The Future of the Dollar

THE FUTURE OF THE DOLLAR

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Economic Education Bulletin (ISSN 0424–2769) (USPS 167–360) is published once a month at Great Barrington, Massachusetts, by American Institute for Economic Research, a scientific and educational organization with no stockholders, chartered under Chapter 180 of the General Laws of Massachusetts. Periodical postage paid at Great Barrington, Massachusetts. Printed in the United States of America. Subscription: $25 per year. POSTMASTER: Send address changes to Economic Education Bulletin, American Insti- tute for Economic Research, Great Barrington, Massachusetts 01230. Contents

Foreword ...... 1 About the Contributors ...... 3 WHAT TO DO ABOUT THE DOLLAR Anna J. Schwartz ...... 7 LET MARKETS DETERMINE THE VALUE OF THE DOLLAR Lee Hoskins ...... 13 HISTORICAL PERSPECTIVES ON GLOBAL IMBALANCES Michael Bordo ...... 17 EXCHANGE RATE REGIMES: CHOICES AND TRADEOFFS Kenneth Rogoff ...... 33 DID POLICYMAKERS LEARN ANYTHING FROM THE 1970s? Margaret Greene Yeo ...... 39 STRONG DOLLAR: THE TREASURY’S POLICY IN THE 1990s Karin Lissakers ...... 45 WHAT THE CLASSICAL ECONOMISTS TAUGHT US ABOUT FOREIGN EXCHANGE John H. Wood ...... 53 FOREWORD

N May 2005, the American Institute for Economic Research (AIER) sponsored a conference at its campus in Great Barrington to discuss a Imatter that has profound effects on the American economy—namely, the future of the dollar. Much of the conference was devoted to discussion of two particular issues that have attracted growing attention in recent years: the foreign exchange value of the dollar and the ballooning U.S. current account deficit. This book is a collection of selected papers and presentations that focused on these issues. From 2002 to 2004, the exchange value of the dollar decreased sharply against most other major currencies, including the euro, the yen, and the pound. When the conference was held in the spring of 2005, the question of where the dollar was headed loomed over discussions of the world economy. Some analysts, including some conference participants, thought at the time that a serious adjustment was underway and that the dollar faced a growing challenge to its role at the world’s major reserve currency. As events turned, the exchange value of the dollar subsequently re- bounded over the remainder of 2005, demonstrating once again that it is hazardous to try to predict or explain exchange rate movements. Still, the underlying questions remain: What determines the exchange value of a currency? What role do governments and their policies play, and what role do markets play? What lessons have we learned from the past 30 years— an era of “managed floating rates,” exchange rate volatility, and periodic efforts by government officials and policymakers to prop up, drive down, or stabilize the exchange rate? As for the U.S. current account deficit—the gap between the value of what America imports and what it exports—it has increased from two percent of Gross Domestic Product in the late 1990s to more than six percent in 2005. This is unusually—and, many economists say, unsustainably—high. There is no consensus, however, on when or how this “unsustainable” trend will end. Will the adjustment be gradual, with the exchange value of the dollar edging downward and thereby fueling export growth and restraining imports? Or might international concern over the U.S. trade deficit (or some other development) prompt foreigner investors (including foreign central banks) to suddenly decide to “dump” their holdings of U.S. dollars, triggering a precipitous and disruptive drop in the dollar? These issues are not new. In the essays that follow, Professors Michael Bordo and John Wood offer historical perspectives on the dollar and the trade deficit, looking particularly to the experiences of the 19th century.

1 Bordo describes the “benign” view and the “gloomy view” of the current situation, and notes encouragingly that a previous period of global imbalances, prior to World War I, had a “benign” outcome. Wood observes that the current problems of the dollar are fundamentally related to our reliance on politicians and central bankers, rather than a mechanism such as the gold standard, to preserve the purchasing power of the dollar. “With neither rudder nor anchor,” he says, “we cannot guess the Fed’s behavior or therefore the future of the dollar. Professors Kenneth Rogoff and Anna Schwartz, and Lee Hoskins, a former president of the Federal Reserve Bank of Cleveland, offer global perspectives. The dollar and the deficit, notes Schwartz, are influenced by factors outside of the United States, such as the amount of saving and lending in the rest of the world. If the market has created imbalances, she and Hoskins argue, the market will correct them, and official intervention is unlikely to be effective or beneficial. Rogoff notes that the U.S. economy is “marvelously flexible” and can “handle shocks better than any other large country in the world.” The eventual correction of current exchange rate imbalances may be harder for other countries, he says, especially Europe. Finally, two contributors offer insights based on their professional experiences in the world of foreign exchange and foreign policy. Margaret Greene Yeo was in charge of foreign exchange operations at the Federal Reserve Bank of New York during the 1970s and 1980s, when the postwar system of fixed exchange rates collapsed and was replaced by a new ar- rangement of floating rates. Although there are important differences between then and now, she says, the experience of that time offers some lessons for today. Karin Lissakers was the U.S. Executive Director for the International Monetary Fund (IMF) in the 1990s. She describes at length the “strong dollar policy” of the Clinton Administration. As with all AIER conferences, the views expressed by the participants are their own and do not necessarily represent the views of AIER. As with previous such events, however, we believe that the discussions in the pages that follow are both timely and pertinent.

2 ABOUT THE CONTRIBUTORS

Michael Bordo is professor of economics and director of the Center for Monetary and Financial History at Rutgers University. He is a research associate at the National Bureau of Economic Research (NBER). He has been a visiting professor at various leading universities and a visiting scholar at the International Monetary Fund (IMF), the Federal Reserve Banks of St. Louis and Richmond, and the Board of Governors. He is the author of many articles and books on monetary economics and monetary history, including A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform, co-edited with Barry Eichengreen (1993). Lee Hoskins is a senior fellow at the Pacific Research Institute in San Francisco. He served as chairman and CEO of the Huntington Bank of Ohio, Columbus, and previously was president and CEO of the Federal Reserve Bank of Cleveland. He is a member of the Shadow Open Market Committee, a private group whose participants meet periodically to discuss the policies and actions of the Federal Reserve Board’s Federal Open Market Committee. He is also a trustee of Carnegie Mellon University and its Gailliot Center for Public Policy. Mr. Hoskins is a director of the Western Economic Association International and was a member of the Meltzer Commission for the study of international financial institutions, which reviewed the performance of the IMF, World Bank, and regional development banks for Congress in 1999-2000. Karin Lissakers currently serves as chief adviser to George Soros on globalization issues. From 1993 to 2001, she was the United States Execu- tive Director for the International Monetary Fund (IMF). A veteran of Capitol Hill, she has served as a staff director of the foreign economic policy subcommittee of the U.S. Senate Foreign Relations Committee, as well as a director of the policy planning staff of the U.S. Department of State. Her 1991 book Banks, Borrowers, and the Establishment: A Revi- sionist Account of the International Debt Crisis is an account of the 1980s international debt crisis. She also has lectured on international banking issues at Columbia University’s School of International and Public Affairs and served as director of its international business and banking studies program. Kenneth Rogoff is professor of economics and Thomas D. Cabot Pro- fessor of Public Policy at Harvard University. He was chief economist and director of research for the IMF from 2001 to 2003. One of the leading economists in the fields of foreign exchange policy, development finance, and international financial institutions, he has written numerous publica-

3 tions on these and related subjects. His most recent article is “Grants versus Loans for Development Banks,” with Jeremy Bulow, forthcoming in American Economic Review. He has taught at Princeton University, University of California at Berkeley, and University of Wisconsin-Madi- son. He is also a research associate at NBER and a member of the Council on Foreign Relations and the Trilateral Commission. Anna J. Schwartz is a research associate at the National Bureau of Economic Research and an adjunct professor of economics at the Graduate School of the City University of New York. She has received numerous honorary degrees in recognition of her contributions to the field of monetary economics. The printout of her bibliography runs to more than 30 pages. Best known for her collaboration with Milton Friedman, A Mon- etary History of the United States: 1867-1960 (1963), she continues to publish scholarly articles and has participated in conferences and the summer program at AIER for the past two years. For a number of years, she has been the principal foreign exchange commenter for the Shadow Open Market Committee. John Wood is Reynolds Professor of Economics at Wake Forest Uni- versity and has been a Visiting Research Fellow and faculty associate at AIER for several years. He is a life fellow of Clare Hall, Cambridge University (UK). He has published frequently on monetary and banking topics. His most recent book is A History of Central Banking in Great Britain and the United States (2005). He has taught at the University of Birmingham (UK), the National University of Singapore, Northwestern University, and the Wharton School of the University of Pennsylvania. He also has been a staff economist at the Federal Reserve Board of Governors and a visiting scholar at the Federal Reserve Bank of Dallas. Margaret (Gretchen) Greene Yeo worked in the Foreign Department of the Federal Reserve Bank of New York for more than 20 years. She was the person immediately in charge of, and later the principal supervisor responsible for, the foreign exchange operations of the New York Fed, 1972-92. She became a senior vice president before retiring from the Bank. She was the first secretary of the Foreign Exchange Committee, a working group of the principal foreign exchange dealers in New York that still exists, which she also was instrumental in organizing. Her duties at the Bank included preparing the quarterly Treasury-Federal Reserve foreign exchange reports and reporting on those operations to the Federal Open Market Committee. She and her husband now own and operate Yeo Farms, a family farm in Lowellville, Ohio, with other operations in North Caro- lina.

4 Chart 1: Indexes of Selected Foreign 500 Exchange Rates (Dollars Per Currency Unit, August 1971 = 100) Swiss 400 Note: After 1998 the exchange rates for Franc marks, French francs, and lira are calculated from their conversion rates to the euro. 300 Japanese Yen

200

Deutsche Mark

French Franc

100

British Pound 50

Euro

(Jan. 1999=100) 120 110 100 90 Italian Lira 80 70 '99 '03 '07

25 1970 ’75 ’80 ’85 ’90 ’95 2000 ‘05 ‘10 End-of-month rates. Latest plots, December 2005. 5 Chart 2 20% U.S. Exports and Imports as Percentages of GDP

15 Imports

Exports 5

0 1889 ‘99 1909 ‘19 ‘29 ‘39 ‘49 ‘59 ‘69 ‘79 ‘89 ‘99 ‘09

Chart 3 U.S. Trade Deficit (-) or Surplus (+) as a Percentage of GDP (Exports minus Imports) 8%

-2

-4

-6

-8 1889 ‘99 1909 ‘19 ‘29 ‘39 ‘49 ‘59 ‘69 ‘79 ‘89 ‘99 ‘09 Note: 2005 data based on 2005 Q3. Source: Bureau of Economic Analysis.

6 WHAT TO DO ABOUT THE DOLLAR Anna J. Schwartz

HE depreciation of the exchange value of the dollar since early 2002 to some observers is a judgment on the future viability of the TU.S. economy. They revive the notion of the “twin deficits” that was popular from the 1980s until it lost its appeal in the late 1990s. From 1983 to 1989, domestic private savings and domestic investment were about equal, as were the trade deficit and the federal budget deficit, foster- ing the notion of a relation between those twin deficits. The idea was that domestic private saving and the trade deficit were sources of supply of capital. Private sector investment and the federal budget deficit were sources of demand for capital. Expansionary fiscal policy created budget deficits that increased domestic demand for capital and imports. Tight monetary policy raised interest rates, which induced foreign investment and appreciated the dollar exchange rate. The strong dollar made American goods expensive for foreigners and imports cheaper for Americans. Thus the current account deficit was said to be related to the effects of the twin deficits. The validity of this framework was shat- tered by developments in the late 1990s when budget deficits declined and became a surplus while the current account deficit surged. What happened to the twin deficits view in the 1990s was that business investment boomed in the 1990s along with productivity increases while private savings declined as low inflation, low unemployment, and soaring stock market values increased private wealth. The contribution of the budget surplus to national saving was insufficient to close the gap with domestic investment. Foreign capital inflows in response to the then U.S. boom closed the gap. In the current version of the twin deficits notion, expansionary fiscal policy has created budget deficits that have increased spending for capital and imports. Loose monetary policy has lowered interest rates, which discourage foreign investment and depreciate the dollar exchange rate. The weak dollar ultimately will cheapen American goods for foreigners and make imports expensive for Americans. In the meantime, the budget deficit has reduced national saving, while private domestic investment has continued to grow, so the gap between the two requires higher foreign capital inflows. Consequently, there is no abatement of the current account deficit. If one looks for causes of the current account deficit, two can be ruled out. The evidence shows that the federal budget deficit is not responsible

