March 2004

Watch Growth, Not Exchange Rates By John H. Makin

The attention being paid to exchange rates and Fixed versus Flexible Exchange Rates to utterances about them by finance ministers and central bankers is misplaced. It is distracting The exchange-rate obsession, like that displayed policymakers from tending to more serious issues at the last G7 meeting in Boca Raton, is danger- such as global excess capacity and attendant ous in this unusual cycle. It really does not mat- risks. ter whether a country decides to pursue fixed or The emergence of as a source not just flexible exchange rates as long as it understands of rapid supply growth but also of rapid demand the rules. Few do. growth has provided some relief to countries A country that chooses to peg its in Asia and Europe that are currently relying value must allow its to be raised by almost exclusively on export growth to avoid a current account surplus and cut by a current recession, especially as the weakening dollar has account deficit. A country that allows its cur- blunted the growth of exports to the United rency to float freely retains control of its money Economic Outlook States—the world’s other growth engine. But supply by relinquishing control of exchange rates. China is a risky place. A policy misstep with Currency regimes, fixed or floating, depend shaky banks or a serious infrastructure bottle- on a number of features, and countries select—or neck could precipitate a bursting of a Chinese say they select—a regime on the basis of consid- bubble. Even if, as is more likely, China contin- eration of such as the size of the economy, its ues to grow, other global risks could be exacer- openness, and other factors. A relatively small, bated by a preoccupation with exchange rates. open economy like that of Canada, with close In the , the Federal Reserve is trading ties to the United States, faces consider- walking a fine line between keeping prices from able challenges regarding its currency regime. If falling and employment rising while simultane- its currency were pegged to the U.S. dollar, ously avoiding an asset bubble. If U.S. growth Canada would become the thirteenth Federal actually lives up to expectations and excess capac- Reserve district; in other words, its monetary ity is absorbed, the resultant much-anticipated policy would be determined by the Fed if Canada reflation will force the Fed to raise rates and intervened to peg its . Conse- disrupt the asset boom. Alternatively, and more quently, Canada has opted for some exchange- likely, if demand growth slows in the second half rate flexibility in order to maintain some of this year as stimulus is withdrawn, global defla- independence of its . tionary pressures will intensify. The need for Sterilization of the impact of intervention in exchange-rate flexibility will increase. So may the currency markets to peg an exchange rate is will to oppose it. an act of denial. If a non-sterilizing surplus coun- try resists currency appreciation by purchasing an excess supply, at a target exchange rate, of for- John H. Makin ([email protected]) is a resident scholar at AEI. eign exchange, that intervention in the currency

1150 Seventeenth Street, N.W., Washington, D.C. 20036 202.862.5800 www.aei.org - 2 - market boosts the money supply, pushes up prices, rapidly accelerating growth in China and the United reduces interest rates, and thereby cuts the surplus and States that is creating rising exports in Asia and Europe. the attendant upward pressure on the currency. The rising euro threatens sustained European growth of If that same country with a current account surplus exports going forward, so European policymakers should sterilizes currency intervention and does not allow a rise press further for a boost to domestic demand—perhaps by in the money supply or lower interest rates and higher lowering interest rates in the spring. In Japan, domestic prices to emerge, it prevents adjustments that would cut demand growth remains weak. Japan has elected to pur- the surplus. As a result, it is forced to chase U.S. securities at a rate of $250 bil- intervene again. Usually in such circum- lion per year, with that purchase rate rising stances (Japan is a classic example) the U.S. employment to an extraordinary $750 billion annual intervening country’s policymakers com- has begun to rise rate in January, to slow appreciation of its plain of “excessive volatility of exchange currency. That problem would end if rates” or “currency movements that do not modestly—by about Japan’s policymakers at the Bank of Japan reflect fundamentals.” They then march and the Ministry of Finance announced 70,000 per month in to G7 meetings and try to craft a state- jointly that sterilization would end, thereby ment complaining about exchange rates to the three months boosting Japan’s money supply massively cover their tracks in hopes of getting other and turning expectations of deflation into countries to adjust their policies in order ending in January, expectations of price stability and, yes, to relieve pressure on their currency. compared to an average even a little inflation. Exchange Rates and Global drop of 47,000 Why Aren’t Asia and Europe Excess Supply per month during Boosting Demand?

