With Alice in Wonderland back on the screen, I guess it’s okay to make up the meaning of words. When I started at the Richmond Fed in August 1968, what they are now calling currency manipulation was the standard, accepted international monetary system. It was set up at Bretton Woods at the end of WWII. The U.S. committed to exchange for gold dollars held by foreign central banks and Treasuries (governments), while other countries used their dollar reserves to peg (i.e. manipulate) their currencies to the dollar. Currencies pegged to the same thing were pegged to each other.
That manipulated, pegged, or fixed-rate system, worked well in the early postwar years when there was apparently an unlimited demand for dollar reserves, which we were happy to provide to the world in the form of external deficits. We sucked in imports beyond what we paid for in exports and our trading partners were happy to hold the dollars provided to make up the difference.
Incipient external imbalances, according to the rules of the game, were supposed to be corrected by governments allowing automatic correcting adjustments within their economies and supplementing them with monetary and fiscal policies. Surplus countries should allow and reinforce expansion in their domestic economies to stimulate demand for imports while deficit countries were supposed to tighten domestic conditions and policies to stimulate exports relative to imports. This internal adjustment might involve inflation in surplus countries and deflation in deficit countries. With prices, and particularly wages, sticky in a downward direction, the deflation tended not to be limited to downward pressure on internal prices; unemployment tended to rise in the deficit countries.
As the world absorbed about all the dollar reserves they wanted to hold, they became reluctant to accept more. They wanted the U.S. to do more than it was doing to correct its external imbalance and they showed an interest in actually cashing in their excess dollar reserves for gold. The U.S. really didn’t want to lose gold, or adopt internal policies to cure its external deficit. It resorted to “voluntary” programs such as the “Voluntary Foreign Credit Restraint” program to curb U.S. banks’ foreign lending. (I was a foot soldier in that effort, the most unpleasant assignment I ever had at the Fed.) There was also “operation twist,” which was an effort to depress long term interest rates to promote domestic growth, while supporting short-term rates to attract or hold onto foreign capital to support the dollar.
My point here is that fixing or pegging exchange rates was official policy all over the world, and the world went to great lengths to support the world’s pegged currencies. In other words, currency manipulation was the law of the land. In emergencies, countries could borrow from the International Monetary Fund to get reserves to continue supporting their currencies while pursuing appropriately subordinate domestic policies. (Root canal.)
As a last resort, a country might devalue its currency by a large finite amount – large because all the resistance to that course of action had let the pressures build up and given speculators a one-way option. Alternatively, a surplus country wanting to avoid the inflationary consequences of capital inflows might revalue its currency upward.
The German Mark and the German Central Bank, the Bundesbank, ruled the roost during those times, with the Swiss not too far behind. Their hard money policies grew out of aversion to their previous hyper inflations. Revaluations by strong surplus countries, of course, implied passive devaluations by the others without the taint of overt action. (Think the current U.S. desire for a Chinese yuan revaluation against the dollar while our politicians claim to be strong dollar advocates.)
During this period of the late 1960s and very early 1970s, Milton Friedman – the fastest gun in the West, according to my monetary professors – kept pointing out the advantages of flexible exchange rates. The same relative real changes can take place to reduce the imbalances without the frictions, and the fallout from the frictions, associated with changing domestic prices and wages. Dollar prices don’t have to fall in the U.S., or don’t have to fall as much, if a decline in the foreign price of the dollar declines. I won’t go into all the technical details of the alternative adjustment mechanisms here, you’ll be happy to learn.
The broad arguments for adopting flexible exchange rates as an alternative to the “currency manipulation” of pegged rates were that the domestic economy was more insulated from the transmission of foreign inflations or recessions and could enjoy a more independent monetary policy. I wrote my dissertation on these arguments, in general, and on the Canadian experience with flexible exchange rates, in particular. When I arrived at the Richmond Fed as their new “international economist,” in August 1968, the first article I wrote for their Economic Review was titled “Flexible Exchange Rates.”
As the new international economist in the early 1970s, I got more than my share of opportunities to make presentations to our Boards of Directors on international matters. The Bretton Woods system was declining rapidly; there were numerous crises to report on; devaluations and revaluations, gold, etc. All the problems of price fixing created opportunities to lecture.
All the while, Milton Friedman kept pointing out that these crises would all go away if we went to a system of flexible or floating exchange rates. It turns out that he was right, as usual. After Paul Volcker, as Treasury Undersecretary for International Monetary Affairs (or some such title), traveled around the world secretly negotiating a flexible rate system and after President Nixon removed the U.S. pledge to buy and sell gold to official foreign entities for $35 per ounce, the crises went away. My over-exposure at monthly board meetings diminished. The market had solved the dollar crisis problem.
Fast forward to the dollar and the yuan in recent years. Yes, the yuan is considerably undervalued relative to the dollar and other currencies by just about any measure, my favorite being the Economist’s Big Mac index. Big Mac’s are cheaper in China than any other place on the globe. Letting the yuan float up would help reduce the trade imbalance between the U.S. and China countries as well as help with the disparate rates of domestic saving.
When I was in China for a couple of weeks in 2003, and again in 2006, I was asked to lecture about the yuan / dollar problem, even though my second visit was to study Chinese research commercialization as Chancellor of the Texas A&M University System. Knowing of my Fed background, they wanted me to talk about two things: should they let the yuan appreciate, and could Ben Bernanke, the new Fed Chairman, fill Alan Greenspan’s shoes. Amazingly, I gave a one-hour TV interview in Shanghai and my interviewer kept coming back to that second question.
Regarding my comments on the yuan, I was very careful to tell them what they did with the yuan was their business, not ours, and that I certainly wouldn’t presume to lecture them on what to do. (I conveniently ignored the fact that when it comes to an exchange rate, it takes two to tango.) Having emphasized that their currency was their business and not mine, I did gently point out the ways a higher yuan would benefit China, and particularly, Chinese consumers. I told them that their exchange rate policy was currently subsidizing poor people who shop at Walmart (WMT) in the United States at the expense of their own poor people.
While I didn’t use the word in my informal diplomacy, I can see why mercantilism, so seductive all over the world, would be especially appealing to the leaders of a totalitarian society. Squeezing down current consumption and encouraging maximum saving and investment produces a higher growth rate and higher standard of living some time in the future. There is no countervailing democratic force in society to say we want the fruits of our labor now – not later. We really do need to add U.S. and Chinese consumers together and divide by two to reduce the enormous imbalance in saving and consumption. They have savers who don’t consume and we have consumers who don’t save. We don’t do deferred gratification well; we want our Twinkies now.
We are alike in so many ways, however. In my late 2006 visit to China, due to the local connections of a Chinese faculty member at Texas A&M, I had lunch with a prominent member of the government. He brought the yuan question up himself, and he assured me that it didn’t need to rise in value. I asked him how he had reached that conclusion. He said he had talked to several Chinese businessmen and they all told him so.
Disclosure: No positions