7 for the increased demand for capital and imports that raised borrowing to finance the current account deficit. One would expect an increased demand for loans to raise world interest rates. That has not happened. Similarly, the low level of the rate of personal savings is not responsible for the current account deficit, although that is often cited as proof of the gluttony of American consumers. If that were the case, the reduction in American saving would have reduced the supply of loans, which, again, should have raised interest rates, contrary to the evidence. One must look to causes other than the twin deficits to explain the rise in the U.S. current account deficit. The main source is the increase in savings and lending since the mid-1990s in the rest of the world, principally the East Asian countries and the emerging market countries. That is why the increased world supply of loans has reduced interest rates, at all maturities, not only in the United States but worldwide. As the rest of the world has increased savings, it has reduced its spending, which accounts for the shortfall in American exports, even as U.S. imports forge ahead, as foreign savings seek investment opportunities in the United States. Role of Savings Outside the U.S. for Investment Inside the U.S. Federal Reserve Governor Ben Bernanke in a recent speech on the causes of the increase in savings outside the United States isolates two factors: 1) precautionary increases by countries in response to recent financial crises or in determining to be prepared in the event of future crises, and 2) savings by oil-exporting countries from increased oil revenues. Bernanke attributes the decline in U.S. personal savings to the increase in savings in other countries, which has lowered U.S. interest rates.1 It remains to note that the world’s surge in savings has sought out investment in the United States, rather than in the stagnant European Union or the Japanese economy. The conclusion is that as long as the rest of the world saves to invest in the United States, growing indebtedness is not a threat to the standard of living here because the United States has financed investment with a positive yield. Unfortunately, that is the point at which apocalyptic predictions by some observers begin. They apparently believe that at some point global investors will regard their portfolios as unbalanced with dollar-denominated assets and will decide to limit their holdings of such assets. They expect the share of euro- denominated assets in time will replace dollar-denominated assets with the ultimate consequence of narrowing the U.S. current account deficit. The main foreboding of those who entertain these views is that foreign holders of dollars may decide to sell them off quite precipitously, dumping dollars 8 on world markets. As a result, the foreign exchange value of the dollar would plummet, U.S. interest rates would rise to limit the fall in the dollar’s exchange value, the economy would plunge into recession, and the rest of the world would suffer a contraction in exports to the United States. Avoiding the Apocalypse Countering the apocalyptic view of what is in store for the United States and the rest of the world, with a catastrophic decline in the exchange value of the dollar, is the projection that as long as the United States maintains price stability and its economy is vibrant, while the European and Japanese economies are stagnant, the United States will not encounter constraints on borrowing from the rest of the world. If there should be a run on the dollar, it would alarm foreign central banks and foreign exporters. Foreign central banks would intervene to prevent appreciation of their national currencies and a loss of their exports. As of the first quarter of 2005, there has been no indication that China, Japan, and Taiwan are shifting their reserves out of dollars. China is re- ported to have increased its $610 billion of total reserves at the end of 2004 to $659 billion at the end of the first quarter of 2005. A flight from the dollar would not be a winning strategy for the Asian countries. Exporting to America is their main priority. Exports mean growth. Their growth- oriented trade surpluses are a main source of finance for the U.S. current account deficit, channeled through their central banks as official providers to the United States. The apocalyptic view would prevail only were the Asian countries to trash their model of exports as the engine of growth and instead promote domestic spending on investment and consumption at home. That may eventually happen, but not soon and not precipitously. The Asian countries are little concerned about the risk/return of their U.S. investment position. It is not the Asian countries that have become worried about their U.S. exposure. It is private investors in Europe, Canada, and Australia who have been responsible for the dollar’s decline by limit- ing their purchases of U.S. assets until there is a rise in U.S. yields, and those investors have been responsible for the euro’s appreciation. Euro- pean domestic savings have remained at home, and European yields have fallen. I would worry less about a fall in the exchange value of the dollar because of some foreign private investor concerns about U.S. indebtedness than I would about growing demands for protection against imports of goods and services. Complaints about unfair trade practices of foreign exporters are not unique to the present situation. Subsidies to promote U.S. crop exports have been a perennial feature of protectionist trade policy

9 here. Current protectionist targets are undervalued Asian currencies, especially the Chinese yuan. The United States has attributed the size of its bilateral trade deficit with China to its undervalued yuan, which currently is pegged at 8.2765 to the dollar and has been pegged at about 8.3 per dollar since 1995. Pressure on China to float the yuan has been exerted by the G-7, not only by the United States. The textile industry in the United States and also in emerging market economies has borne the brunt of Chinese competition, particularly so since early 2005, when the Multi-fiber Agreement that limited Chinese textile exports expired. A motion was lost to kill a protectionist measure, supported by members of both parties in Congress, that would impose tariffs of up to 27.5 percent on all Chinese imports if China does not permit the yuan to float more freely. China has responded to the call to relax the exchange rate peg by agreeing to do so at some unspecified date.2 It is doubtful, however, that even a dramatic appreciation of the yuan would be sufficient to balance U.S. trade with China, much less the overall U.S. trade with the rest of the world. The decline in profitability of U.S. textile firms and the loss of employment by their workers creates a political problem for the Bush Administra- tion. Protectionist measures and government subsidies will not prolong the life of an industry facing low-cost competitors. U.S.-made moderately- priced textiles may be doomed by developing country proficiency. One solution would be for the U.S. industry to restructure itself to specialize in the production of expensive high-fashion goods. Younger workers should be offered compensation and retraining under the federal Trade Adjust- ment Assistance program for manufacturing. Older workers should be given financial aid for a transitional period. Regions with concentrated textile firms should aim to attract other industries.3 Conclusion What to do about the dollar? My answer is, Nothing. If the market has overstated the decline in the dollar’s exchange rate, the market will correct the overstatement. In a floating exchange rate system, currencies fluctuate. Correction of the underlying problem of an imbalance between U.S. national saving and investment is dependent to a great extent on the behavior of the United States’ trading partners. They have surplus savings and seek investment opportunities in the United States. Activist solutions for policy changes in the United States, such as reducing outsourcing or imposing tariffs on imports and barriers to open capital markets will serve special interests but not U.S. living standards. The single beneficial thing the administration can do is to oppose protectionism. Protectionism has not served to narrow the current account deficit in the past, and it won’t do so 10 now. The risk of a sudden stop in foreign financing of the current account deficit, precipitating a financial crisis here, is a scare story. Even if it were to happen, the size of the world capital market, the ample existing liquidity, and the ability of the Federal Reserve to provide additional liquidity defy the prediction of a financial crisis. At some point, as the dollar depreciates, in line with expectations, the United States will experience a trade surplus, with United States exports expanding more than its imports. That will enable the United States to pay the interest and even principal on its foreign debt. United States net foreign debt is likely to decline through expected changes in exchange rate-adjusted asset prices, as yields on American assets earned by foreign investors fall below the yields on foreign assets earned by American investors.

11 Endnotes 1 Ben Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit,” Homer Jones Lecture, Federal Reserve Bank of St. Louis, St. Louis, MO, April 14, 2005. 2 China did revalue the yuan (also called the renminbi) by 2.1 percent, from 8.28 to 8.09 per dollar, in early July 2005, but the Chinese authorities have not allowed that value to fluctuate much since then. —Editor 3 See generally, Alan C. Stockman, “How I Learned to Stop Worrying and Love the Current Account Deficit,” University of Rochester, Shadow Open Market Committee presentation, May 1-2, 2005.

12 LET MARKETS DETERMINE THE VALUE OF THE DOLLAR Lee Hoskins

think Anna Schwartz is correct to debunk the “twin deficits” theory, the idea that our federal budget deficit and the external current account Ideficit are jointly a big cause of financial or monetary problems inter- nationally. The United States might have a big problem with how we manage our federal budget deficit. But I do not see the budget deficit as a cataclysmic event that is likely to cause a run on the dollar. These markets are so broad and so deep now that it seems almost impossible to me to imagine how they could unravel simultaneously. I joined the Federal Reserve Bank of Cleveland in September 1987, just in time to witness my first market collapse in October that year. That was some time ago, but all that we did as Reserve Bank presidents and Federal Open Market Committee members was to call the banks to see if they were still lending to customers and find out whether there was panic in the markets or anything like that. We worked our way through that collapse with the loss of one or two financial firms, I believe; nothing major. That experience reinforced my views that markets are the best forces to handle these kinds of problems. I am less sanguine, however, about a group of Asian finance ministers or central bankers owning the public debt of the United States than I would be if a profit-seeking individual, bank, or investment company owned that debt. Central bankers are not as sensitive to the profit motive as private investors, but, worse yet, they also may be sensitive to some other things that are political and that could cause a problem. I am not sure whether the Asian central banks as investors will be comfortable when the first shots are fired across the Taiwan Strait, for example, or when the first big bank collapses inside China. That could cause, it seems to me, some disgorgement of the current hoard of dollars that they have. But barring some such event, I think that fears over large foreign holdings of dollars are generally overstated. Our real problem is protectionism. Perhaps we need to begin worrying about something happening that would cause world trade to decline. The spread of retaliatory tariffs in pursuit of or in resistance to judgments from the World Trade Organization, rising transportation costs due to higher energy prices, an outbreak of new communicable disease epidemics in East Asia—these are all examples of threats to the further expansion of mutually beneficial trade. After we dismiss some of the scares like those just mentioned, the principal remaining scare, I think, is protectionism. 13 Another issue related to the fluctuation of the dollar in foreign exchange markets that deserves further discussion is moral hazard. I think that a lot more moral hazard exists today than most people have acknowledged. The pattern emerging from the last two decades or so of central banking experience is that we, the public, simply back everybody’s play in the markets with a no-fail policy if the player is big or important enough. However, I do not foresee any near-term danger from excesses of moral hazard commit- ted by the United States authorities as causing us to have a major run on the dollar. What should be done regarding our government’s policy toward the external value of the dollar? In one sense, I agree that the answer is to do nothing. However, I also think the government’s policy on inflation is relevant to this question, and here I offer a different answer. In my view, a good government policy would be a pre-commitment to a zero inflation target. Remove Restrictions on the Movement of Capital Another policy that the government could adopt and that would be beneficial would be for the United States to work with other countries to remove remaining cross-border capital controls. A liberalized financial system would help many developing economies to become major developed countries some day. Generally, it is the retention of capital controls, not exchange rate fixing, that is the main international economic problem for China. Hong Kong has had an exchange rate peg at around 7.8 local currency units per U.S. dollar since 1984, but no one detects any protectionist concerns there because the money flows in and out freely and the goods flow in and out freely. The currency peg has helped build and sustain Hong Kong’s prosperity. If we really want to help China and other low-income countries to develop, and probably even more so the middle- income developing countries, we should work toward liberalizing their internal financial systems. Overall, I believe that we need to emphasize the avoidance of protectionism more strongly, especially the lingering negative influences of capital controls and currency inconvertibility. Currency Market Interventions Regarding the massive foreign exchange market interventions by the U.S. government in the 1970s, I believe that, if you are in a floating rate system, intervention makes no sense. I see no gains to it at all. Period. I do not mind countries fixing their currencies against each other or the dollar, but I think that there are risks to such a currency regime. I think that

14 the risks probably outweigh the benefits. The risks are that the junior partner in the rate peg will get himself or herself into trouble. The junior partner ends up with two policy targets, an inflation target and an exchange rate target. But you only have one policy instrument, domestic monetary policy, which usually means an inflation target. The risks are high that such a central banker is going to get caught unless he or she is very lucky at picking the right exchange rate to match the inflation target that is derived from domestic monetary policy. Very few central bankers can perform such a juggling act successfully over time, which explains why there are so many build-ups followed by blow- ups in the last 30-plus years of floating rates. If the global exchange rate mechanism were a purely floating system, which it pretends to be but is not, then I would wonder why anybody worried about foreign exchange reserves at all. Perhaps some reserves could be justified if a country issued bonds denominated in a foreign currency, or in some situation like that. But the whole issue of gaining reserves or worrying about losing reserves no longer would be important. Conclusion It seems ironic to me that most contemporary economists say that they trust free markets to price everything out there, but many of them still do not trust markets to price currencies, even for a little while. Milton Fried- man once said that “Economists may know very little, but they do know how to create surpluses and shortages through fixing prices by government edict.” That is how I regard foreign currency market intervention. Those who intervene end up in the fix in which China finds itself, having to absorb the currency reserves arising from a large trade surplus with the United States. Similarly, rent control and rent stabilization in New York City are government interventions in the housing market that have the effect of setting the price of covered housing too low. As a result, very few rent-controlled houses or apartments come onto the rental market. Another good analogy is the milk production subsidy, which causes the milk marketing board to set the price of milk too high, with the result that the market for fresh milk never clears. We taxpayers wind up financing the production of a lot of cheese down the road, but I doubt that we’ll ever get to eat it.

