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Note: This paper was prepared for a session on "Implications for the IMF's Role in Surveillance and Policy Coordination" of the Roundtable on International Economic Cooperation for a Balanced World Economy convened by the Reinventing Bretton Woods Committee, the Chinese Ministry of Finance, the People's Bank of China, and the World Economic Forum held in Chongqing, March 12-13, 2005. The author is indebted to his colleague C. Randall Henning for helpful comments on a previous draft.
International economic policy coordination is an idea that is not nowadays at the top of the international agenda. The usual idea these days is that if each country pursues its own national interests, then the world will do as well as possible: There are no exploitable bargains of the type "it will pay [both][all] of us to change policies simultaneously even though if one of us made the change individually we would suffer" available. Even if there are no opportunities of that type (let us call them type A) available, there might still in principle be the chance of gaining by subscribing to a set of rules: Country X might expect to gain more over time from countries Y and Z respecting the rules than it would lose at other times from being obliged to modify its behavior according to the rules. Let us call these type B gains.
Even neglecting the possibility of type B gains (which were the essence of the Miller-Williamson "blueprint" for policy coordination, see Miller and Williamson 1987), I would argue that there are two type A gains that are potentially available at the present time. One of these is in achieving an appreciation of the East Asian currencies relative to the US dollar without inappropriate disturbance of intra-Asian exchange rate relationships. The other is in achieving what is now referred to as a "rebalancing" of world demand, in which American demand was cut at the same time as demand in the rest of the world was stimulated so that the US balance of payments deficit could be corrected without a world recession as part of the process. Both are going to be needed if the US balance of payments deficit is to be cut to something that may be sustainable without traumatic disruption of the world economy.
An East Asian Realignment
It is widely, though doubtless not universally, agreed that the further additional dollar depreciation that is needed to secure a reasonable measure of adjustment of the US balance of payments deficit has to be primarily against the Asian currencies. The euro, the Anglo-Saxon currencies, and even most of the currencies of Latin America have already experienced significant bilateral nominal and real appreciations against the dollar, and somewhat smaller effective appreciations. In contrast, most of the Asian currencies have appreciated relatively little (or even remained constant) bilaterally against the dollar, and even where they have appreciated bilaterally they have almost all (the exception being the Korean won) depreciated in effective terms. This has occurred despite the fact that almost all except Vietnam are running substantial surpluses on current account, on the basic balance, and on the overall balance (see table 1). Arguments have been advanced for maintaining highly undervalued exchange rates as a tool of export-led growth in order to drive development and the absorption of surplus labor (Dooley, Folkerts-Landau, and Garber 2003), but this analysis omits the possibility of using the resources being locked up in low-yielding reserves in order to increase consumption or investment. It is a pure demand-side analysis; Keynesianism of the crudest type, which sees virtues in digging holes and filling them up again simply because it will increase demand. These countries have better ways of stimulating demand than to export more than they import and pile up reserves that will almost certainly have a negative real yield in terms of their own consumption bundle.
Yet there is a serious problem that could rationally deter an individual Asian country from revaluing its currency. This is that there is a great deal of interchange among the Asian countries, much of which is predicated on maintaining a stable pattern of exchange rates between these countries. Up to now the way in which the Asian countries have maintained appropriate exchange rates among themselves is by using the US dollar as the common anchor currency. Any country that allows an appreciation of its currency while other Asian currencies remain unchanged risks a loss of competitiveness not just against the outside world but also against its Asian peers.
In this interpretation, what is deterring an Asian appreciation is not pursuit of export-led growth (whether this is rational or irrational), but a classic collective action problem. The way to resolve a collective action problem is for the participants to talk about the issue among themselves. The fact that it happens to be what we earlier called a type A opportunity for policy coordination should simplify assembling a winning coalition.
In the past I have argued that the obvious solution to this problem is for all the countries involved to adopt a common basket peg (e.g. Williamson 2000, especially appendix 2). This would avoid their exchange rates becoming over or undervalued as a capricious result of changes in the exchange rates between the dollar, the euro, and the yen, while avoiding their gaining or losing competitiveness vis-à-vis one another. As a long-term solution, I believe this analysis remains correct: It is a tragedy in retrospect that this system was not adopted in 2002, before the dollar's depreciation. In particular, the competing proposal of JPMorgan to tie emerging Asian currencies together in a regional bloc analogous to the ERM (Suttle and Fernandez 2005) seems to me to suffer from a critical problem that is dismissed by its authors: that the envisaged bloc lacks a center country capable of playing the role of nominal anchor as Germany did in the ERM. It is possible, perhaps likely, that China will in due course emerge as a power capable of playing this role, but one may doubt if other countries yet have the necessary confidence in China's monetary stability, given its need to clean up the banking system so as to obviate the threat of a monetary crisis.
However, there is now an additional problem that could not be resolved simply by adoption of a common basket peg (or by creating an Asian version of the ERM), namely the currency disequilibrium that involves undervaluation of all the Asian currencies against all the non-Asian currencies. Correcting this without an inflationary surge in Asia is bound to involve a revaluation of the Asian currencies. It is this that I believe demands conscious policy coordination, so that none of the countries need feel that it has unduly lost competitiveness vis-à-vis its neighbors. The following steps would be involved:
- Explicit or at least implicit agreement on the body that is to be responsible for organizing the concerted exchange rate realignment. The obvious extraregional candidate is the International Monetary Fund (IMF). (However, the IMF's failure to fulfill this role up to now leaves the field wide open for a regional competitor.) A major advantage of using the IMF for this purpose is that it would not be necessary to announce in public an agreement to proceed before the coordinator could set to work. (Any public announcement would inevitably provoke major speculative tensions.)
