Rules and More Rules

This week I have been conducting a running conversation with Desmond Lachman about the currency markets and the potential role of the IMF. Mr. Lachman believes that the IMF should be more involved in the market to prevent countries such as China from manipulating their currencies to gain a trade advantage. I share Mr. Lachman's desire to see a more stable currency exchange rate system. The current system has a mix of systems that are inherently incompatible. China feels free to maintain the exchange rate of the Yuan (RMB) at a level that, in the opinion of Mr. Lachman and others, gives them an unfair advantage in trade. Japan likewise is accused of manipulating its currency by maintaining an artficially low interest rate structure. Meanwhile the value of the US dollar and the Euro are left to be determined by the market. The Chinese and other Asian countries stand accused of distorting these values by maintaining their current systems.

More stable exchange rates between the various countries would certainly seem desirable. A company or individual making a cross border investment must consider the affects of the currency on that investment. Should they hedge? If so, what is the cost associated with that hedging? Will the investment still make sense after considering the currency volatility? Surely it would be easier to make investment decisions if currency values were more stable. This desire for stability was certainly a factor in the decision to implement a single currency in Europe. The imposition of stable exchange rates in Europe (through the introduction of the Euro) however seems to prove that the stability of exchange rates will not, by itself, result in better economic performance.

In his previous response, Mr. Lachman mentions the "inter-war" years and the troubles that resulted. Presumably he is talking about the 1920s and 30s which saw repeated currency devaluations in pursuit of a trade advantage. By invoking this period, he must believe that the Great Depression was caused by these competitive devaluations. In a sense he is correct; tariffs were used as a way to defeat the currency devaluations and there is little doubt that these trade restrictions were a primary cause of the economic misery of the time. The result in 1944 was the Bretton Woods system which sought to prevent this type of competitive devaluation cycle and the political impulse to retaliate through tariffs.

The aim of the Bretton Woods system was currency stability and convertibility. A system of fixed exchange rates was introduced whereby most currencies were pegged to the dollar and the dollar was pegged to gold. The IMF was created in 1947 to police this new system. The IMF charter bans competitive devaluations and established the IMF as a sort of lender of last resort for countries that had temporary balance of payments issues. The system worked fine until domestic US policies in the 1960 and 70s undermined the system. Faced with an outflow of gold after years of excessive government spending (Vietnam and the Great Society) Nixon closed the gold window and withdrew the US from the Bretton Woods system in 1971. The dollar promptly lost value and the inflation of the 70s was the result.

Since that time, we have operated essentially with no system. There have been attempts at coordination of currency values such as the Plaza Accord in 1985 between France, West Germany (that sounds odd now doesn't it?), Japan, the US and the UK. The goal of the Plaza Accord was to devalue the dollar in an attempt to remedy the trade and current account deficits of the US and particularly the trade deficit with Japan. The Plaza Accord didn't have the intended effect as the current account deficit continued to grow. Furthermore, the unintended effect was that the BOJ loosened monetary policy in an attempt to offset the drag on their economy. This loose monetary policy led to the bubble in Japanese stocks and property in the late 80s.

The dollar devaluation continued until the Louvre Accord of 1987 which sought to reverse some of the effects of the Plaza Accord. None other than Alan Greenspan undermined the Louvre Accord when during an interview with Fortune magazine he stated that the dollar was overvalued and needed to depreciate at a rate of 2% per year for some time to reach an appropriate value. In my opinion, this was a major catalyst for the stock market crash of 1987. Ultimately, these currency stablization agreements failed because the countries involved could not (or would not) coordinate domestic economic policy (interest rates, etc.).

So with all this history, let's take a closer look at what Mr. Lachman would like. In his response he states:

"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...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."

The problem with this idea as I see it, is that there is no reference point. In the old Bretton Woods system, the dollar was pegged to gold and the other currencies were pegged to the dollar. In a free floating system as we have now, there is no reference point. If countries are not permitted to engage in currency intervention other than for smoothing purposes, what currency is the reference point? Can China intervene to smooth the exchange rate with the Euro or the US dollar? If China intervenes in the market to effect the exchange rate with the Yen, will that effect the Yen/dollar exchange rate? If it does, can they intervene again to smooth the effects on the dollar? I don't see any way that a rules based system could be implemented that would take into account all the cross currency exchange rates.

Another problem is that central banks must consider domestic concerns when adjusting monetary policy. Mr. Lachman believes that Japan manipulates its currency by maintaining an artifcially low interest rate structure. In his rules based system, will the IMF determine interest rate policy in Japan? This was the problem with the Plaza and Louvre Accords. The Louvre Accord in particular had a list of indicators that were supposed to be used as inputs in determining the needed exchange rate coordination. The Louvre Accord fell apart precisely because the Central Banks of the countries involved pursued domestic policies that were in their countries own best interests. As they should.

Mr. Lachman makes some good points in his response. He states: "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." Well that is probably true but exchange rate flexibility is as much a domestic political concern of the Chinese as anything else. For true exchange rate flexibility in China would require that the Chinese government allow its citizens to hold and invest in foreign currencies, something which they are reluctant to do as it would limit their control over their population. For sure, it would be desirable for China to implement a policy such as this, but it is politically unlikely. Furthermore, it is possible (I believe likely) that given the opportunity to invest abroad, many Chinese would do exactly that and the effect on the Yuan may not be what Mr. Lachman desires.

Mr. Lachman is also correct that "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." We saw the effects of the unwinding of the carry trade a few weeks ago when a rise in the Yen was concurrent with a large drop in US stocks. He wants the Japanese to normalize interest rates, but what would be the effect on the Japanese economy if that happened? I contend that the problems with the Japanese economy are structural and have little to do with monetary policy. If I'm right, how would Mr. Lachman address that situation. Would the IMF punish Japan in some manner until it got its fiscal house in order?

Finally, Mr. Lachman believes that a devaluation of the dollar in the range of 20-25%, presumably in the trade weighted dollar value, would reduce the current account deficit to a more sustainable rate of about 4%. What would be the effect on US inflation if we devalue that dollar by 25%? How would that affect Fed policy? Since the devaluation of the dollar in the 80s did not have the desired effect, what makes Mr. Lachman believe it will work this time? What is different?

In conclusion, Mr. Lachman and I share a concern about the current exchange rate system. We would both like to see more stable exchange rates as this would have beneficial effects for the world economy. Mr. Lachman would have the IMF make and enforce a set of rules to coordinate exchange rate movements. I believe this effort would be doomed to failure as the Plaza and Louvre Accords were. Absent an anchor such as gold, it seems highly unlikely that a group of economists at the IMF could correctly determine the "proper" exchange rates. It is also highly unlikely that countries would allow an organization such as the IMF to have so much control over their domestic policies.

The role of the IMF has been superseded by events. It is high time to eliminate the IMF, not expand its role in the world economy. There are probably better ways to structure the exchange rate system, but longing for a world that no longer exists is not the answer. Bretton Woods failed because governments (particularly the US) would not submit to the restrictions inherent in the system. And that hasn't changed.