15 16 HISTORICAL PERSPECTIVES ON GLOBAL IMBALANCES Michael Bordo

ECENT discussions of reform of the international monetary system are rooted in concerns that have been expressed about the Rpossible unpleasant consequences of unwinding the global imbalances that are reflected in a large United States current account deficit and comparable current account surpluses in East Asia. Some have called for establishing a new Bretton Woods system; others, for strengthening the mechanisms of policy coordination developed in the 1980s. An historical approach may be useful in putting these matters in perspective. The present international monetary regime of managed floating exchange rates was preceded by three regimes that had different experiences with imbalances and their adjustment. Under the classical gold standard, with fixed exchange rates, smooth adjustment to imbalances occurred through the price specie flow mechanism and capital flows, with a very limited role for monetary policy. The interwar gold exchange standard (1925-1931), which tried to repli- cate the performance of the gold standard, failed because, opposite to the gold standard, monetary authorities subordinated maintenance of external balance to domestic considerations. Also, the United States and France, key surplus countries, were unwilling to allow the necessary domestic adjustment of rising prices, thereby imposing the burden of deflation and recession on the United Kingdom, the key deficit country. The Bretton Woods system was established in 1944 to overcome the fatal flaws of the interwar period. Adjustment to imbalances was supposed to be symmetrical between deficit and surplus countries, with international reserves and assistance from the International Monetary Fund (IMF) to serve as buffers to international shocks. The original Bretton Woods system broke down because it evolved into a gold dollar system under which the central reserve country did not have to adjust to a growing balance of payments deficit. Such a system also required the central reserve country, the United States, to follow stable monetary policy, which it did until 1965. Then the U.S. authorities shifted to an inflationary policy. A further cause of the breakdown was that the Bretton Woods system required capital controls, which became ineffective as time passed. The present system of managed floating has gone through several cycles of perceived misalignment since 1973 that were viewed with alarm, much like today. After a rocky start in the 1970s, adjustment has been relatively

17 smooth, working primarily through the exchange rate, relative prices, and domestic expenditure. In this paper, I first discuss the current set of imbalances, contrasting the views of those who believe that its resolution will be benign with those who expect it to be painful. I then give some historical evidence from each of the four regimes that may have some resonance for today. I consider the smooth adjustment to the massive international transfers of capital in the pre-1914 period and then contrast them with three episodes that were less benign: the late 1920s and early 1930s; the breakdown of Bretton Woods, 1965-1971; and the so-called dollar crisis of 1977-1979. In conclusion, I consider the questions: How does today’s experience fit in with the historical patterns, and is there a valid case for international monetary reform? The Current Situation A. The Gloomy View Recent concerns about global imbalances associated with the U.S. current account deficit-to-gross domestic product (GDP) ratio in excess of 5 percent (see Chart 1) and U.S. net foreign liabilities of $2.7 trillion or 25 percent of GDP (see Chart 2) have raised fears of a drastic readjustment. Such readjustment could involve a massive depreciation of the dollar (as great as 90 percent in some scenarios)—the dollar already has fallen about 30 percent in nominal trade-weighted terms against its major trading partners (see Chart 3)—with attendant potentially serious effects on the U.S. and global economies. The adjustment would involve reallocation of consumption and production in the United States from non-traded to traded

Chart 1: U.S. Current Account Balance

200 2

100 1

0 0

-100 -1

-200 -2

-300 Percent of GDP -3

-400 -4

Billions of Dollars Percent of GDP Billions of Dollars -500 -5

-600 -6

-700 -7 1990 1995 2000 2005 Source: Federal Reserve Bank of Cleveland. 18 goods and a possible rise in inflation, leading to greater tightening of monetary policy, which would induce a recession. The decline in income would reduce both the demand for imports and domestic consumption, which would encourage domestic saving. Thus, the two faces of imbalance—the current account and the savings-investment gap—would improve simultaneously. At the same time, the adjustment would have opposite effects in Eu- rope and Japan, areas with current account surpluses and excess savings (see Charts 4 and 5). To the extent that European nominal rigidities prevent the Euro Zone from adjusting to the decline in demand for Euro- pean exports to the United States, the European real economy could suffer. China, with its currency pegged to the dollar, would not have to

Chart 2: Net International Investment Position of the U.S. (Assets valued at current market)

20 2.0 15 1.5 10 1.0 5 0.5 0 0.0 -5 -0.5 -10 -1.0 -15 Percent of GDP -1.5 Percent of GDP

-20 -2.0 Trillions of Dollars -25 Trillions of Dollars -2.5 -30 -3.0 -35 -3.5 1980 1985 1990 1995 2000 2005

Chart 3: Nominal Trade-Weighted Exchange Rate of U.S. Dollar vs. Major

Currencies (March 1973 = 100) 150 140 130 120 110 100 90 80 70 60 1973 1977 1981 1985 1989 1993 1997 2001 2005 Source: Federal Reserve Bank of Cleveland. 19 adjust much and would gain a competitive advantage in the U.S. market, especially against Europe. In addition, it is argued that, to the extent that the imbalances have been financed by foreign, especially East Asian, central banks’ accumulation of U.S. Treasury bills (up to 66 percent of all non-U.S. central banks’ international reserves), some point will be reached at which the Asian central banks will dump their depreciating dollar assets and shift their portfolios toward the euro (currently about 25 percent of all central banks’ international reserves), thereby aggravating the situation. The current situation often is attributed to the information technology boom of the 1990s, which

Chart 4: Euro-Area’s Current Account Balance

30 1.5

20 1.0

10 0.5

0 0.0

-10 -0.5 Percent of GDP Billions of Euros

Billions of Euros -20 -1.0 Percent of GDP

-30 -1.5 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 Chart 5: Japan’s Current Account Balance

6 6

5 5

4 4

3 3

2 2

1 1

0 0 Trillions of Yen Percent of GDP -1 Trillions of Yen -1

-2 Percent of GDP -2

-3 -3 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 Source: Federal Reserve Bank of Cleveland. 20 induced a massive private capital flow into U.S. equity markets. The burst- ing of the technology boom, which many analysts treat as a bubble, in 2000 was followed by the events of September 11, 2001, a U.S. recession, and the commencement of the Afghanistan and Iraq wars. These events led to a shift of the U.S. budget from surplus to a deficit close to 4 percent of GDP. This so-called twin deficits problem often is viewed as a key determinant of the deteriorating external position of the United States. B. The Benign View An alternative view does not regard the outlook for the United States in such bleak terms. This view posits that adjustment will be smooth, pro- tracted, and benign, very much like what happened in the late 1980s, when the U.S. current account deficit reached a peak of about 4 percent of GDP. Proponents of this view (for example, Federal Reserve Chairman Alan Greenspan, in a 2003 speech) stress the underlying force of financial globalization—a burgeoning phenomenon since the 1970s—and encourage residents of open economies to increase their holdings of foreign assets as a way to diversify portfolios and smooth out shocks to consumption. Global assets and liabilities have mushroomed in the past three decades, especially in the 1990s. Globalization and a decline in home bias—a ten- dency of domestic investors to prefer domestic assets in their portfolios— have deepened and broadened financial markets around the world and above all in the United States, which has seen a disproportionate growth in demand for its assets because it offers a comparatively higher real rate of return. Expectations of continuation of such a return are based on the economy’s long-run good performance. Moreover, according to economist and Federal Reserve Chairman-des- ignate Ben Bernanke, U.S. external imbalances largely reflect a glut of global savings due partially to the aging of populations in Japan and some European countries but primarily reflect the zealously cautious reactions of East Asian monetary authorities to the effects of the Asian financial crisis of 1997-1998. The Asian central banks, nearly all of whose currencies are pegged to the dollar, prefer to hold dollar assets to protect themselves against similar shocks. In this benign view, the U.S. current account deficit and the rise in U.S. net foreign liabilities reflect the demand for U.S. instruments by foreigners. Adjustment, to the extent that it needs to occur, will be benign because the underlying, long-run, positive fundamentals will continue. Proponents of the benign view provide two additional reasons for optimism: valuation effects—to the extent that dollar depreciation is unexpected, it will reduce the value of U.S. foreign liabilities; and a reduced pass-through—recent

21 empirical evidence shows that only a very small fraction of dollar depreciation passes through to higher inflation. Globalizing Capital Flows and the Adjustment Mechanism: A Benign Outcome a Century Ago A different and perhaps enlightening perspective on the decision to re- establish some international cooperative mechanism like Bretton Woods is suggested by the economic history of earlier episodes of global imbalances which may have some resonance today and which may tell us what is in store for the future. An important precedent for the benign outcome view is the previous era of financial globalization from 1870-1914. It was charac- terized by a rapid global buildup of external assets and liabilities and also by long-standing current account imbalances comparable to today’s experience. The 50 years before World War I saw massive net private flows of capital from the core countries of Western Europe to the countries of recent settlement overseas (mainly the rapidly developing Americas and Australasia), financing railroads and other infrastructure as well as budget deficits (especially in the form of bonds but also in the form of foreign direct investment). At the peak, the associated current account surpluses in Great Britain reached 9 percent of GDP and were almost as great in France, Germany, and the Netherlands. For the principal capital importers in the late 19th century (Argentina, Australia, and Canada), current account deficits exceeded 5 percent of GDP on average. Earlier in that century, the United States experienced similar capital inflows but, by century’s end, it began to run current account surpluses. In addition, data on ratios of stocks of foreign assets and liabilities to GDP for selected countries and regions present a picture of a U-shaped pattern. At its pre-1914 peak, the ratio of foreign assets to world GDP was approximately 20 percent. The ratio declined from that level to a low point of 5 percent in 1945, with the prewar level only being reached by 1985. Since then it has risen to 57 percent by 1995. A similar picture emerges from the ratio of foreign liabilities to world GDP. The British held the lion’s share of overseas investments in 1914, 50 percent of GDP, followed by France at 22 percent, Germany at 17 percent, the Netherlands at 3 percent, and the United States at 6.5 percent. The latter amount should be compared with the U.S. holding of global assets in 1995 at 25 percent of GDP. Inward investment of overseas funds in turn repre- sented up to one half of the capital stock of one of the major debtors (Argentina) and close to one fifth for Australia and Canada in 1995. A striking feature of the pre-1914 data is the persistence of the current 22 account imbalances. There is statistical evidence of significantly greater persistence in both the deficits of the principal capital recipients and the surpluses of the capital exporters compared to the recent experience. Finally, the adjustment mechanism for the massive capital transfers of the pre-1914 era worked very smoothly. It occurred through the “price- specie flow” mechanism of the classical gold standard. The transfer of long-term capital from Europe to the New World to finance railroads and other infrastructure was also accompanied by gold flows as the demand, for example, for U.S. railroad bonds by British investors led to a demand for dollars, which pushed the dollar to the gold import point. The gold inflows in turn tended to raise the price of U.S. exports relative to imports, thereby improving the terms of trade, as well as raising the ratio of the prices of traded and non-traded goods. The gold inflows also allowed the United States to import more goods than otherwise would have been possible—many of the imports consisted of capital goods like rails from Great Britain. As relative prices adjusted, the gold flows tended to be reversed, closing the imbalance. Moreover, short-term capital movements speeded up adjustment because gold flows into the United States reduced interest rates relative to those of Britain. The smooth adjustment to the capital transfers of the pre-1914 era, many believe, reflects the fact that the world was on the gold standard, which provided a stable and credible nominal anchor for money or the price level. The gold standard also served as a signal of fiscal rectitude, a “good housekeeping seal of approval,” which assured investors that their debt would be serviced and repaid. Also many of the capital recipients were part of the British Empire. The Empire established institutions and safeguards, such as giving colonial (dominion) governmental debt trustee status in the United Kingdom (that is, having a de facto British government guarantee), which virtually eliminated country risk. However, the adjustment mechanism in the earlier era of globalization was not always benign. Indeed, although current account imbalances were more long-lived in the pre-1914 era than in the recent period, they were punctuated in some countries by severe reversals, especially in the crisis- ridden 1890s. The classic financial crisis of the era was the Barings crisis of 1890, which began with a debt default in Argentina and spread like wildfire to the rest of the emerging world. Lenders in London and Paris cut off capital flows to emerging countries like Brazil with fundamentals similar to those of Argentina, while other countries deemed sound, like Canada, were affected only marginally. Thus, the emerging market crisis problems of the last 20 years or so had historical precedents. Most of the countries affected, especially those of Latin America and Southern Europe, lacked

