Friday, February 04, 2005
How to tell Bretton Woods from the Dollar Standard, part 2
Here is the post I promised describing Ronald McKinnon's view on the current international monetary dilemma.
McKinnon argues that the conventional wisdom that “china must revalue” in order to correct the US trade imbalance is plain wrong. Not because china isn’t big enough, but rather because currency revaluation will not do anything to reduce China’s trade surplus with the US. McKinnon argues that the only way to get the US current account deficit down is to reduce the budget deficit or somehow convince US consumers to save more. The story of Japan is a useful example here. Despite Japan’s chronic currency strength, the Japanese trade surplus has never disappeared. Japan is a chronic creditor.
Because the fall in exports is coupled with a fall in imports, the net effect on their trade balances is unpredictable (McKinnon and Ohno 1997, chs 6 and 7). The ever-higher yen from 1971 to 1995 led to even bigger Japanese trade surpluses.
And there is no way around this for countries like China. If Asia decides to form a currency union and thus the world’s currencies appreciate jointly against the dollar, this will only create an unacceptable inflation in the US, much like happened in the 1970’s.
So, what is the method of adjustment? Here McKinnon argues that, if the currency of the high productivity country (China, in this case) is credibly fixed, then wages will naturally rise in line with the productivity growth, so that there will be no competitiveness differential.
To me, this sounds very nice in theory, but in practice relative wage adjustment tends to be painful. In particular, not only do wages tend to rise faster in China, but there also tends to be dislocation of employment in the low productivity growth countries. This bleeding of manufacturing jobs in the US is what has created the political pressure for the government to just let the dollar go. Frankly, I agree that it would be best to let the adjustment take place through prices other than the exchange rate, but I find that politically infeasible.