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.

 

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The possibility that some Gulf states, particularly the United Arab Emirates, might abandon their long-time pegs to the dollar has been getting increasing attention recently (for example, from Feldstein and, especially, Setser).   It makes sense.  The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries.  The economic dynamism — most striking in Dubai –  is admirable and fascinating as a longer term phenomenon, but also now clearly shows signs of overheating.  Indeed inflation has risen alarmingly, as predicted. Among other ill effects, it is producing unrest among immigrant workers.   An appreciation of the dirham and riyal is the obvious solution.

 

Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies.   This would be an improvement.   Kuwait, for example, made this switch a year ago.

 

But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as they have in recent years, monetary policy is constrained to be looser than it should be.    Similarly, when oil prices fall generally (not just against the dollar), as they did in the 1990s, monetary policy is constrained to be tighter than it should be.   A floating exchange rate regime is the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall, thus accommodating the terms of trade shocks.  But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy. 

 

Today’s reigning orthodoxy is to add an inflation target as the new nominal anchor.  But this doesn’t solve the problem, if the targeted price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.

 

I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg.   I have laid out the case elsewhere (including also for the case of Iraq).  I call the proposal PEP, for Peg the Export Price.   I was pleased to see that the FT mentioned this option approvingly yesterday (“Dollar-pegged Out,” July 7):

“The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak.”

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