@Rambuchan: Sorry for being late. RL is really getting hectic for me. I have not posted on CFC for almost a week now.
Exchange rates, Trade, IMF, dollar and all that
As promised I will talk about exchange rates, more on dollar hegemony, and how it affects world trade. It is advisable to read up on the IMF Wikipedia article linked above. That should provide some historical background. Some history is necessary to explain this topic. Hence, for completeness sake I will spend some time on explaining the history of how all this came to be. The history has to start with the problems of world trade and how it was solved.
It all started with Mercantilism during the Great Depression. Basically, nations took a doomed approach to increasing their GDP. They looked to trade. Nothing wrong with that as such except that the common point of view was that global trade is a zero-sum game. So if A and B is trading with each other C saw that to trade more with A its only way is to lessen B’s trade with A. Hence it would lower its currencies exchange rate vs. A and A would stop buying the stuff it would buy from B and chose C instead. { Interestingly, this is exactly the same approach many of the current political scientists – and many common people – have about political relationships between nations. I guess it will take another 70 years for them to realize their mistake. } This mutual price cutting of currencies led to a veritable trade war which included putting tariffs too. Thus the whole effect snow-balled into making the Depression worse. Also, if currencies fluctuate widely, then international trade seems to be less lucrative for traders. Unless, you can predict exchange rates to some distance in the future you cannot predict your earnings and profits entailing from your merchandise if you sell internationally.
Apart from just increasing your GDP there is another reason for a nation to manipulate its currency. As explained in my earlier post in this thread any nation (apart from US) must pay for what it needs with something it can produce. If it cannot then it runs a trade deficit which in other words is called a
Balance of Payments problem. While a momentary –ve BoP problem can be easily solved a medium to long term BoP problem for a nation is equivalent to declaring bankruptcy of individuals. In that case the only way out for a nation is to devalue its currency in the hope that imports are reduced by force and exports are increased also by force. Once again globally this currency manipulation is not desired.
Evidently, there was a need to come to some sort of agreement among nations not to manipulate their currencies and make exchange rates stable, while also providing relief to nations that run balance of payments problem.
The result of this agreement was the IMF which was forged in Bretton Woods, New Hampshire, US in 1964. I will not deliberate on its contents since you can easily
look it up. Suffice to say that its main goals are to solve the above-mentioned problem and stabilize/increase world trade. So how has it fared so far in its original goal of stabilizing world trade? If quantitative value of trade is any measure the fund is a complete success. Since the early days of the Fund (leaving out the abnormal post-war lows), world trade has grown, from 10% of world GDP in 1960 to almost triple that in 2005. Since world GDP itself has increased by a factor of more than 10 in that time, world trade has grown more than 30 times what it was pre-IMF. So is IMF must be the next best thing to slice bread, right? Given that it was the first step to dollar hegemony, many would argue that it is not.
Four steps to dollar hegemony
IMF - The first step on the road to dollar hegemony
One main feature of this Bretton Woods system was that all currencies were tied to the dollar and dollar was tied to gold – in the sense that each currency had its price fixed in terms of the dollar – and was allowed to fluctuate in a narrow band – and the price of dollar was fixed absolutely with gold (specifically $35 per ounce of gold). So indirectly everything was tied to gold. While it is obvious that this system will stabilize the currencies one question immediately arises.
Why peg everything to the US dollar and not say the British pound?
The answer to that question is: history. Interestingly, the result of that answer is also, as they say, history. After the 2nd World War US was the only economy that came out ahead, i.e. it was the only country in the world whose economy was better than what it was before the war as a result of the war. The reason for that is also obvious. Apart from Pearl Harbor US never had any attack on its mainland. So its factories and farms were always untouched by the war. Its manufacturing production capacity outstripped everyone else by far. Its reserves were overflowing with gold. Its military might was unmatched. It was far ahead economically speaking than its next nearest competitor (farther than it ever was and ever will be again). So that there is one reason to peg everything to dollar. However, that is not the only reason.
