Global Imbalances: Equilibrating Exchange Rates vs Quantity Controls

Can we find an equilibrium exchange rate system (e.g. fixed or floating) that might reduce global imbalances or should we rely on penalties, caps or liquidity provisions to create sustainable balance of payments.

For example at the Oct. 22, 2010 G20 summit, Timothy Geithner argued that reducing current account imbalances would strengthen global growth and make it more likely to last. The U.S. pushed to commit each Group of 20 nations to keep its surplus or deficit to less than 4 percent of gross domestic product.  But the manner in which this was to be achieved offered little change from previous measures amounting to deflation in deficit countries and no change in surplus countries.

Criticisms of such policies hark back to the reforms of global imbalances put forth by luminaries such as John Maynard Keynes and Nicholas Kaldor.  Both economists were skeptical of the powers of flexible exchange rates to equilibrate imbalances.  In particular, Kaldor in 1977 found empirically that appreciations of the Japanese and German exchange rates, and even rising labor costs relative to their trading partners, did little to change their increasing share of world trade in 1960s and 70s, typically at the expense of the US and UK. Looking at the history of currency realignments, the success of devaluations in reducing surpluses is variable at best.

Kaldor’s instead proposed a solution that would focus on the terms of trade between manufactured goods and commodities – the raw materials essential to industry. Ordinarily, devaluation will raise a country’s cost of raw materials (if such inputs are primarily imported), create inflation and possibly lead to rising wages.  This would raise the cost of manufactured exports and lower competitiveness. During the period that Kaldor studied, he found that the appreciation of the Japanese and German currency compensated for rising prices of food, industrial materials and oil. This, along with Verdoorn’s law (increasing returns in production and the positive feedback in market share and labor productivity) allowed these countries’ trade surpluses to grow.

Consider today’s currency environment, if China was alone in maintaining a low exchange rate relative to the US dollar, then they would necessarily lower the price of their own manufactured goods (i.e. the price of the ‘value added’ by its processing activities) in terms of basic inputs (food and raw materials).  However this trade off between competitiveness and terms of trade is not occurring because there are many other emerging market nations that are also devaluing their currency, including those that primarily sell commodities, all are hoping to create a competitive edge and develop their manufacturing base through export-led growth.

Kaldor designed a trading system that would balance the manufacturing trade between the highly industrialized nations and prevent the industrially dominating ‘go-ahead’ countries from growing through unrequited exports, at the expense of other industrial countries, effectively stopping them from exploiting their own growth potential and ability to pursue policies of full employment.  Kaldor felt that only with cost push inflation pressures and/or a limited supply of labor (although this was rarely binding due to immigration) would an export-led country have an incentive to ever raise their exchange rate enough to counter their competitive advantage in manufactured exports.

Kaldor’s preferred solution was the institution of a new reserve currency, backed by a basket of commodities.  He called this commodity reserve currency (CRC) his ‘gadget’ and once instituted he believed that it would be an apolitical, automatic stabilizer that would resolve global imbalances, promote even growth and effective demand throughout the world (Kaldor initially took this idea from Benjamin Graham and worked on it with Albert Hart at Columbia University in the 1960s and 70s).

In addition a CRC would create a bufferstock of storable raw materials and allow for the stabilization of their price index over the cycle.  The stockpiling of these goods (located at regional futures exchanges and trading centers) would be paid for by the issuance of the reserve currency (redeemable inventory receipts for the basket).  The targeting of a commodity price index could be done with open market operations – buy the basket and increase the supply of CRC when demand and commodity prices were low, or sell the basket and decrease the supply of CRC when demand and commodity prices were high.  This new currency offered a standard of value that can grow or contract counter cyclically to world trade, and most importantly provide a source of stable income to commodity producers (including the developing world).  Unlike the SDR this currency could be internationally traded by public or private participants and did not require liquidity or mass acceptance to make it valuable.  It would be independent of national currencies, hence exempt from the Triffin paradox, and its supply was endogenous to rising world demand

This new reserve would exist alongside individual sovereign currencies which could peg or float to the international reserve. Importantly, each nation would be free to choose their monetary, fiscal, exchange rate and trade policy with their own citizens’ priorities in mind.

In 1977 Kaldor thought his commodity reserve currency proposal was at least 20 years ahead of its time.  Keynes back in 1943 was far more pessimistic.

“The right way to approach the ‘tabular standard’ [CRC] is to evolve a technique and to accustom men’s minds to the idea through [individual] international buffer stocks. When we have thoroughly mastered the technique of these, which is sufficiently difficult without the further complications of the tabular standard and the oppositions and prejudices which this must overcome, it will be time enough to think again” (Keynes 1943).

Keynes thus took the pragmatic route and instead of finding an equilibrating exchange rate process he proposed the balancing of deficit and surplus reserves through member cooperation and agreement to automatic rules and penalties. His international clearing union (or world central bank) would impose penalties on trade surplus and deficit countries and offer strong incentives for surplus countries to spend their reserves held in excess of their quota. (I can offer details here if requested). Exchange rates would for the most part be fixed with capital controls, though adjustable to equate wage efficiencies across countries and balance trade. The International Clearing Union would finance commodity stockpiles to stabilize individual commodity prices and thereby create a counter cyclical international incomes policy to smooth the world business cycle.

Both the Kaldor and Keynes proposal required a new international central bank (or IMF) and both called their international reserve ‘bancor’.  Kaldor’s was backed by commodities, Keyes’s was not. Kaldor’s was meant to be an automatic stabilizer primarily non discretionary in reserve expansion or contraction, while Keynes’s was much more discretionary and required coordination, penalties, and lender of last resort functions. Both had endogenous reserve supplies, although Kaldor’s was fully backed and Keynes’s was not.

Kaldor thought that he had found a tool that would not only cure global imbalances but would create investment into renewable resources that could sustain the industrialization of the developing world in a steady and sustainable manner without the need for coordination.

It is easy to say that both plans remain futuristic utopian policies. But I believe it is important to understand the mechanisms of each and work out whether they can actually do what they promise, regardless of political viability. And then put them in the tool box for future reference.

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