23 the fundamentals (institutions and policies) associated with the more successful recipients. Although the imbalances of the previous age of globalization have considerable resonance for today, especially the fact that both eras were char- acterized by stable monetary regimes—the gold standard then and the adherence by many countries today to credible domestic nominal anchors such as inflation targeting and norms for fiscal balance—there also are considerable differences. First, under the gold standard, countries of new settlement—the emerging markets of the time—ran current account deficits, while the major European economies ran surpluses. In the current era, major economies as well as emerging markets can run either persistent deficits or persistent surpluses. Second, gross capital flows are much larger today, and gross asset and liability positions were very close to net zero positions before 1914, in contrast to today, when most major industrial countries are both major creditors and major debtors. The earlier pattern reflects the prevalence of long-term investment by the core countries in the countries of new settlement. The substantial growth of two-way flows between advanced countries since 1980 has been associated with both international financial di- versification and intertemporal consumption smoothing. Third, the adjustment mechanism is different today. The historical record shows that adjustment to the significant and persistent external imbalances in the pre-1914 era occurred largely through the “price-specie flow” mechanism of the classical gold standard (a mechanism first described by the 18th century Scottish philosopher and economist David Hume). In contrast, the global economy is now on a managed floating exchange rate regime, and instead of gold flows, the brunt of the external adjustment occurs through changes in the exchange rate and levels of international reserves, along with relative price movements, short-term capital flows, and valuation effects. Finally, in the pre-1914 era, Great Britain was the dominant country. Its currency, the pound, served as the international medium of exchange and as a key reserve asset. Great Britain ran considerable current account surpluses throughout the period. By contrast, the United States is the dominant economy today, and the dollar is the key currency. However the United States has been running persistent current account deficits. Further Lessons from History: Some Bad Outcomes History also provides three other not so rosy scenarios of global imbalances and how nations adjusted to them: the interwar gold exchange standard, the Bretton Woods system, and the 1977-79 dollar crises. 24 A. The Interwar Period World War I ended the classical gold standard because all of the belligerents except the United States abandoned gold convertibility. Pri- vate capital flows also ceased. After the war, by 1926, the major countries returned to a variant of the gold standard, the gold exchange standard, in which members held most of their international reserves in dollars, ster- ling, and francs, and the United States, Great Britain, and France held gold. But the interwar gold standard had serious flaws that prevented smooth adjustments to the imbalances that built up. The key problem was that the major countries returned to gold at misaligned real exchange rates. All the belligerents had serious inflations during the war, and the restoration of the original gold parities involved deflation and recession. As it turned out, Britain restored parity at $4.86 in 1925 with an overvalued real exchange rate, while France and Germany each greatly devalued their currencies and restored parities at undervalued real levels. The United States never left the gold standard, but U.S. prices did not return to the prewar level, thus causing its real exchange rate also to be undervalued. This misalignment meant that the United States, France, and Germany tended to run current account surpluses while Great Britain, its Empire, and countries economically linked to Britain, ran deficits. Under the gold standard, this meant that gold tended to flow toward the surplus countries. Also, under the gold standard rules, both creditors and debtors were supposed to adjust to the imbalances: creditors by allowing domestic price levels to rise, and debtors by deflation. Meanwhile, both the United States and France continuously sterilized their gold flows and prevented adjustment. As a consequence, they imposed deflationary pressure on Brit- ain and on the rest of the world. Another important difference between the classical and interwar gold standards that impaired the adjustment mechanism in the latter was the lack of credibility for the member countries’ adherence to gold convertibility. Unlike the earlier period, markets had limited confidence that countries always would put external balance considerations before domestic policy concerns. This meant that short-term capital movements could be destabilizing. In the end, the system collapsed after 1929 in the face of the Great Depression. Speculative attacks against countries that used expansionary monetary policy to alleviate banking panics and to stabilize their real economies forced country after country to abandon the gold standard. This was not the case for the United States, however, because it had ad- equate gold reserves to withstand speculative attacks. The United States left the gold standard in 1933 as part of President Roosevelt’s policy package to reflate the U.S. economy. 25 B. Bretton Woods Under the post-World War II Bretton Woods system, a distant variant of the gold standard, the United States was the dominant country with the largest gold reserves. Under Bretton Woods rules, the United States had to peg the dollar to gold at $35 per ounce, and the rest of the world pegged to the dollar. The rest of the world used dollars as international reserves, and the dollar served as the international medium of exchange. The United States also was supposed to follow stable monetary and fiscal policies. During the period 1959-1971, when the Bretton Woods system operated fully (most members of the IMF had current account convertibility by then), the United States ran persistent current account and trade surpluses and also engaged in considerable foreign investment. The overall balance of payments was generally in deficit, and the rest of the world absorbed dollar claims. At the same time it is argued that the principal continental European countries and Japan kept their real exchange rates deliberately undervalued in order to foster export-driven growth in their economies. This policy meant that they kept accumulating dollars which, like the United States and France in the interwar period, they sterilized. It also has been argued that, during this period, the United States acted as financial intermediary to the rest of the world, importing short-term capital (dollar claims) and exporting long-term capital. From 1961 to 1967, European and Japanese holdings of dollar claims convertible into gold kept increasing relative to gold holdings in the United States, suggesting the possibility of a run on the dollar. Some have argued that the system could have continued for an extended period as a de facto dollar standard. However two factors led to the collapse of the Bretton Woods system. First, the French resented the U.S. “exorbitant privilege” of not having to adjust to its payments imbalances because it was the principal reserve country. They wanted a return to a pure gold standard, and to facilitate this outcome, they converted their outstanding dollar claims into gold. Second, the United States began to follow inflationary monetary and fiscal policies, beginning in 1965, to finance the Vietnam War and the Great Society. Expansionary policies increased both the U.S. payments deficit and European central banks’ reserves as the United States exported its inflation abroad. As a consequence, the Europeans began converting their dollar claims into gold, threatening U.S. gold reserves. The system collapsed when President Nixon closed the gold window in August 1971. It has been argued that a reincarnated Bretton Woods system exists today. China, possibly India, and other countries are seen as deliberately

26 running an undervalued peg against the dollar to encourage export-driven growth, the same way that Europe and Japan did it 40 years ago. The central banks of those countries willingly accumulate dollar assets conse- quent to their current account surpluses. According to this view, such a relationship could persist for as long as a decade to allow China to absorb its 200 million surplus agricultural workers into the manufacturing sector. Others argue that, unlike Bretton Woods, the reincarnated system will not last for 10 years but will collapse much sooner because, differing from the Europeans in the 1960s, Asian central banks do not have a stable cartel. Furthermore, while in the Bretton woods era there were no good substitutes for the dollar as the world’s reserve asset (the pound was a reserve asset, but it was weak), today we have the comparatively strong euro as an alternative to the dollar. Proponents of this view predict the reincarnated Bretton Woods system will collapse quickly. C. The United States 1977-1979 After the Bretton Woods regime finally collapsed in 1973, the major countries of the world shifted to managed floating exchange rates. Coun- tries used exchange market intervention both to smooth disorderly markets and, as a residual from the Bretton Woods era, to maintain what were perceived to be equilibrium exchange rates. The 1970s were also the decade with the highest peacetime inflation rates in U.S. history. Inflation that began in the mid-1960s did not abate. A similar pattern occurred in most other countries, with the principal exceptions of Germany and Swit- zerland. Rising inflation was fueled by monetary growth. There is considerable debate over the causes of the Great Inflation: explanations include a mistaken belief in the Phillips curve tradeoff (usually summarized as unemployment vs. inflation); basing policy on the wrong indicators of monetary policy; and errors in the data that central banks used. Two oil price shocks in 1973 and 1979 were also said to have contributed heavily to the upward trend in inflation, although some have argued that the oil price hikes by the Organization of Petroleum Exporting Countries (OPEC) were an endogenous response to prior inflation. The United States, the United Kingdom, Canada, and others used expansionary monetary policy to prevent the oil price shocks from reducing output and employment. Germany and Switzerland did not accommodate the oil shocks. Japan accommodated the first but not the second. These countries had lower inflation in the 1970s than the United States, the United Kingdom, and Canada. Between 1975 and 1977, the deutschemark/dollar and yen/dollar rates traded in a narrow range. Then in the fall of 1977, the dollar began a rapid depreciation that continued into 1978. At the same time, the United States

27 was running ever larger current account deficits, while Germany, Switzer- land, and Japan were running significant surpluses. According to former Federal Reserve Board economist Robert Solomon in his 1982 book, The International Monetary System, the imbalances triggered capital flight from the United States, which made things worse. The capital flight was triggered by concerns about the effectiveness of the Carter administration and the belief that the United States was following a policy of “benign neglect” of the dollar. The Europeans blamed the United States for encouraging the depreciation of the dollar to gain competitive advantage and for destabilizing their economies. The United States criticized the Europeans and Japanese for not dealing with their surpluses. Solomon viewed intervention by the Treasury and Federal Reserve in January 1978 as ineffective, and beginning in the late spring of 1978, the dollar fell “at a disorderly rate.” The Fed then reacted by raising the discount rate to 8 percent in late September 1978, and the Carter administration promised to trim the fiscal deficit. The dollar continued to fall. In a speech given October 24, 1978, President Carter proposed an anti- inflation package with tighter monetary and fiscal policy, including volun- tary wage and price controls and regulatory reform aimed at deregulation to improve competitiveness. According to Solomon, the dollar strength- ened by close to 2 percent against the deutschemark. Carter’s speech soon was followed by a rescue package put together by the Treasury and the Fed. It included the following elements: $30 billion to defend the dollar via an IMF drawing; increased central bank swap lines (U.S. borrowings from foreign central banks); the issuance of $10 billion in Carter bonds (U.S. securities denominated in foreign currencies); Treasury gold sales; and the Fed raising the discount rate to 9.5 percent and establishing a supplemen- tary reserve requirement of 2 percent against large time deposits. In response to this package, the dollar appreciated 7 percent against the deutschemark and 5 percent against the yen. According to Solomon, the package led to the end of belief in the “benign neglect” doctrine. In the summer of 1979, the dollar resumed its decline, attributed by Solomon to the trouble that the Carter administration was having in handling a recession, continued inflation, the second oil price shock, and the Iranian political crisis that erupted in a hostage seizure at the U.S. Embassy in Tehran in November 1979. In July, Paul Volcker replaced G. William Miller as chairman of the Fed’s Board of Governors; Miller became Secre- tary of the Treasury. The inflation rate kept rising, reaching double-digit figures in September 1979. On October 8, Volcker announced his famous “shock” policy, involving a rise in the discount rate to 12 percent, an increase in reserve requirements, and a change in the Fed’s operating

28 procedure away from targeting the federal funds rate toward a non-bor- rowed reserves aggregate. Following that announcement, the pressure on the dollar eased. Compared to the present period, the imbalances of 1977-1979 may seen small, at less than 2 percent of GDP, but the underlying problems were far more serious. They reflected the bad monetary policy in the United States that created the Great Inflation. The depreciating dollar just reflected the poor record of inflation and recession and the expectation that monetary policy would not improve. In that sense, the adjustment at the time well reflected the underlying fundamentals. Conclusion: What Will Happen to the Dollar? Four historical episodes of external imbalances and their adjustment have been illustrated. The first worked remarkably well. Two ended in a collapse of the international monetary regime. The fourth led to a fundamental change in the monetary regime. Which episode is the most relevant to today’s environment? My bet is on a benign outcome like that of the pre-World War I gold standard era. In today’s world, the underlying fundamental of globalization and the basic strength of the U.S. economy, which will continue to underpin the dollar as a reserve asset, suggest that adjustment to the present set of imbalances will be gradual. When all is said and done, the current experience will be viewed as similar to what happened in the late 1980s. What is the case for international monetary reform, especially the attempted re-establishment of the Bretton Woods international monetary order? The interwar and Bretton Woods debacles both reflected the collapses of regimes with fundamental flaws and the pursuit of inappropriate policies by the major countries. The 1970s U.S. experience reflected a failure in domestic monetary policy management and had little to do with problems in the international monetary framework being followed. The reaction to the 1970s experiences and to later large swings in the major countries’ exchange rates led to a concerted move by the G-7 countries toward policy coordination, of which the best-known examples were the Plaza (1985) and Louvre (1987) accords, the former to lower the exchange rate of the dollar and the latter to raise it. Subsequent research has led me to conclude that these coordinated rate-setting efforts were not very successful. To the extent that the situation today is not too dissimilar to the earlier episodes in the 1980s, the case for coordination does not seem evident. Moreover, calls for a reinvented Bretton Woods system, given the inherent flaws the last time and the sorry experience of yielding to those calls then, doubtless would lead to the same outcome.