Think what would happen if any currency, say pound for example is the peg. A nation trades with everybody excluding Britain and come out ahead having an excess of pounds. Now trading with Britain, the nation has three choices. (a) It takes in more pounds (b) It takes in actual goods and services or, (c) it takes in what the pound is pegged to – gold. Although theoretically there is no difference between (a) and (c) practically there is. (c) is completely immune to even the minute fluctuations of the exchange rates of various currencies since the peg of pound to gold is absolute and unchanging. So every nation will go for (c) unless it needs goods and services immediately. This also means that whoever has the peg currency must have a large reserve of gold. Since at the end of the war US had about 80% of the world gold reserves it was the ideal choice for the peg currency.
As and when the US ran a trade deficit it gave out a little of its gold reserves. When it had a trade surplus it got back its reserves. As an example here are some figures. In 1950, the United States imported US$11.4 billion of goods and services and exported $12.7 billion, for a foreign-trade total of $24.1 billion, constituting a mere 7.3% of a gross domestic product (GDP) of $329 billion. The US trade deficit for 1950 was $1.3 billion, which came to an insignificant 0.4% of GDP. It was an amount the US could easily sustain as World War II had left the country the richest and most productive economy in a war-torn world.
Note, that while the foundation of the fiat dollar and dollar hegemony has been laid it was not in effect since the US could not print dollars at will.
1971 Gold standard abolishment – The second step on the road to dollar hegemony
The wikipedia article of
Nixon Shock explains what happened in 1971. Basically, US ran a huge trade deficit and budget deficit owing to wars abroad (not unlike what is going on now). To fund this deficit it had to print dollars. But there was one crucial difference between now and then. Then since the US dollar was backed with gold and as many nations saw that US debt was rising higher and higher without any limit they lost confidence in dollar and used their option (c) mentioned above. Thus there was a huge outflow of gold out of the US. To stop that Nixon unpegged the dollar from gold. So from that point in time the nominal value of a dollar was exactly the worth of the paper it was printed on.
We are decidedly on our way to the dollar hegemony now. One more step and we will be there.
1973 Oil crisis – The thrid step on the road
In my earlier article I mentioned that a fiat currency has to be enforced. Within a nation the government of the nation enforces the fiat. Internationally, although the US could enforce the dollar militarily that would be pretty crude. There was a much subtler way to do it. Imagine two nations for example China and India who have large populations and production capacity. Could they just abandon the dollar and just trade/barter with each other using their currencies since between them they could produce pretty much everything they need. If somehow there still remained some items they could not produce they could surely find somebody else and between these three they could produce everything they need. If there still remained another item they needed among them they could add a fourth, and a fifth nation and so on.
So a sufficiently large group of nations could come up with a conglomeration who do not need the dollar for trading as long as they resort to barter or their internal currencies (this is not a hypothetical scenario since this has been tried and is being tried with limited successes).
So for someone who wants to impose dollar hegemony an effective way of doing it would be to find someone who by the nature of the good being sold by that someone will always be included in a group trying to achieve dollar independence. Now, if that someone insists on trading in dollars then dollar independent groups will never form.
Thus, you have the oil producing nations who everyone needs to trade with and their insistence of pricing oil in dollars. IMHO, this was devil’s bargain for the US. The autocrats of the Middle east nations decided to give US the advantage of dollar hegemony and the quid pro quo was that US will forever look the other way as these autocrats carry on their medieval governance system and refuse to integrate with the 20th century world.
With this last step we have all the problems of dollar as a fiat currency firmly in place.
1991 Deregulated global financial markets
But this still does not explain why any country needs to continue to horde dollars far in excess of their oil or other import needs (say). China and Japan obviously can buy all the oil it needs with a small % of their dollar reserves; so why do they need to hold on to their large stockpile of dollars. To understand this we need to understand a little about International currency markets.
