The field of International Monetary Economics is not without its own cycles and fads.

In a speech at the European Central Bank over the summer, “On Global Currencies,” I identified eight concepts that I saw as having recently “peaked” and eight more that I saw as newly rising in relevance. Those that I viewed as losing traction were: the G-7, global savings glut, corners hypothesis, proliferating currency unions, inflation targeting (narrowly defined), exorbitant privilege, Bretton Woods II, and currency manipulation. Those that I saw as receiving increased emphasis now and in the future were: the G-20, the IMF, SDR, credit cycle, reserves, intermediate exchange rate regimes, commodity currencies, and multiple international currency system.

A condensed version appears this month in Finance and Development, from the IMF, titled “What’s ‘In’ and What’s ‘Out’ in Global Money.”  I boil the list down to five concepts that I pronounce “on the way out” and five more that I see as replacing them:

• The G-7 has been rendered largely obsolete by its lack of representation of developing countries, and thus in the course of 2009 has been overtaken by the G-20.

• The corners hypothesis had become conventional wisdom by the end of the 1990s. This was the idea that all countries were or should be abandoning intermediate exchange rate regimes (bands, baskets, crawling pegs, adjustable pegs, and heavily managed floats) in favor of either the floating corner or the institutionally fixed corner (currency boards, dollarization, or monetary union). Since 2001 the tide has turned against the corners hypothesis, and far fewer economists would now assert it as a sweeping generalization.  Certainly a huge fraction of the members of the IMF continue to follow intermediate regimes.

• The language of “unfair currency manipulation,” has been in US law since 1988 and the IMF Articles of Agreement for longer. China during the years 2004-2008 was pretty much the first large country to face charges of unfairly manipulating its currency to keep it undervalued. But US Congressmen who have for years urged China to abandon its link to the dollar could well live to regret it, if they were to get their way and the People’s Bank of China did in fact stop buying US treasury bills. It is finally beginning to sink in among Americans that having China as its largest creditor carries with it some new constraints.  What concept is “on its way in,” to replace the idea that intervening to prevent one’s currency from appreciating is anathema?   Reserves.  Two short years ago, Western economists were lecturing surplus countries that they were acquiring too many reserves.  Today we see that the developing countries that have weathered the 2007-09 crisis the best are countries that had previously piled up the most reserves, other things equal.

• Most controversially, I assert that Inflation Targeting — narrowly defined, I hasten to add — has seen its best days. The definition of IT I have in mind is the proposition that the monetary authorities should set a target range for the increase in the CPI each year, and then should focus all their efforts on hitting it. This orthodoxy says that the central bankers should pay no attention to asset prices, the exchange rate, or commodity prices, except to the extent that they carry implications for the CPI. For large rich countries, it has become clear since 2007 that Alan Greenspan was wrong when he (plausibly) abjured all attempts to identify or discourage bubbles in real estate and stock markets. As a result, the credit cycle view of monetary policy has been resurrected , after a long period when only inflation was thought to matter. For smaller and developing countries, I would also argue that volatility in commodity prices has made it clear that monetary policy should let currencies depreciate, at least somewhat, when the terms of trade worsen, rather than the opposite as is implied by a strict interpretation of CPI targeting. For them, I would propose replacing the CPI target with a more production-oriented price index, such as a target for the PPI or even an export price index.

• The United States has benefited throughout the post-war period by an unlimited ability to borrow in dollars. A popular view two years ago, supported by some of the best scholars, was that the US had earned the dollar privilege by establishing a unique comparative advantage in supplying a saving-glut world with high-quality assets. Then the sub-prime mortgage crisis in 2007 revealed that US assets were not so high-quality after all. The dollar did retain the benefit of being the safe haven currency in 2008, as an exorbitant privilege — contrary to the predictions of those of us who had predicted that the unsustainable current account deficit would lead to a large depreciation. Nevertheless, some developments in the course of 2009 have suggested a global movement away from the unipolar dollar standard, and toward a new multiple international reserve system. These events include the gradual rise of the euro as an international currency to rival the dollar, the sudden and unexpected resurrection of the SDR from near-death, new interest in the yen and gold as safe haven assets (including among central banks), and the very first glimmerings of an international role for the RMB.

[Any readers wishing to post comments are referred to the Seeking Alpha version.]

The current visit of Secretary Tim Geithner to Beijing once again shines the spotlight on the Renminbi (RMB) and on demands by US politicians that the People’s Bank of China (the country’s central bank) abandon the peg to the dollar.  

Throughout the period 2003-2008, I, as some others, have thought that demands from American politicians of both parties that China loosen the dollar link have been misguided in a number of particulars.    They were misguided in thinking that an appreciation of the RMB would, alone, do much to boost US output or employment.  The demands were especially misguided in putting such high priority on the entire exchange rate issue, given that we need China’s help on more important things, such as preventing a nuclear-armed North Korea.   But my arguments during this period might reasonably have been viewed by non-wonks as quibbles.   After all, I did agree, along with a majority of other economists, that an increase in the flexibility of China’s exchange rate would be a good thing.