29 References [Note: In the citations below, “NBER WP” means “National Bureau of Economic Research, Working Paper,” followed by the Working Paper series number.—Editor] Robert Barsky and Lutz Killian. “Oil and the Macroeconomy since the 1970s.” NBER WP 10855 (October 2004). Ben S. Bernanke. “The Global Saving Glut and the U.S. Current Account.” The Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, March 10, 2005. Olivier Blanchard, Francesco Giavazzi, Filipa Sa. “The U.S. Current Ac- count and the Dollar.” NBER WP 11137 (February 2005). Michael Bordo. “The Bretton Woods International Monetary System: A Historical Overview,” in Michael Bordo and Barry Eichengreen, eds., A Retrospective on the Bretton Woods System. Chicago, IL: University of Chicago Press, 1993, pp. 3-108. Michael Bordo. “The Gold Standard: The Traditional Approach,” in Michael D. Bordo and Anna J. Schwartz, eds., A Retrospective on the Classical Gold Standard, 1821-1931. Chicago, IL: University of Chicago Press, 1984, pp. 23-119. Michael Bordo, Ehsan Choudhri, and Anna J. Schwartz. “Was Expansion- ary Monetary Policy Feasible During the Great Contraction?” Explora- tions in Economic History, vol. 39, no. 1 (January 2002), pp. 1-28. Michael Bordo and Barry Eichengreen. “Is Our Current International Eco- nomic Environment Unusually Crisis Prone?” in David Gruen and Luke Gower, eds., Capital Flows and the International Financial System. Sydney, Australia: Reserve Bank of Australia, 1999, pp.18-75. Michael Bordo, Barry Eichengreen, and Jong Woo Kim. “Was There Re- ally an Earlier Period of International Financial Integration Compared to Today?” The Implications of Globalization of World Financial Mar- kets. Seoul, Korea: Bank of Korea, 1998. Michael D. Bordo, Barry Eichengreen, Daniela Klingebiel, and Maria Soledad Martinez- Peria. “Is the Crisis Problem Growing More Severe?” Economic Policy, vol. 32 (April 2001), pp. 53–82. Michael Bordo and Antu Murshid. “Are Financial Crises Becoming More Contagious: What Is the Historical Evidence on Contagion?” in Stijn Claessens and Kristin J. Forbes, eds., International Financial Conta- 30 gion. Boston, MA: Kluwer, 2001, pp. 367-403. Michael Bordo and Hugh Rockoff. “The Gold Standard as a Good-House- keeping Seal of Approval,” Journal of Economic History, vol. 56 (1996), pp. 389-428. Michael P. Dooley, David Folkerts-Landau, and Peter Garber. “An Essay on the Revived Bretton Woods System.” NBER WP 9971 (September 2002). Barry Eichengreen. “Global Imbalances and the Lessons of Bretton Woods.” NBER WP 10497 (May 2004). Barry Eichengreen. Golden Fetters. New York, NY: Oxford University Press, 1992. Jeffrey Frankel. “Twin Deficits and Twin Decades.” Harvard University mimeograph, May 2004. Pierre-Olivier Gourinchas and Helene Rey. “International Financial Ad- justment.” NBER WP 11155 (February 2005). Alan Greenspan. “Current Accounts.” Remarks given at Advancing Enter- prise 2005 conference, London, UK, February 4, 2005. Alan Greenspan. Remarks at the 21st Annual Monetary Conference, co- sponsored by the Cato Institute and The Economist, Washington, DC, November 20, 2003. Mervyn King. “The International Monetary System.” Remarks at Advanc- ing Enterprise 2005 conference, London, UK, February 4, 2005. Philip R. Lane and Gian Maria Milesi-Ferretti. “Financial Globalization and Exchange Rates.” IMF Working Paper no. 05/03 (January 2004). Ronald McKinnon. “Private and Official International Money: The Case for the Dollar.” Essays in International Finance, no. 74 (April 1969). International Finance Section, Princeton University, Princeton, NJ. Allan Meltzer. A History of the Federal Reserve, Volume I: 1913-1951. Chicago, IL: University of Chicago Press, 2003. Allan Meltzer. “U.S. Policy in the Bretton Woods Era,” Review, vol. 73 (May/June 1991), pp. 54-83. Federal Reserve Bank of St. Louis. Maurice Obstfeld. “Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies.” Paper C04-137 (October 1, 2004). Institute of Business and Economic Research, Center for Inter- national and Development Economics Research, University of Califor- nia- Berkeley, http://repositories.cdlib.org/iber/cider/C04-137. 31 Maurice Obstfeld. “The Adjustment Mechanism.” NBER WP 3943 (Janu- ary 1993). Maurice Obstfeld and Kenneth Rogoff. “The Unsustainable Current Ac- count Position Revisited.” NBER WP 10869 (October 2004). Maurice Obstfeld and Alan Taylor. Global Capital Markets: Integration, Crisis, and Growth. Cambridge, UK: Cambridge University Press, 2004. Robert Solomon. The International Monetary System: 1945-1981. New York, NY: Harper and Row, 1982. Gail D. Triner and Kirsten Wandschneider. “The Baring Crisis and the Brazilian Encilhamento, 1889-1891: An Early Example of Contagion among Emerging Capital Markets,” Financial History Review, vol. 12, no. 2 (October 2005), pp. 199-225. Marc Uzan. “Reinventing Bretton Woods?” Paper presented at 60 Years of Bretton Woods: The Governance of the International Financial System, Central Bank of Austria/Reinventing Bretton Woods conference, Vienna, Austria, June 21, 2004.

32 EXCHANGE RATE REGIMES: CHOICES AND TRADEOFFS Kenneth Rogoff

EFORE I say a word about the dollar and the United States current account, I need to issue a disclaimer: For a long time, dating from Band building on my own work at the Federal Reserve in the early 1980s, empirical research on exchange rates has shown time and again that it is virtually impossible not only to predict major currency exchange rates but to explain why they moved after the fact. That is, researchers find it very hard to trace exchange rate movements systematically to any kind of fundamental macroeconomic factors. However, this opening disclaimer notwithstanding, there do appear to be a couple of exceptions, and they appear to be relevant to this discussion. First, and very importantly, there is quite a bit of empirical work showing that central banks systematically lose money when they intervene in foreign exchange markets. Today, of course, the Asian central banks have accumulated more than two trillion in reserves, predominantly in dollars, on which they will suffer deep losses when the dollar ultimately depreciates. The dollar seems destined to depreciate if the U.S. trade balance and current account deficits are ever to close up significantly. Conversely, when the central banks are intervening extensively in the market, the same research suggests that private traders can make money by betting the central banks will not always be successful in stemming exchange rate movements. A second principle or exception is that when a country is running an exceptionally large and sustained current account deficit or surplus, this fact has some mild predictive power for exchange rates. With the United States absorbing about 75 percent of global current account surpluses, we are certainly in a situation like that today. A third possible exception is to look at whether real exchange rates are out of line on what we call a “purchasing power parity” basis, which measures what you can buy for your money in different countries. While one can hardly say right now that the dollar is wildly overvalued against the European currencies, it clearly is overvalued by virtually any measure against the Asian currencies. While the overwhelming preponderance of research says that it usually is impossible to tell what is going to happen to exchange rates, we certainly have many red lights blinking now for the dollar. Foreign central banks are intervening heavily, the United States is running large current account and

33 trade balance deficits, and the dollar is patently overvalued in real terms against Asian currencies. The U.S. Current Account Deficit and the Dollar Turning to the U.S. current account, the main question is not so much, “Does there need to be an adjustment?” After all, the United States today is borrowing somewhere between 70 and 80 percent of all net surpluses generated by all the countries in the world. The principal contributors are Germany and Japan (which, by the way, are by far the two biggest surplus countries), plus China, Brazil, the Scandinavian countries, and the oil exporters. There are a lot of smaller countries with surpluses against the United States, also. There are many reasons to think this situation is not sustainable. Eventu- ally, the U.S. personal savings rate will rise from its phenomenally low level. Eventually, we shall see some productivity catching up in the rest of the world. Of course, this whole house of cards could collapse in a darker scenario: The Asian central banks could decide that they are no longer thrilled about funding U.S. deficits and about holding so many dollars. The real question, then, is, “How big are the risks?” Is the correction of the current imbalance going to be like the 1980s under Ronald Reagan, when the U.S. current account collapsed along with the dollar? That whole experience was fairly benign for everyone except, perhaps, Japan. How- ever, as I suggested in a Foreign Policy article earlier this year, and as Maurice Obstfeld and I have suggested in our joint academic work, the collapse of the current account in the 2000s could look a lot more like the 1970s than the 1980s.1 Parallels to the 1970s include rising energy prices and open-ended U.S. military commitments (including homeland security expenditures). An- other factor is that in the 1970s the world was emerging from the Bretton Woods system of fixed exchange rates. The countries pegging to the dollar back then were largely European, except for Japan. Today we may be nearing the end of Bretton Woods II, in which it is the Asian countries that are fixing their exchange rates. Also, there is the government budget deficit, which remains deeply in deficit on a cyclically adjusted basis. Last but not least, we are coming out of a rather intense political business cycle where the economy was stoked up in 2003 and 2004 by extraordinarily accommodative fiscal and monetary policy. These policies were not necessarily wrongheaded, but nevertheless they were very accommodative. Over- all, today looks a lot more like the 1970s than the 1980s to me. All that being said, I would not argue that the coming current account reversal is going to signal the end of the world. A sustained shutdown in 34 Saudi Arabia’s oil fields would be more traumatic than reversal of the current account. But nevertheless we have left ourselves vulnerable in an increasingly risky and uncertain world. Vulnerabilities like the relative weakness of the dollar and our excessive dependence on foreign borrowing are a concern for both the United States and the world, especially if these vulnerabilities come home to roost under otherwise adverse geo- political circumstances. Perhaps the risk that the current valuation of the dollar poses to the rest of the world is even greater than to the United States. The United States has a marvelously flexible economy that can handle shocks better than any other large country in the world. Europe is another matter. Europe had trouble when the euro was at 83 cents and it had trouble when the euro was $1.37. Europe has trouble with any kind of change and so do many other countries. Currency Systems in Developing Economies Ironically, for emerging markets, the Brazils, the Turkeys, and other countries that so often run into trouble, this is an extraordinary benign period. U.S. profligacy is making them look good. Brazil’s currency, the real, is under enormous upward pressure, as are most emerging market currencies. That is because they are running big surpluses right now. In- deed, emerging markets in 2004 ran a collective surplus of $260 billion versus the United States, which had an aggregate deficit of over $600 billion. In the short run, the current situation is good for emerging markets. Unfortunately, in the long run, it might not be because those countries also have trouble handling volatility. Policies in some countries have improved mildly, but the benign global environment has encouraged many countries to slide back into their old ways. Look, for example, at Brazil, where government expenditures, especially the wage bill, have been rising sharply. Let me finish this review of developing economies’ current account surpluses by mentioning China. China really is a special case, just because its trade looms so large in the world. There is a lot of debate about what China should do. Should the Chinese float their currency (for real), or should they keep it relatively fixed to the dollar?2 From a global perspective, a more flexible yuan would be very helpful, but from a domestic perspective, it is not such an easy call. The problem is that China is really two countries. First, there is coastal China, where 450 million people live in a modern emerging market economy. That part of China already looks like Korea and probably should have a floating exchange rate 35 But then there is the other two thirds of the Chinese population. I would not quite say that they are living in the 16th century anymore, but I am not sure that they have gotten past the 19th century. They are very poor, and they are not allowed to move freely to the coast, or there would be a mass exodus. In my opinion, rural China really could use a fixed exchange rate. Indeed, rural China really could use its own separate currency. In a recent review of research on the choice of exchange rate regimes, my co-authors and I found that, for advanced countries, having a more flexible exchange rate regime is quite a good system. It is very stable, it promotes growth, and it does not cause higher inflation. But for poorer developing countries, fixed exchange rates really do not do a bad job as a currency system.3 For a long time, most of the policy making community has believed that everyone should have a floating exchange rate in order to avoid having crises like those in East Asia in 1997-1998. But the fact is that if a poor country’s capital market is effectively cut off from international markets— either because of controls or, as in Africa, lack of investor interest—then the risk of a classic emerging market debt crisis is very low. Also, a fixed rate can be more transparent and provide a better anchor for resisting inflation than other monetary policies. Review of Exchange Rate Regime Choices There were many studies of exchange rate regime choices over the last 15 to 20 years. One of the most famous was a paper by Baxter and Stock- man (1989) that showed that it was very hard to demonstrate that anything real, like output variability or growth, or interest rates, or anything else was different between more fixed exchange rate regimes and more flexible regimes.4 Starting around 10 years ago, the “bipolar view” of exchange rate regimes came to the fore, holding that everything was moving to one extreme or the other. Either a country was going to join a fixed-rate currency union like the euro, or it would go to the other extreme with a completely floating exchange rate like, say, Australia today. In fact, what has emerged is that a lot of regimes are really in the middle, with some exchange rate flexibility, but often only mildly so. These intermediate regimes have proven quite durable.5 The class of regimes that has proven most consistently problematic is in countries that have high inflation (over 40 percent), whose choice of regime Carmen Reinhart and I have labeled “freely falling.” Those countries generally have attempted to implement severe exchange controls.6 This is an area where the IMF actually has done a great job, encouraging countries 36 to withdraw from such regimes, especially in Africa, but also in Latin America. Attempting to predict the future of exchange rate regime choices, in some recent research, my co-authors and I categorized types of exchange rate regimes at various dates, first looking at 1975 and 2001. In 1975, pegged rate regimes were the most important, and intermediate regimes were the next most important, with floating exchange rates then being relatively unimportant. By 2001, intermediate regimes were the largest category, with some freely falling and some floating, but the biggest other category was the pegged rate regimes.7 Projecting our data forward, we suggested some possible future makeup of the world exchange rate system, using alternative assumptions about how countries will go in and out of exchange rate regimes. Under one assumption, transitions would occur at a rate similar to what we have seen in the past. Under a second assumption, all countries would have faster transitions, resembling more closely what one sees in middle-income emerging market countries. Under the first assumption, by 2020, there are no freely falling regimes, floating rate regimes are slightly fewer than in 2001, pegged rate regimes are reduced slightly below the 2001 level, and intermediate rate regimes are about the same. Under the second assumption, by 2020, there still are no freely falling regimes, floating rate regimes still exist but are reduced significantly (perhaps to 5 percent of the total), pegged rate regimes are reduced to about one quarter of the total, and all the rest (about 70 percent) are intermediate regimes. China’s Currency Regarding the prospects for a revaluation of China’s currency, what I actually would like to see is for China to move to a more flexible exchange rate and not just a one-time revaluation. The problem with doing a revaluation is that eventually, as the Chinese economy becomes more integrated with the rest of the world, China will have an increasingly difficult time maintaining its capital controls. China also will have a more difficult time controlling its domestic financial markets. At some point, if China keeps the current fixed rate, there will be a speculative attack against the currency. Right now, all the pressures are upward on the Chinese currency, but that can change in the blink of an eye. Also, I do not believe that Chinese revaluation would be a panacea for what ails the United States. Even if all the Asian currencies went up by 20 percent against the dollar, I do not believe that the revaluation would knock even one percent of GDP off the U.S. current account deficit. 37 Endnotes 1 Kenneth Rogoff, “Let It Ride,” Foreign Policy (March/April 2005). See also, Kenneth Rogoff and Maurice Obstfeld, “The Unsustainable US Cur- rent Account Position Revisited,” forthcoming, with revisions, in Richard Clarida, ed., U.S. Current Account Adjustment and Exchange Rate Over- shooting (June 2005 version); also in National Bureau of Economic Re- search, Working Paper 10869 (November 2004). 2 China effectively revalued the yuan in early July 2005 by allowing it to rise in a heavily managed float from about 8.28 yuan per dollar to about 8.08 yuan per dollar. However, the exchange rate has barely budged since then.—Editor 3 See, e.g., Kenneth Rogoff, Aasim Husain, and Ashoka Mody, “Exchange Rate Durability and Performance in Developing versus Advanced Econo- mies,” Journal of Monetary Economics, vol. 52, no. 1 (January 2005), pp. 35-64. 4 Maryann Baxter and Alan Stockman, “Business Cycles and the Exchange Rate Regime: Some International Evidence,” Journal of Monetary Eco- nomics, vol. 23 (1989), pp. 377-400. 5 See, Carmen Reinhart and Kenneth Rogoff, “The Modern History of Exchange Rate Arrangements: A Reinterpretation,” Quarterly Journal of Economics, vol. 119, no. 1 (February 2004), pp. 1-48. 6 Reinhart and Rogoff, note 5 above. 7 Reinhart and Rogoff, note 5 above. 8 Reinhart and Rogoff, note 5 above.