To attract the maximum amount of investment into a country – which in turn bolsters its present GDP and future growth – a country must allow its investors to take profit (or at least some part of it) out of the country. For example, if you are a large investor in Japan and you can invest in China you would want that your Chinese investment will earn profit for you in Chinese Yuan should be convertible back to Japanese Yen if necessary since you as a Japanese will most probably like to spend your profits in Yen. Otherwise you would have no interest in investing in Yuan (for which you would have to first convert your Yen to Yuan) since they will be forever unusable to you. This is called capital convertibility. So basically a country has to allow convertibility between its currency and dollar. Since dollar is the common currency allowing convertibility for a currency to dollar immediately allows convertibility for that currency to any other convertible currency. Many countries have done this. But there is extreme peril for developing countries who have fully convertible currencies (which is the reason neither the Chinese Yuan or the Indian Rupee is fully convertible and I doubt they ever will be in the current system).
Basically, full convertibility means that the reserve bank of that currency (the equivalent of the federal reserve of US) promises to give you dollars equivalent to the currency to anyone. So if Chinese Yuan was fully convertible then, if you hold 1 million Yuan you could take it to PBoC (People’s Bank of China) and ask for the dollar equivalent of that sum and PBoC is obliged to give you those dollars for the Yuan.
Can you see the problem now?
Basically, in the worst case scenario PBoC must have the dollar equivalent of all Chinese Yuan that is not held by the Chinese. Of course this is the worst case scenario. Usually it can hold much less since not everyone is asking to change their Yuan for dollar at the same time. But it can happen and it has happened. Read up on
Asian Financial Crisis. If someone who has large reserves of a certain fully convertible currency and starts to sell that currency for dollar, that drives the currency price down (simple demand vs. supply) which forces other who are holding that currency to sell too driving down the price further till we are in a vicious downward circle that no one can stop and the country defaults. While the Asian currency crisis was caused by many factors purely speculative attacks have also happened.
Hence, a country with even partial convertibility must hold reserves of dollars. With the dollar reserves growing the total number of dollars in the world increase. And the Quantity Theory of Money dictates that the more the US prints greenbacks i.e. the more dollars there are in the world, the higher the price of US assets will rise. And by neo-classical definition, a rise in asset value is not inflation as long as wages lag behind. Thus a strong-dollar policy gives the United States a double win while workers everywhere, including those in the US itself, are handed a double loss. This idea is key and will be the cornerstone of the solution that is proposed later. The rising of US assets in price also create asset bubbles. The stock market bubble of the late 1990s and the current housing market bubble are partly the result of this money supply inflation. Rising asset bubbles in US lead to rising debt owing to the peculiar consumer behavior of the US consumer. That in turn leads to rising credit risk of the US lender who are primarily US dollar holders i.e. PBoC.
So is there a solution?
Well, a solution will present itself eventually without doubt. That we are sure of. Question is: will the solution be palatable to most of us? Before we embark on finding a solution lets try and identify a few non-solutions:
Removal of a peg currency
This is a non-solution. You need a common benchmark to compare currencies. Otherwise it is impossible to stabilize currency rates. If you have a peg then to stabilize rates against all currencies all you have to do is stabilize it against the peg. Without a peg you have to stabilize it against all currencies at once which is impossible.
Focus on one currency
This is the typical US senate approach. Focus irrelevant debate on one currency (in this case the Chinese Yuan) and assume that doing something about it will solve the entire problem. Appreciating Chinese Yuan will make no difference to the US trade deficit or to the dollar reserves held elsewhere (like Japan and South Korea) will are at least as large as China’s and combined significantly larger than China’s.
Regulate global financial markets
This is another non-starter. The argument against this is the exact argument against Communism vs. Capitalism. Given enough information and processing power and control we can make a communist system that is Star Trek like which is much better than our existing capitalist system. Unfortunately, we do not have the necessary information, cannot process information fast enough and we have nowhere near the control on the market entities involved. So we have to just assume that the free market forces that we have in the global financial markets are the best we can get and have to live with it as a necessary evil.
Peg the dollar to gold
This would work except that there is not enough gold in the world to do this; and if our current growth rates continue there will not be enough gold in out solar system to do this in another hundred years.