- An agreement on the principles that would underlie the calculation of a set of equilibrium exchange rates, and thus of the changes in exchange rates that would be needed to achieve the new rates. In my own work (e.g. Williamson 1994) I have argued that countries should aim for current accounts that match sustainable capital flows; one reasonable interpretation of this is that countries should target a basic balance of zero (or a small positive trend increase in reserves). The IMF calls this "the underlying balances approach".
- Agreement on the actual set of figures that would be used as current account targets in the analysis just described. I discussed the nature of such payments objectives in Bergsten and Williamson (2004, chapter 2), where I argued that there is ample scope for identifying the counterpart to the needed improvement in the US current account without compromising the interests of other countries.
- Calculation of the set of rates that would achieve the specified balance of payments targets when the economies are all at "internal balance". This will require access to a reasonably sophisticated macroeconometric model that covers individually all the East Asian currency areas that might be involved in a realignment. (The best such exercise of which I am aware is Cline 2005. Perhaps surprisingly, he concluded that China's bilateral appreciation against the dollar would be median for the countries of East Asia, rather than larger than all others. Of course, all East Asian countries' effective appreciations would be much smaller than their bilateral appreciations against the dollar. That is the attraction of a concerted move.)
- A simultaneous realignment undertaken over an agreed weekend by all the participating countries.
Even after the initial realignment has been accomplished, the IMF should focus its surveillance on the evolution of balance of payments positions and levels of internal demand. The objective would be to ensure that current account positions evolve along the expected lines, and that all countries maintain appropriate levels of demand so that payments adjustment does not jeopardize prosperity.
Rebalancing World Demand
As the last remark implies, achieving adjustment of the US balance of payments while maintaining world prosperity is going to require not just changes in exchange rates but complementary changes in the generation of world demand. This is going to need demand restraint in the United States, which most economists believe would be best accomplished by tightening fiscal policy. Given the reluctance of the Bush administration to admit that there is a need for actions beyond those that have already been announced (which will supposedly halve the fiscal deficit by 2008), it seems all too likely that the needed demand restraint will only be applied as inflation accelerates, by the Fed rather than the Treasury. This implies that it is likely to happen undesirably late, and with the possibility of an attenuated impact on the current account.
Be that as it may, the other half of the desirable rebalancing of world demand consists of an expansion of demand in the rest of the world. For some years Japan has faced real difficulties in stimulating demand, while Europe has (at least in the view of some of us) badly prioritized the competing objectives of controlling inflation and stimulating demand. Policy coordination will need to focus on helping those countries to find ways around their difficulties, for example by helping nurture financial innovations in Japan and Europe that would enable the elderly to consume closer to their lifetime income over the course of the life-cycle. At the same time, the developing countries face a psychological problem: that those economists (like me) who urged them to pursue a policy of export-led growth have succeeded too well. Many developing countries nowadays think of export-led growth as implying a current account surplus, rather than the pattern in several East Asian countries (Indonesia, Malaysia, and Thailand) prior to 1997 in which success in developing exports made countries creditworthy and so enabled them to borrow to finance a current account deficit. One needs to ask which strategy is more likely to raise intertemporal welfare. Once a country has amassed sufficient reserves to rule out the possibility of a crisis, it is better to absorb all the resources potentially available in domestic demand rather than make low-yield investments in US Treasury securities.
Concluding Remarks
Policy coordination ought at this juncture to be directed overwhelmingly at securing an adjustment of the US balance of payments deficit without the world economic crisis that seems all too likely on present trends. As the textbooks tell us, adjustment requires both expenditure-changing policies (expenditure-reducing policies in the deficit countries and expenditure-increasing policies in the surplus ones) and expenditure-switching policies (nominal appreciations of the currencies of the surplus countries and depreciations in the deficit countries). Policy coordination should focus on both issues. That requires both securing complementary changes in demand and a concerted realignment of those currencies (primarily the Asian ones) that have not yet adjusted to the new realities.
References
Bergsten, C. Fred, and John Williamson. 2004. Dollar Adjustment: How Far? Against What? Washington: Institute for International Economics.
Cline, William R. 2005 (forthcoming). The United States as a Debtor Nation: Risks and Policy Reform. Photocopy. Institute for International Economics, Washington.
Dooley, Michael P., David Folkerts-Landau, and Peter Garber. 2003. An Essay on the Revived Bretton Woods System . NBER Working Paper 9971. Cambridge, MA: National Bureau of Economic Research.
Miller, Marcus H., and John Williamson. 1987. Targets and Indicators: A Blueprint for the International Coordination of Economic Policy . Washington: Institute for International Economics.
Suttle, Philip, and David Fernandez. 2005. Emerging Asia's Monetary Future. New York: Economic Research of JP Morgan Chase Bank, January 27.
Williamson, John. 2000. Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option. Washington: Institute for International Economics.
Commentary Type