38 DID POLICYMAKERS LEARN ANYTHING FROM THE 1970s? Margaret Greene Yeo

have been asked to comment on the lessons learned during the foreign exchange market crises of the 1970s. This was a period of massive Ichanges in the structure and institutions of the international monetary system. One of those was the change in the exchange rate mechanism The move from a system of fixed exchange rates to a mixed system of exchange rates after 1971, and especially the formal adoption of the floating rate system in 1973, did not remove the exchange rate as a policy matter for the United States. At first, there was simply a lot of confusion about how the new arrangements were going to work, a confusion shared by both the public and private sectors. Because financial markets and foreign monetary authorities both dislike uncertainty, this confusion com- plicated the adjustment to the new exchange rate arrangements. The exchange rate was more than an important economic variable. It also served as a symbol of national merit. A rising currency was deemed an indication of economic and political virtue. A declining currency frequently was interpreted as symptomatic of economic or political weakness. Economic changes brought with them large adjustments in exchange rate values that had not been experienced before and that few were equipped to handle. For example, we discovered that the J-curve effect—the initially perverse effect of an exchange rate change on the trade account—could be significant enough both in size and duration to undermine confidence that the ultimate result of the change in the exchange rate could be secured. We found that international corporations that had underlying positions denominated in foreign currencies would take actions to protect their accounts and in so doing had the effect of exaggerating any movements of exchange rates. Trends in exchange rates also turned out to be anything but benign. In fact, we found that movements in one direction or the other came to be selfsustaining. Even after new policies to combat the move in the exchange rate were introduced, it seemed difficult for a country to break out of the cycle. The exchange market was, by comparison to today, a relatively unde- veloped marketplace for handling the challenges then being thrust upon it. Although the need to exchange one currency for another was universal, the business of trading in currencies was limited to a small group of special- ists. The institutions that performed these services were limited to the 39 commercial banks authorized to trade foreign exchange by their monetary authorities. Liquidity in a particular currency pair could be quite variable, and end users of foreign exchange were not particularly sophisticated in meeting their currency needs. The variability in market conditions invited a few market operators to take advantage of situations to try to manipulate exchange rate moves for their own, sometimes nefarious, purposes. When the dollar was floated in 1973, there were those who hoped that the U.S. authorities then would be free to concentrate economic policy on internal objectives without regard to the exchange rate or our balance of payments position. This hope proved unfounded. Whatever the theoretical arguments may have been for allowing the dollar to float, U.S. monetary authorities found themselves taking policy actions to influence the dollar throughout the 1970s. This was not because of any particular commitment to the dollar. They acted because pressures on the dollar became so intense as to have adverse effects on domestic conditions and threatened to undermine their other policy objectives. During the 1970s, we learned the importance of expectations in pricing determination. The abrupt changes in exchange rates we observed could not be explained by changes in economic fundamentals alone. The sudden changes in fortunes of a currency often had more to do with attitudes than realities. From where I was sitting at the time, designing our foreign exchange intervention strategies, I did not imagine that we were changing the underlying, long-term, equilibrium value of the dollar but, rather, trying to influence short-term expectations. Depending on the objective of the operations, we wished at times to be seen as reassuring; at other times we wanted to insert an element of surprise so as to prompt market participants to adjust their expectations. The 1970s was the time the United States learned to use intervention as a policy tool. I know that there are people who look back on that time and believe that the U.S. authorities intervened simply to prop up a weak currency without making needed domestic policy changes to restore internal and external balance. That is an unfortunate oversimplification. The operations in which I participated—and I was in charge of the New York Fed’s Foreign Exchange Trading Desk from 1972 to 1992—had many different objectives: • Some were exchange rate related; • Some few were politically motivated; • Some reflected a desire to cooperate with foreign monetary authorities;

40 • Some were used to reinforce an announcement of U.S. policy signifi- cance; and • Some were directed at dealing with concerns about market performance. Intervention that was conducted with an exchange rate objective served one of three purposes: • Buying time for the authorities to consider what, if any, policy changes needed to be made to address a problem in the U.S. economy; • Giving the authorities time to get new policy initiatives in place, announced, and implemented; and • Reinforcing the announcement of policy changes, showing policy resolve by “putting our money where our mouth is,” and in other ways giving any new policy initiatives a chance to prove effective. The U.S. authorities used intervention as a tool in a manner that was both discretionary and flexible. Led by the U.S. authorities, with considerable input from central banks of other countries, the authorities developed tactics that were quite different from those used previously for a par value system. We entered the markets at a multitude of different exchange rates. Once engaged, we constantly were moving the rate at which we were willing to trade in response to market forces. Not only did we have no intention of defending any particular level of the dollar, we went out of our way to behave so as not to enable others to misconstrue our actions as signifying that we were trying to establish even a temporary floor for the dollar or otherwise to interfere with a long-term trend in dollar rates. Measuring the results of these operations against their objectives, there were three types of outcomes: Some were successful, some failed totally (in part because they were silly or misconceived at the outset), and some proved to have been constructive despite having failed to achieve the immediate exchange market objective. Of the three possible outcomes, it was this last category that was the most difficult for me. Why? Because these were the times when the Desk’s officers had to go back to Washington and, basically, tell the principals at the Treasury and Federal Reserve that more policy review was needed. Messengers of bad news are never popular. Still, I came to believe that this was an important role for intervention. Indeed, I ended the decade thinking of intervention as a two-way communication device: Sometimes the authorities used intervention to communicate policy intentions to market participants, and sometimes market participants used it to communicate to policy makers the policy prerequisites as they saw them. Though person- 41 ally painful, I believed that the adjustment process was becoming more efficient through this device. What at the beginning of the 1970s took months, waiting for data to be published that would show that the economy had been out of balance and that we should have done something about it at the time, was now getting done in a matter of a few weeks of repeatedly unrewarding intervention operations. That was progress. Are These Lessons Useful Today? How much of the experience of the 1970s is relevant for today is hard to assess. Although there are similarities between the 1970s and today, there also are important differences. The traumas of the late 1970s spawned a yearning for change—change that would eliminate the dislocations of high and rapidly accelerating inflation and change that would restore a sense among Americans that we were in control of our country’s destiny once again. Largely as a result of the U.S. stabilization efforts of the 1980s, inflation rates here decelerated, and inflation, as conventionally measured, stayed relatively low, not only during periods of cyclical weakness but also during periods of expansion. Until just recently, standard expectations of inflation settled in around levels comfortably consistent with price stability. The exchange rate remains an important economic variable, but it does not carry, to the same degree as in the 1970s, the excess baggage of being a leading symbol of national success. The change in exchange rate arrangements has shifted much of the policy focus, at least within the developed countries, to monetary policy. The role of central banks and the extent to which the developed countries have accepted the premise that the central banks should be independent of their finance ministries for the conduct of monetary policy have made for quite a different policy environment than the one that existed in the 1970s. It is not coincidental that these central banks have come to express a target objective or expectation for domestic inflation. Meanwhile, the international cowboys of the financial markets have moved from foreign exchange to international bonds and hedge funds. In this environment, the long-term interest rate came to take on the burden of serving as a gauge of the effectiveness ofthe monetary authorities in delivering price stability, at least until the U.S. Treasury stopped issuing 30-year bonds a few years ago. With the more recent reduction in the supply of long bonds, technical market factors now are blunting the effectiveness of long-term rates to serve as an indicator of good monetary

42 policy performance in the United States. The prevalence of carry trade operations creates a demand for long-term paper in conditions that, in the past, would have required a substantial rise in interest rates to clear the market. Under these circumstances, we have not had as clear a signal of changing inflation expectations in the marketplace as we should, though to some extent prices of precious metals may be serving this function. With the Treasury announcing recently that it will again begin issuing 30-year paper again, I hope that long-term interest rates can revert back to the role they played in the 1990s. It is just a lot easier to muster political support to fight inflation when the market indicator of the effectiveness of monetary policy has a clear, “made-in-the-USA,” brand name. The U.S. authorities have not conducted foreign exchange market intervention in the way they did in the 1970s for some time. The New York Fed is still the agent for foreign exchange operations for both the Federal Reserve and the Treasury, but I am told that the Foreign Exchange Trading Desk as I knew it does not exist any more. According to published reports covering the periods through December 2004, the last foreign exchange market operation occurred in September 2000. Even when the authorities have intervened in recent times, they have done so in a limited way, with respect to both duration of the operation and tactics. Using the imagery earlier in this paper, I generally would characterize U.S. use of intervention as a one-way communication device. The authorities intervene rarely and, when they do, the purpose is to send a signal to the market that the authorities have a particular concern and that this is a concern that they may share with the authorities of other countries who are intervening at the same time. To the extent that there are “artificially maintained exchange rates” today, these exchange rates are being upheld by a totally new cast of characters—not the United States, not the Europeans, and not countries with whom the U.S. monetary authorities have, as in the past, longstanding and good working relationships. I mention this point because, in reading Martin Mayer’s The Fate of the Dollar (1980) in preparation for this conference, I was impressed by how lucky we were to have had in place individuals of talent, courage, and commitment to get us through the crises of the past. I am not sure that we will always be so endowed. Arguably, the size of any manipulation of exchange rates today could be more massive than before, as measured by the size of the economies involved and the movements in official reserves. There eventually will have to be some kind of accommodation or adjustment to this currency misalignment. How, when, and whether there will be a means to keep the adjustment process orderly: these are the issues that today’s policy makers

43 need to address. Meanwhile, the financial markets are far more developed today, have greater participation, and have offered to customers a variety of products that can be used to hedge exposures that, in the 1970s, could not be covered. The extent to which markets today can deal with the pressures of large and unexpected changes in circumstances depends on the robustness of these products and the ability of market participants on both sides of these transactions to understand them and to use them properly. Given the amount of innovation and the complexity of some of these transactions, there is room for concern about some type of market failure, just as there was before. As in the 1970s, the problems today are not all abroad. We have our own sources of dislocation, not the least of which is in the real estate sector—an apparent bubble attributable to a long period of monetary expansion. One way that our internal situation could lead to a result similar to that of the 1970s could be this: The internal source of imbalance in our economy expresses itself in a manner that the authorities do not expect and therefore do not recognize in time to take corrective action before the cost of adjustment becomes high. Another similarity could be that the political will to contain inflation is compromised by fear of the pain from fighting inflation. With the sharp rise in housing prices, the middle class today might feel that it has more of a piece of the action in an inflationary spiral than it did during the preceding decades. In the 1970s, the manifestation of imbalance happened to be the dollar’s exchange rate. The authorities thought they had “solved” the balance of payments problem, only to realize that they had not. Today in the United States, we believe that we have succeeded in fighting inflation. I am not sure that we can afford to be so complacent. Also, we cannot rely on hopes that the way any internal imbalance will manifest itself would come in ways that insure that we receive the message in time.