Now, in 2009, the situation has changed in some important ways.   Continued demands from American congressmen that China should stop intervening in foreign exchange market to keep the RMB fixed against the dollar have become especially foolish.  This is because of two developments over the last year.   

The first development: in mid-2008, the top leaders in China decided to abandon the policy they had followed in 2007 – which had consisted of the long-desired evolution away from  the dollar peg and the placing of a substantial weight on the euro.  They changed horses in mid-stream:    After mid-2008 they returned to their old policy  of a fairly close peg to the dollar (similar to 2005-06).   Evidently the motivation for the return to the dollar was complaints from Chinese exporters who had lost competitiveness in 2007 as the euro and therefore the new basket appreciated against the dollar.  (Barry Naughton, 2008, gives a glimpse inside politburo politics.)  

Why, then, are American congressmen wrong to complain that the return of the dollar link has given American firms an additional price disadvantage in world markets?   The first reason on the list is that over the last year, the euro (surprisingly) depreciated against the dollar.  In other words, at precisely the moment when the RMB jumped back on the dollar horse, the dollar horse and the euro horse changed directions vis-à-vis each other.  If the Chinese authorities had kept the (loose) basket policy of 2007 instead of switching back to the dollar peg in 2008, the value of the RMB would be lower today, not higher, and dollar-based producers would be at a more of a competitive disadvantage, not less.

The second development is that, in early 2009, the stratospheric rate of rise of China’s foreign exchange reserves fell abruptly.  In some months, the PBoC actually lost reserves.   This means that an increase in exchange rate flexibility – in the extreme case, a move to floating – under current conditions might not result in an appreciation of the RMB, and might even result in a depreciation.  Again, that does not correspond to what the congressmen actually want, nor to the public opinion that they represent.

In the near future, we could see a return of substantial surpluses on China’s overall balance of payments and a return of the 38-year trend dollar depreciation.   In that case, intervention would once again imply suppressing RMB appreciation against the dollar.  But that leads us to the third point.

The third development, this spring, is the appearance in the dollar’s garden of the first “red shoots.”   Red as in deficits and red as in China.   For decades, the United States has been able to count on foreigner investors, and in a pinch foreign central banks more specifically, to buy dollars to finance US current account deficits.   In recent years, the PBoC has been the lead facilitator, piling up $2 trillion in reserves, most of it in dollars (the estimate is 70%).  Many argued that the United States could continue to enjoy this “exorbitant privilege” indefinitely.   But during the past two months we have seen the first signals that this might not continue forever.   The possibility that rating agencies might eventually downgrade US debt is in the air, and US longer-term interest rates have finally begun to rise. 

The most telling warning shots have come from Chinese officials.   Premier Wen in April expressed worry that US Treasury securities would lose value in the future;  that required an unprecedented public assurance from President Obama.   Then PBoC Governor Zhou in May proposed replacing the dollar as an international currency, with the SDR.   Another official told Americans that his countrymen “hate” having to hold a currency that they believe will lose value in the future as it has in the past.  Interpreted separately and literally, each of these statements raises interesting economic questions worthy of extended discussion.  Taken together, they constitute a simple wake-up call for oblivious Americans.   The message is that we are heavily and increasingly dependent on China to buy our treasury securities, at a time when big budget deficits lie in America’s recent past (the big debt that Obama inherited from George W. Bush), in America’s present (the record budget deficits caused by the current recession), and in America’s future (rising medical costs and the retirement of the baby boomers), .   If they and other Asian and commodity-exporting countries stop buying our treasuries, the result would almost certainly be a hard landing for the dollar.  I define a dollar hard landing as the combination of a big fall in its value together with a big increase in US interest rates.  The outcome might be stagflation.

As a general proposition, it is somewhat obtuse to make strident demands on one’s biggest creditor without taking any consideration of the change in the power relationship that debtor status entails.   It is astoundingly obtuse to make the demand that the Chinese stop buying dollars, at the same time as we depend on them continuing to buy dollars to finance our deficits.    But demanding that they stop buying dollars is precisely what we have been doing for six years, every time we respond to trade concerns by demanding that they stop intervening to prevent the RMB from rising.

Fortunately, Secretary Geithner’s April decision not to declare China guilty of unfair currency manipulation, in Treasury’s semi-annual report, suggests that he understands the subtleties of the situation.   Now if those congressmen would just learn some economics…

[Any readers wishing to post comments are referred to the RGE Monitor version or Seeking Alpha version of this post.]

Tags: basket, China, dollar, exchange rate regime, renminbi, Schumer-Graham, ShangJin Wei, yuan
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