Now that we have talked about non-solutions lets talk about a solution that I think
will work – notice that I have no hesitation in using the word will instead of “may”. Hopefully, it will be obvious after you have read some more. Ask yourselves why is there a trade imbalance? Because China has more stuff to sell to US than more stuff to buy from US (apart from meeting the criteria of keeping sufficient dollar reserves)? So why does US not have more stuff to sell to China? Because they cannot make thing cheaply enough? But why not, since the basic raw materials to make any stuff is the same and over time basic manufacturing technology should also be the same! The only thing that is not same in China and US is cost of labor (and the other added costs which is related to labor, like insurance, retirement funds etc). So what would happen if we somehow magically made the cost of labor in China and US the same?
In that scenario China will make stuff where they have other advantages, like lower costs of materials (maybe because they have the materials or maybe because they are closer to the source), or they have better technology of production. This is precisely the comparative advantage we are looking for. What will not happen is that one can no more slave a Chinese villager to produce at a low cost of labor what a Michigan suburbanite refuses to make. So here is the unexpected but unequivocal conclusion.
Once labor costs are equalized throughout the world all currency and trade imbalances will sort themselves out. Not only that it will also mean a huge reduction in poverty to a lot of people who slave at far less wages in the developed and underdeveloped world. Before we all dream about this utopia lets consider a few more things.
How can we equalize the labor costs? Obviously, it is not a good idea to give US workers Chinese wages. They will die. Period. Neither can we give Chinese workers US wages. Since wages translate to consumption (or ideally should translate to consumption) we have a thermodynamic impossibility here. If all workers everywhere were given US wages and consumed on US standards then the Earth would be red hot. So obviously, the solution needs to happen in a middle line. US wages/consumption needs to fall while Chinese wages/consumption needs to rise. That this is viable and is beneficial can be seen from another example. The wage differential between software jobs in Bangalore, India and Silicon Valley, USA has been slowly getting smaller for the last several years. This differential at the beginning of 1999 was somewhere around 7:1. Today it is somewhere around 4:1 because wages have risen in India and wages have decreased in US. This also means that this trend forces both parties to be more efficient and as everyone knows this has not led to any decrease in software trade between US and India; quite the opposite in fact.
But we still have not answered the really hard question. What needs to be done to bring this change? Here I must admin ignorance. While I have some vague ideas on why this situation is happening between Silicon Valley and Bangalore I do not understand the reasons clearly enough to generalize it to make it work in a generic situation.
In case, someone misunderstands the above concepts and solutions are not mine (although I have presented them in a rather unconventional way). There are a small group of economists who are proposing these ideas. Of course, they are not mainstream since mainstream economists work for World Bank and IMF.
Finally, let me end this post with a last question.
Do we need the IMF?
Let take into account the following facts.
(a) As late as 1975, nearly half of Fund lending was to industrial countries, but by the late 1980s, it was zero.
(b) While it was created to help stabilize the global economy, since 1980 over 100 countries have experienced a banking collapse that reduced GDP by four percent or more -- far more than at any previous time in history. The considerable delay in IMF response to a crisis, and the fact that it tends to only respond to rather than prevent them, has led many economists to argue for reform.
(c) Developing economies which affect the world economy considerably like the BRICs do not pursue fund assistance anymore actively. Hence fund control on their activities are nil
(d) It is arguable whether particular crisis was actually the result of Fund intervention
(e) The Fund has no response on the dollar hegemony. In fact US being the primary supporter of the Fund, it can be said that the Fund actually relies on dollar hegemony.
(f) Additionally, the fund does not really provide any service to meeting its own objective of stabilized exchange rates anymore. Exchange rate stabilization is done by member countries by hoarding dollar which they can do anyway with or without the funds assistance.
Given all this IMHO, we should say goodbye to the fund and disband it completely. Of course if do you a Google search you will find many essays by fund consultants who argue what role the fund could play in our current world. Even a cursory reading of those will show you that even they themselves are at a loss on why they should exist anymore.