44 STRONG DOLLAR: THE TREASURY’S POLICY IN THE 1990s Karin Lissakers*

would like to talk about the strong dollar policy in the 1990s, which of course means the Clinton Administration era. I believe that the first Iunambiguous signal from the new administration that it intended to adopt an exchange rate policy stance different from its predecessor’s came in the summer of 1994, when Under Secretary of the Treasury Lawrence Summers testified to a congressional committee that “The Administration believes that a strengthening of the dollar against the yen and the mark would have important economic benefits for the United States. It would restore confidence in financial markets, but it also is important to sustaining recovery. It would boost the attractiveness of United States assets and the incentive for longer-term investment in the economy, and it would help to keep inflation low. In addition, we believe—and this view is shared by other G-7 countries—a renewed decline of the dollar would be counterpro- ductive to global recovery.”1 The day before Summers’ testimony, Federal Reserve Chairman Alan Greenspan had told the Congress that “evidences of weakness [in the United States currency is] neither good for the international financial system nor good for the American economy.”2 These carefully orchestrated, back-to-back statements marked a shift in U.S. Government policies vis-à- vis the dollar and the adoption of a strong dollar stance that would endure through the remainder of the Clinton Administration. The preceding period—especially from the late 1980s to the early 1990s—had been marked by extensive foreign exchange market turmoil, a blow-up in the European Exchange Rate Mechanism, frequent heavy and sometimes coordinated G-3 foreign exchange market intervention as well as unilateral exchange market intervention, involving both the U.S. and other foreign monetary authorities. Throughout this period, there had been a shifting U.S. stance and mixed signals on the dollar. Going into the presidential election year, the dollar continued to be weak, prompting the Treasury to intervene to prop it up in the summer of 1992 in order to “show the flag.” The Fed, however, was easing monetary policy going into the autumn in order to help the economic recovery.

* The views expressed here are entirely my own and do not necessarily represent the views of my employer, the Soros organization. They are based solely on the basis of my experience with the International Monetary Fund (IMF) and my participation in the Clinton Administration as U.S. Executive Director for the IMF. 45 After the election, the Clinton Administration’s strong dollar policy was not adopted immediately; quite the contrary. Views on exchange rate policy were quite divided initially on the Clinton economic team, and the divi- sions showed publicly. Some cabinet members and certain members of the Council of Economic Advisers (CEA) initially favored currency depreciation to help jobs and exports. Secretary of the Treasury Lloyd Bentsen said publicly at one point that a weaker dollar might help exports—something he later said that he greatly regretted. And the President weighed in, too, commenting occasionally on the dollar and triggering hiccups in the exchange markets. Beginning of the Strong Dollar Policy The Administration’s first interventions in the second quarter of 1993, purchasing dollars against the yen, did not change market perceptions of the Administration’s “weak dollar” bias. However, the two dominant Ex- ecutive Branch economic figures of the Clinton era, Treasury Secretaries Robert Rubin (1995-1999) and Larry Summers (1999-2001), did not believe that a weak dollar was good for the U.S. economy or helpful to the global recovery, which was barely getting started in 1993—and neither did the Fed. But it took time for the strong dollar school to take control and even longer for the dollar to strengthen. The struggle over exchange rate policy brought to the fore the attitudes, personalities, and coalitions that helped shape much of the Clinton era’s economic program. In my observation, that program emerged from four main factors: first, a strong concern for and sensitivity to financial market reactions, to policy and policy statements, and particularly to the behavior of the bond markets; second, the weight given to international economic developments and very close cooperation and collaboration with the other G-7 financial authorities; third, development of a very close working relationship between the Treasury Department and the chairman of the Federal Reserve, Alan Greenspan; and fourth, Bob Rubin’s and Larry Summers’s superior skills in the “inside Washington” turf battles and power brokering. Regarding the bond market, Robert Rubin, the former managing partner of Goldman Sachs and the principal campaign advisor to candidate Bill Clinton on economic policy, initially served as director of the National Economic Council (NEC), newly created to coordinate economic policy the same way that the National Security Council is supposed to coordinate foreign policy for the White House. Nevertheless, Rubin’s market experience and analysis carried great weight in the internal economic policy debates from the beginning. The first big challenge facing the new Admin- istration was how to stimulate the economy while simultaneously tackling the Republican legacy of a whopping budget deficit. And the budget defi- 46 cit was supposed to be reduced while also trying to deliver tax cuts and other domestic spending programs promised during the campaign. A consensus developed on the economic team that the budget deficit had to be tackled first. The Rubin argument—strongly supported by Greenspan—about the behavior of the bond market and interest rates was seminal in bringing the Keynesians among the advisors and the main economic policy team on board for a big deficit reduction package. That is, Rubin believed that reducing deficits would increase market confidence and thereby bring down long-term interest rates. The Fed weighed in with an economic model and an analysis that projected a reduction of one-tenth of one percentage point in long-term interest rates for each $10 billion of annual deficit reduction. Rubin writes in his recent autobiography that “We thought that lower- ing the deficit and bringing down long-term interest rates should have an expansionary effect that would more than offset the contractionary Keyne- sian effect. And that conversely, the expansionary effects of continued large deficits would be more than offset by the adverse impact on interest rates.” Lower interest rates would do more to spur consumers to spend and businesses to invest. The international aspect also played into this analysis. Rubin states that “In Japan, Europe, and the Middle East, as well as in the United States, investors would increase their demand for dollar-denominated bonds if they believed that a sound fiscal pattern was going to be re- established.” He adds, “And that our focus was the international bond market rather than just the U.S. market was a sign of how far the globalization of financial markets had already come by 1993.”3 In the event, the first Clinton budget (proposed in 1993) laid out a $500 billion multi-year deficit reduction plan—half in spending cuts and half in tax increases. The strong dollar policy, which was adopted the following year, was a logical corollary to the deficit reduction strategy in its underlying goal of restoring market confidence and bringing down interest rates. By the early 1990s, net investment inflows into the United States were significant, nearly $100 billion dollars in 1993, but those look pretty mod- est by today’s standards. These foreign flows into U.S. Government bonds, corporate bonds, and equities in fact had declined sharply during the 1990- 1991 slump. The Clinton Administration believed that a weak dollar policy would scare away foreign investors, with an adverse impact on U.S. interest rates and the recovery. Summers, in his 1994 testimony mentioned above, stressed that a stronger dollar would boost the attractiveness of U.S. assets to foreign investors. Rubin’s autobiography says very clearly, as did Clinton Administration officials at the time, that they did not believe that a given dollar exchange 47 rate should be a policy goal per se. Economic fundamentals determine the exchange rate, at least over time, and policy should focus on strengthening economic performance overall and on sound government finances. Never- theless, he states, “A strong currency means that American consumers and businesses can buy imported goods and services more cheaply and that inflation and interest rates will tend to be lower.” Rubin and Summers rejected outright the notion that a weak dollar would stimulate U.S. exports. Improved productivity and a higher savings rate were the keys to an improved balance of trade, they believed, and a stronger dollar actually would put pressure on U.S. industry to improve productivity. The lagging European and global recoveries also were factors weighing on the dollar discussions. The first year of the Clinton Administration, the advanced economies grew only about 1.4 percent. The European Union actually was in recession, and Japanese growth was weak (up 1.1 percent). The U.S. economy was growing a tepid 2.7 percent, and the economies in transition, which were not economically significant but were politically important, were falling off a cliff. The fact is that, for all the G-7 and IMF rhetoric in 1993 and throughout the 1990s, as I experienced that rhetoric about the need for domestic economic stimulus and domestic demand-led growth in Europe and Japan, the rest of the world continued to look to the U.S. market to provide the stimulus to the rest of the world. A weak dollar thus was cause for great anxiety in the rest of the G-7 and was not seen as helpful to the global recovery. Both Summers and Greenspan in their 1994 statements above stressed the international aspect of economic policy as a motivation for favoring a stronger dollar. It was no accident that their congressional testimony took place around the time of Clinton’s second G-7 economic summit. Of course the dollar did not recover immediately, and long-term interest rates did not decline, despite the fact that Clinton delivered big on his promise of fiscal deficit reduction and that the economy began to recover. The Strong Dollar Takes Off The dollar continued to weaken into mid-1995, and complaints about the failures of U.S. policies reached a crescendo in 1994-1995. The Econo- mist magazine opined that the dollar’s persistent weakness was caused by America’s bad habits, mainly a lack of savings and stubborn budget deficits. Steve Hanke, an economics professor and Forbes magazine colum- nist, said that private investors were growing reluctant to fund our current account deficit. Now, it’s worth pointing out that the U.S. current account deficit in 1993 was trivial by today’s standards, only 1.2 percent of GDP, and was only slightly larger at 1.7 percent of GDP in 1994. And the U.S. budget deficit already was on a steady decline. The fact is that only Ger- 48 many and Japan, temporarily, had smaller fiscal deficits than the United States among the G-7 countries. France, Italy, the United Kingdom, and Canada all had much bigger fiscal problems than the United States in this period. It also is worth noting that the effort to bring sound finances and international credibility to U.S. policy was carried out against the backdrop of serial international financial crises in the 1990s, beginning with the tesobono [dollar-linked Mexican treasury bonds] collapse in Mexico and ending in Russian default and the Brazilian crisis in the second half of 1998 and early 1999. The high-risk, massive U.S. financial package for Mexico in 1995 arguably had a negative effect on the dollar’s standing at that time. The long-term interest rate in the U.S. bond market remained sticky and comparatively high. Rubin confesses in his book that perhaps the link between fiscal discipline and, by extension, a strong dollar on one side and long-term interest rates and investor behavior on the other side is less direct than he and the other principal Clinton advisors assumed when they prepared the first deficit reduction strategy in 1993. He says that, in retrospect, the effect of the Clinton economic plan on business and consumer confidence may have been more important than the effect on interest rates. Maintaining the Strong Dollar When the dollar finally began to rally in the late summer of 1995, the Treasury, supported by European and Japanese central banks, intervened to buy dollars, reinforcing the upward trend and sending a strong policy signal to markets. Please bear in mind that U.S. intervention of any kind was rare at that point. From then on the dollar marched onward and upward, with only one significant retreat after the Russian default and the collapse soon after of Long-Term Capital Management in the third quarter of 1998. The strong dollar mantra from the Treasury, “The strong dollar is in our national interest,” soon became a joke in the international financial press. Journalists played the Greek chorus in the Treasury Secretary’s regular, pre-World Bank/IMF annual meeting briefings, chanting the mantra before the Secretary could answer the standard dollar question. Part of the success of selling and maintaining the strong dollar policy was the primacy in economic matters that the Treasury managed to establish early in the Clinton I Administration. Just as George W. Bush has had a Pentagon- dominated cabinet, so Clinton II quickly became a Treasury-dominated cabinet, with the NEC and the CEA becoming secondary players. I believe that the Treasury’s standing was enhanced by the close working relation-

49 ship that first Rubin and then Summers developed with Alan Greenspan, who was assuming legendary status in the world of central banking. With policy primacy came discipline, which extended to dollar policy. After the first period when there were many official voices speaking on the dollar—thereby spreading confusion in the markets—Rubin wrung a commitment from the White House that no one, other than the Secretary of the Treasury or possibly the Under Secretary, was allowed to say anything at all about the dollar—nothing. Not even the President. In fact, President Clinton joked at Rubin’s farewell party in 1999 that perhaps Secretary Rubin’s greatest single accomplishment was to instill discipline on the dollar commentary. Even he, Clinton, the man of many words and free flowing public discourse, had obeyed that rule to the very end of his two terms. The succeeding Bush Administration, I note, did not immediately take this lesson to heart. President Bush spoke about the dollar early on in 2001, and Rubin’s successor at the Treasury, Paul O’Neill, had to beat a hasty retreat after ruminating in public about a weaker exchange rate perhaps not being all bad. He later tried to recover by declaring famously that if he meant to change the dollar policy, he would rent Yankee Stadium and make a public announcement so that everybody would know it. Now for all the talk, there was very little intervention during the Clinton years. Edwin M. Truman, Assistant Secretary of the Treasury for Interna- tional Affairs, 1998-2001, has pointed out that there were open market operations in foreign exchange on only 22 days of the eight years of the Clinton Administration, and only two such interventions after August 1995. Instead, words and, more importantly, supportive policies provided the primary underpinnings for the dollar. The whole purpose of the discourse on the dollar and the repeated declarations about the Treasury’s commitment to a strong dollar was foremost—especially in the beginning—to make clear that the new administration would not encourage dollar depreciation to stimulate exports and jobs. And second, from Rubin’s and Summers’s points of view, they intended to “take the dollar off the table” as an economic policy instrument. Rubin shifted from an occasional call by Summers for a stronger dollar to a statement that a strong dollar was good, indicating neutrality on exchange rates. The basic Clinton policy, says Truman, actually was non-intervention.4 Preparing to Allow the Dollar to Weaken Eventually the time came, in the late 1990s, when the Treasury and the other G-7 finance ministers became convinced that the dollar either already was or was becoming overvalued—at least that the other major currencies were overshooting in the other direction. At one point, the Treasury crafted a carefully worded adjustment in the standard dollar man- 50 tra, which the Secretary used in a briefing to the national press corps. He said, “A strong dollar is in our national interest,” but this time he added, “and we have had a strong dollar for some time now.” I can tell you that I knew firsthand that this little nuanced addition was debated very extensively in the Treasury and was framed carefully. In fact, it elicited just the desired interpretation from the press: that the U.S. Government would not be unhappy to see the dollar weaken somewhat, but that it was not aban- doning the basic strong dollar view.5 In fact, in September 2000, when the euro had depreciated by almost thirty percent from its 1998 opening rate against the dollar, the Treasury very reluctantly yielded to pleas from Europe to engage in joint currency market intervention, selling dollars and buying euros. However, the ac- companying statement from the Treasury emphasized that this was not a unilateral U.S. action taken for its own benefit but was in response to external demands. The action came “at the initiative of European central banks,” said Treasury. And Larry Summers—the same day—told the press (he was by then the Treasury Secretary), “Our policy on the dollar is unchanged; as I have said many times, a strong dollar is in the national interest of the United States.” Was the Strong Dollar Good for America? For the World? This mantra, which was spoken consistently through at least the last seven years of the Clinton Administration, was it true? Was the strong dollar good for America and good for the global economy? Certainly the strengthening of the dollar was associated with and accompanied by a greater market confidence, a strong demand for U.S. assets, a long-term investment boom, low inflation, and global recovery, just as Summers had postulated in 1994. But I think that it also is fair to say that the strong dollar was more a consequence than the cause. Also, in retrospect, the strength of the dollar masked trouble brewing. The current account, from 1999 on, started its worrisome expansion, and eventually the economic boom and the investment boom became the bust. But I have to say that I do not think that one can blame the bust on the Treasury’s support for the dollar or statements of belief in the benefits of a strong dollar. I think the problem rests more at the Fed’s door in its failure then—and perhaps now—to react in time to a huge asset-price inflation.

