipated losses in the global financial system. It would seem to be in Japan’s own interest to induce a gradual unwinding of the carry trade through a gradual return of interest rates to more normal levels. Clearly Japan also needs to address its pressing long run fiscal problem.

Disorderly unwinding. With the United States presently running an external current account deficit of around US$800 billion, or 6 ½ percent of GDP, I would not want to be overly sanguine about the risks of a disorderly unwinding of this imbalance. A deficit of this size has no precedent in the US over the past sixty years. I would particularly not want to be sanguine about the dollar against the backdrop of the present mess in the sub-prime mortgage market, which in my view is clearly not going to be confined to that sector of the housing market. If we do indeed have US housing prices falling at a significant pace in 2007, it is very likely that foreigners will not be as keen as they were in the past in buying US dollar denominated assets in general and mortgage backed securities and US equities in particular. If that indeed turned out to be the case, the US would have trouble financing its current account and the dollar would swoon. I would also want to keep an eye on what foreign central banks, including that of China, do with their large US dollar holding as these central banks make more noise about wanting to diversify out of the dollar.

Size of depreciation. It is true that the United States dollar would have to depreciate a lot against China if the US were to be competitive with China in high labor content goods. However, the US trades with many countries where it does not need that large a depreciation to make inroads into their markets. Most mainline econometric studies suggest that a 20-25 percent depreciation of the US dollar against a basket of currencies from its present level would be all that is needed to reduce the US current account deficit to a more sustainable level of around 4 percent of GDP. As I mentioned before, however, a devaluation of the dollar would need to be accompanied by markedly improved savings performance in the US if the dollar devaluation were to work.

Best regards,


I'll post my comments soon.

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