In a world of excess supply such as we are all of 2002. Why don’t the central banks of Asia now experiencing, no country wants a and Europe act to boost demand growth? stronger currency, U.S. statements to the One view has it that they fear an asset contrary notwithstanding. That is because countries with bubble—especially in the United States—will arise deflation and weakening employment (Japan) or with from further monetary easing. This is a legitimate fear, slowing growth (Europe), all of which are dependent on but it represents a wrong choice in a difficult situation. exports to China and the United States for continued The asset bubble argument states that keeping interest growth, want to shift demand toward their own producers rates low (the Federal Reserve’s approach) to stabilize of goods and services. falling prices and boost lagging employment also As it happens, the United States has an advantage encourages too much borrowing to finance purchases at this currency-weakening game, with a half a trillion- of riskier financial assets like low-grade corporate debt, dollar current account deficit that spews out $1.5 billion emerging market debt, and real estate. A building asset per day of dollar supply into global currency markets. bubble created by unusually narrow spreads between Beyond that, the U.S. has elected to hold risky assets and treasury securities creates a high degree interest rates very low in order to alleviate its own symp- of vulnerability to a rise in interest rates, which, in the toms of excess supply, intensifying deflation, and weak anticipated-asset-bubble view, must come when infla- employment growth. Indeed, U.S. stimulus efforts have tion finally picks up and central banks must tighten. started to show modest positive results. About 10 percent The possible asset bubble story is complicated by the of fourth-quarter demand growth was due to rising exter- emergence of China as a major economy growing at 10 nal demand, and U.S. employment has begun to rise percent a year, soaking up raw materials as well as modestly—by about 70,000 per month in the three sophisticated manufactured goods from Europe and months ending in January, compared to an average drop Asia as production platforms are relocated in that labor- of 47,000 per month during all of 2002. rich country. The urgency for European and Asian cen- Of course in a static world U.S. gains in demand growth tral banks to respond to the pressure from a weaker would come at the expense of losses in Asia and Europe. dollar with easier monetary policies is reduced since Fortunately, overall global growth is positive, thanks to exports to China from both regions are rising. - 3 -

The painful truth is that the alternative to risking might claim such a reaction would be painful but less an asset bubble—tighter monetary policy in the painful than the reaction that would follow in a year or United States—is even more dangerous than the so after a long-delayed tightening was forced by refla- asset-bubble risk itself. Those who advocate a tighter tion or higher growth. This need not be the outcome. monetary policy by the Fed claim that raising short- If, a year from now, Europe and Asia have boosted term interest rates by 100 or 200 basis points to around domestic demand and moved toward absorbing global 3 percent would, in effect, move those rates to “neu- excess capacity, and, as inflation stabilizes and starts to tral” while still being accommodative. rise while U.S. employment rises, a Fed This is a very risky claim. Suppose the tightening will make sense. But the boost Federal Reserve raises rates this spring, The painful truth is that to domestic demand in Europe will as “neutrality” advocates suggest. If the alternative to risking require letting interest rates fall there—a employment is rising, while inflation is constructive response to the message stable or rising, such a move would make an asset bubble—tighter from an ever-strengthening euro that sense. But with employment rising at monetary policy in the ECB monetary policy is too tight. And just 3,000 a month on average over the Japan needs to stop sterilizing its growing past twelve months and core inflation at United States—is even intervention in currency markets so that or below 1 percent, such a step is just too deflation is brought under control. Both more dangerous than the risky. Federal Reserve Chairman Green- areas need to focus on growth and forget span in effect said as much in his Febru- asset-bubble risk itself. about exchange rates. ary 11 Humphrey-Hawkins testimony to Meanwhile, we must hope that the Congress. U.S. expansion holds up and that there A premature tightening by the Fed would cause asset are no accidents in China before Europe and Asia refo- markets to plunge, while U.S. growth would slow cus on growth. Perhaps that is what Chairman rapidly, with negative consequences for growth in Greenspan and the Federal Open Market Committee China and the rest of the world. Neutrality advocates mean when they talk about “patience.”

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