Exchange Rates Are Not Monads
IPE at UNC submits: by Thomas OatleyDan Drezner suggests that current international monetary conflict is a consequence of governments making different choices about which element of the unholy trinity they are willing to forgo. He suggests that China has given up free capital mobility and the US has given up a stable / pegged dollar.But in what sense does the US not pegging the dollar imply that the dollar is not pegged? China and the other East Asian governments peg to the dollar. And even Japan, which doesn't peg the yen, does limit its fluctuation as if it has a target zone. For all practical purposes, then, the dollar is pegged against many of its most important creditors (the Euro is the only exception, but the euro area as a whole is a debtor rather than creditor area). If this wasn't the case, we wouldn't be having this conflict. More generally, any discussion about the unholy trinity needs to recognize the n-1 problem. In any system of n countries there are n-1 independent exchange rates. Think about a three-country system. If China pegs to the dollar and South Korea pegs to the dollar, the China-South Korean rate is fully determined by the cross rate. As a result, every exchange rate system (other than a gold standard) has one degree of freedom: one country can attain a fixed exchange rate, and capital mobility, and monetary independence. Whichever country holds this position gets to set monetary policy for the system as a whole. International monetary politics revolve who gets this degree of freedom and how it is employed.
- The US held this position in the original Bretton Woods system. Because everyone pegged to the dollar, the US didn't have to use monetary policy to sustain its peg. The system collapsed as governments became increasingly dissatisfied with how the US set its monetary policy.
- Germany held this position in the European Monetary System. Everyone pegged to Germany, and Germany used monetary policy to manage German monetary conditions. General dissatisfaction with German monetary policy played an important role in the shift to monetary union.
This suggests that we are back in a world very much like the late Bretton Woods: the US has a pegged exchange rate against many of its major creditors and capital mobility and monetary autonomy. The current conflict is a consequence of East Asian governments forcing the US to accept a peg at a rate it does not think is appropriate. Like Geithner and Co. now, the Nixon administration believed it couldn't devalue an over-valued dollar unilaterally. One might argue that the Nixon administration blew apart the Bretton Woods system by embarking on what at least one German called the biggest monetary expansion in history (I think Emminger said this). Pouring dollars into the global economy forced Germany to purchase more and more dollars and accept higher and higher inflation. There was a clear limit to how much inflation Germany would accept. When that limit was reached, in early 1973, the Germans floated the mark the system disintegrated, and the dollar fell sharply. Devaluation achieved. Is current US policy trying to blow East Asia out of their dollar pegs? I don't know, but it sure seems that one consequence of QE has to be further accumulation of the dollar abroad. In the face of pegged rates and imperfect sterilization, this must increase inflation in China and East Asia. QE thus essentially amounts to external pressure to embrace a more expansionary monetary policy--exactly what the US is pressing China to accept in the G-20. So, is China more tolerant of imported inflation than Germany? We may be about to find out.Complete Story »