51 Endnotes 1 Lawrence Summers, Under Secretary of the Treasury for International Affairs, “Global Economic Situation,” Testimony before U.S. Senate, Com- mittee on Banking, Housing, and Urban Affairs, 103rd Congress, 2nd Ses- sion, July 21, 1994. 2 See, Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, “Statement,” U.S. Senate, Committee on Banking, Hous- ing, and Urban Affairs, 103rd Congress, 2nd Session, July 20, 1994, in Federal Reserve Bulletin, vol. 80, no. 9 (September 1994), pp. 793-799; Board of Governors, “Monetary Policy Report to the Congress,” July 20, 1994, in Federal Reserve Bulletin, vol. 80, no. 8 (August 1994), pp. 681- 701. 3 Robert E. Rubin and Jacob Weisberg, In an Uncertain World: Tough Choices from Wall Street to Washington, New York, NY: Random House (2003). 4 Edwin M. Truman, “The Limits of Exchange Market Intervention,” in C. Fred Bergsten and John Williamson, eds., Dollar Overvaluation and the World Economy, Washington, DC: Institute for International Economics (2003). 5 Rubin and Weisberg, note 3 above, p. 184.

52 WHAT THE CLASSICAL ECONOMISTS TAUGHT US ABOUT FOREIGN EXCHANGE John H. Wood

do not propose a return to the gold standard as a solution to the current problems of the dollar because it is not on the political horizon. The Imonetary system is a political decision. Politicians are not free agents, however, and it could be useful to consider what we are missing—which is a lot. Let me begin, as in all genuine examinations of economic behavior, with objectives and constraints, with incentives and knowledge. Econo- mists of all stripes agree that central bankers have behaved badly, and their reason is always the same: “They don’t use my model.” Monetarists object for one reason; Keynesians for another. However, all these groups reason- ably could be asked, “Why should they use your model, or any particular model?” What are their objectives? What are their constraints, their incentives, their information? All these inputs are known—and must be known or assumed—in all modeling studies of the behavior of private agents. This is not so with government agencies, which are given tasks that are unconnected with the incentives of their officials. We need to remember that an incentive or constraint does not deserve the name unless it “matters”; that is, unless its violation hurts. The absence of incentives is especially important to the unpredictability of the Federal Reserve because it is unconstrained even by the budgets (congressional allocations) that limit other government agencies. The Fed can print as much or as little money as it likes. It is confronted by no economic or technical constraint correspond- ing to the production functions and earning abilities of firms and consumers. The Fed’s founders saw it as an “altruistic institution.” It was free of “interests” and “acquisitiveness,” Representative Carter Glass (D-VA) de- clared on the floor of the House of Representatives in 1913. There are no obvious connections between the Fed’s performance and the rewards of its officials. The Lender of Last Resort Problem These incentive problems were not solved before the Fed’s creation (they never are completely solved), but they were addressed. Consider the concept of the lender of last resort (LLR), a term that is bandied about today with a meaning so far removed from that of the 19th century that it does not deserve the name. It was not meant as a bailout, although it still raised problems that the responsible authorities were unwilling to assume. Walter Bagehot urged the central bank to increase its reserve and make

53 clear to “the public that since the Bank [of England] hold our ultimate banking reserve, they will recognize and act on the obligations which this implies; that they will…lend it in times of internal panic as freely and readily as plain principles of banking require.”1 This was Bagehot’s rebut- tal to the Bank’s rejection of an earlier version of his recommendation. Thomson Hankey, a director and former governor of the Bank, had called Bagehot’s LLR notion “the most mischievous doctrine ever broached in the monetary or banking world in this country; viz., that it is the proper function of the Bank of England to keep money available at all times to supply the demands of bankers who have rendered their own assets un- available.”2 Contrary to the usual insinuation that Bagehot’s proposal became the normal practice of the Bank after 1873, the Bank never accepted it. When in 1891 the Chancellor of the Exchequer pressed the Bank for a larger reserve, the Governor replied that “the larger the Bank’s own reserves, the less the bankers like to keep their money unused.”3 In the post-Keynesian world, Nobel prizes are awarded for “discoveries” of concepts that were commonplace in previous generations. This does not diminish the validity of Kydland and Prescott’s “Time Inconsistency of Optimal Plans” (1977), but the concept is without practical implications for policymakers who will not bear the costs of current excesses. The directors/stockholders of the private Bank of England under the gold standard faced a genuine problem in deciding how far to assist the financial system. This is not true of public officials with access to the printing press. Who would not help a friend in need if money grew on trees (which it does) and refusal might be politically or publicly embarrassing? The costs are all on one side. Must the Unsustainable Thing Finally Stop? Journalistic warnings of looming though inexplicable disasters have always been with us. The recommendation that the Bank of England hold a large reserve in the event of massive withdrawals reminded the British banker and politician Samuel Jones Loyd of “the man who, because he had accumulated an unusual quantity of water, thought he could therefore fill with it a tub which had lost its bottom,” rather than “taking measures for putting a bottom to its tub” by means of a credibly prudent policy.4 Large reserves can disappear very quickly in financial markets, which are highly sensitive to expected returns. The credibility of its policies was essential to the profits and even the survival of the 19th-century Bank. Its directors knew that their policies were understood by markets which acted upon them. The Bank had learned that not everyone could be fooled all the time. Rational expectations also had to be restated in the next century. In 1848, John Stuart Mill pointed out that those who

54 maintained that a rise of prices produced by an increase of paper currency stimulates every producer to his utmost exertions, and brings all the capital and labor of the country into complete employment [assumed the] prolongation of what would in fact be a delusion; contriving matters so that by a progressive rise of money prices every producer shall always seem to be in the very act of obtaining an increased remuneration which he never, in reality, does obtain. It is unnecessary to advert to any other of the objections to this plan than that of its total impracticability. It calculates on finding the whole world persisting for ever in the belief that more pieces of paper are more riches, and never discovering that, with all their paper, they cannot buy more of anything than before.5 At the end of the 19th century, economist Knut Wicksell wrote: Those people who prefer a continually upward moving to a stationary price level forcibly remind one of those who purposely keep their watches a little fast so as to be more certain of catching their trains. But to achieve their purpose they must not be conscious . . . of the fact that their watches are fast; otherwise they become accustomed to take the extra few minutes into account and so after all, in spite of their artfulness, arrive too late.6 Fiat-money central bankers have no reason to care what people think. They have recently adapted to the public’s revulsion against inflation. However, as far as their constraints and incentives are concerned, they would be just as happy, as they have demonstrated in the past, to monetize (inflate away) fiscal deficits. One need not pay attention to economic relations if he is free of them. It is incorrect to say that what happened in the 1960s and 1970s will not happen again because we have learned what caused inflation. We have known the cause of inflation for hundreds of years. Its realization has been due to fluctuations in political pressures, which I am afraid we do not know how to control. American Historical Experience with a Stable Exchange Rate It is not always remembered that the long period of American economic growth during the eight decades preceding 1914 occurred without the offices of a central bank. Money was under the direct control of Congress, subject to the gold standard. Congress has been accused of fiscal irrespon- sibility, but the public does not like inflation, and the absence of an institution such as a central bank interposed between voters and their representatives may be conducive to an efficient monetary policy; that is, to a closer connection between goals and actions, not only regarding monetary policy but finance in general. The gold standard’s delivery of long-run price stability is well known, but its contributions to efficiency may be equally important. The credibility of the convertibility of the currency on fixed terms cannot survive blank 55 checks like deposit and pension insurance or the unbridled promises of social security, medical care, and international bailouts. Concluding Observations on Inflation Targeting Inflation targets also have important deficiencies relative to the gold standard. Although low inflation is certainly an improvement on the high and fluctuating inflation policies of the 1960s and 1970s, as a target, low inflation is more rigid and less conducive to growth than the gold standard. The credibility that is an essential part of the gold standard allows prices to vary with levels of demand and desired money holdings. For example, the bank finance of Joseph Schumpeter’s (1911) waves of innovation permit- ted aggregate price movements and enabled growth. Modern inflation targets are very imperfect substitutes for the gold standard. We tie the central bank to a number because we don’t trust it. Every day is a crisis, or potential crisis, with an inflation-targeting central bank because we do not know what it will do. The tie is as invisible as the emperor’s clothes. Any deviation from the assigned target justifies our fears and unleashes our expectations. The range of possibilities would be greatly reduced by the gold standard, which also would relieve us of the impossible tasks of choosing and measuring the right price level and money stock, as well as exchange rate wars and futile efforts to manipulate exchange rates. In recent years, the Fed has aimed at a credible low-inflation policy while reeling between Mexican, Asian, and other international and domestic bailouts. This is an unsustainable combination of policies, but with neither rudder nor anchor, neither guide nor constraint, we cannot guess the Fed’s behavior or therefore the future of the dollar.

56 References Bagehot, Walter. Lombard Street: A Description of the Money Market. London, UK: Henry King, 1873. Bagehot, Walter. “What a Panic Is and How It Might be Mitigated,” Econo- mist (May 12, 1866), pp. 554-555. Clapham, J.H. The Bank of England: A History. Cambridge, UK: Cam- bridge University Press, 1944. Gregory, T.E., ed. Select Statutes, Documents and Reports Relating to British Banking, 1832-1928. Oxford, UK: Oxford University Press, 1929. Hankey, Thomson. The Principles of Banking, Its Utility and Economy; with Remarks on the Working and Management of the Bank of En- gland. London, UK: Effingham Wilson, 1867. Kydland, Finn, and Prescott, Edward C. “Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy, vol. 85 (June 1977), pp. 473-490. Loyd, Samuel Jones (Lord Overstone). Remarks on the Management of the Circulation, and on the Condition and Conduct of the Bank of England and of the Country Issuers during the Year 1839. London, UK: Pelham Richardson, 1840. Mill, John Stuart. Principles of Political Economy with Some of Their Applications to Social Philosophy, 7 eds., 1848-1871, with introduc- tion by W. J. Ashley. London, UK: Longmans, Green. Schumpeter, Joseph A. The Theory of Economic Development (1911), translated by Redvers Opie. Cambridge, MA: Harvard Economic Stud- ies, 1934. Wicksell, Knut. Interest and Prices (1898), translated by R.F. Kahn. Lon- don, UK: Royal Economic Society, 1936. Wood, John H. A History of Central Banking in Great Britain and the United States. Cambridge, UK: Cambridge University Press, 2005.

57 Endnotes 1 Bagehot (1873), p. 71. 2 This passage in Hankey’s Principles of Banking (1867), p. 25, was a response to Bagehot’s article in The Economist after the crisis of 1866. Representatives of the Bank had made the same point previously. In 1841, George Warde Norman testified to a parliamentary committee of inquiry that “the public have always looked to the Bank for assistance [in time of pressure] with too much confidence, and entertained what I consider exag- gerated views as to the means and duties of the Bank.” “Do you conceive that parties have been induced to neglect precautions which they otherwise would have taken in consequence of their reliance upon that assistance…?” the chairman asked. “I have no positive means of knowing; but I should think so,” Norman answered. Report of the Select Committee on Banks of Issue (1841), Q1770, in Gregory (1929). 3 Clapham (1944), pp. 344-345. 4 Loyd (1840), pp. 42, 51. Bagehot was not the first to advocate a large reserve (see, Wood 2005, chapters 4-5). 5 Mill (1848), Book 3, chapter 13, section 4. 6 Wicksell (1898), pp. 3-4.

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