Bernanke Has Learned What Richard Duncan Knew in 2005

by: Howard Richman

When Singapore-based economist Richard Duncan read Federal Reserve Chairman Ben Bernanke's November 19 speech, he wrote:

Fed Chairman Bernanke’s speech on Friday was his most important since his “helicopter money” speech of November 2002. In it he conceded the Dollar Standard is flawed. He said, “As currently constituted, the international monetary system has a structural flaw: It lacks a mechanism, market based or otherwise, to induce needed adjustments by surplus countries, which can result in persistent imbalances.”

With that statement, the Fed revealed it has been won over by the logic expressed in my book, The Dollar Crisis (John Wiley & Sons, updated 2005). The first two lines of that book state: “The principal flaw in the post-Bretton Woods international monetary system is its inability to prevent large-scale trade imbalances. The theme of The Dollar Crisis is that those imbalances have destabilized the global economy by creating a worldwide credit bubble.”

In his 2005 book, Duncan had predicted the Great Recession that began in 2008. Duncan understood that the trade-deficit countries, especially the United States, would not be able to continue purchasing more and more imports without the income that would come from exports. Countries can only borrow so much from abroad to buy imports until they experience financial crises.

But when the Great Recession hit in October 2008, American economic leaders pretended that the U.S. economy could be fixed by shoveling debt from the private sector to the public sector and through fiscal and monetary stimuli. It has been two years now and, as Bernanke noted in his speech pointing to the data graphed below,

As you can see, generally speaking, output in the advanced economies has not returned to the levels prevailing before the crisis, and real GDP in these economies remains far below the levels implied by pre-crisis trends.

Why aren't the Advanced Economies Recovering?

According to Bernanke, one of the reasons that the United States and the other advanced economies are not recovering is that many emerging countries are manipulating the exchange rate of their currencies. Bernanke said:

The exchange rate adjustment is incomplete, in part, because the authorities in some emerging market economies have intervened in foreign exchange markets to prevent or slow the appreciation of their currencies....

It is instructive to contrast this situation with what would happen in an international system in which exchange rates were allowed to fully reflect market fundamentals. In the current context, advanced economies would pursue accommodative monetary policies as needed to foster recovery and to guard against unwanted disinflation. At the same time, emerging market economies would tighten their own monetary policies to the degree needed to prevent overheating and inflation. The resulting increase in emerging market interest rates relative to those in the advanced economies would naturally lead to increased capital flows from advanced to emerging economies and, consequently, to currency appreciation in emerging market economies. This currency appreciation would in turn tend to reduce net exports and current account surpluses in the emerging markets, thus helping cool these rapidly growing economies while adding to demand in the advanced economies. Moreover, currency appreciation would help shift a greater proportion of domestic output toward satisfying domestic needs in emerging markets. The net result would be more balanced and sustainable global economic growth.

Bernanke noted that those emerging market countries who manipulate their currencies are growing more rapidly than those who do not:

(NYSE:T)he current system leads to uneven burdens of adjustment among countries, with those countries that allow substantial flexibility in their exchange rates bearing the greatest burden (for example, in having to make potentially large and rapid adjustments in the scale of export-oriented industries) and those that resist appreciation bearing the least.

Who are the Currency Manipulators?

The following chart regraphs the data from one of Bernanke's tables. It shows the foreign exchange reserves accumulated by each of the emerging market countries from September 2009 to September 2010, as a percentage of that country's GDP:

What Will Bernanke Recommend?

Bernanke understands that the currency manipulating countries are keeping the advanced countries from recovery and that they are gaining a competitive advantage over those emerging market countries that do not manipulate their currencies. Richard Duncan thinks that Bernanke will soon advocate tariffs:

The world has been put on notice that the United States will take steps to correct this defect and the destabilizing trade imbalances it permits. If the flaw cannot be corrected through international coordination, then unilateral actions by the United States should be anticipated. These actions would likely include trade tariffs. Tariffs would have a devastating impact on the countries pursuing an export-led growth strategy, particularly China.

When Bernanke is ready to recommend a solution, the scaled tariff could be his best option. Since it would only be applied to currency manipulating countries, it would give countries that play by the international rules (Chile, India and Turkey in the above graph) an advantage in American markets.

Moreover, since its rate goes up when our trade deficit with a currency manipulator goes up, down when our trade deficit goes down, and disappears when our trade deficit with that country disappears, it would force China and the other currency manipulators to buy more of our products, which would stimulate our economic recovery.

The 2008 crisis demonstrated that imbalanced trade is not sustainable. In contrast, balanced trade can grow forever. If the United States were to enact the WTO-legal scaled tariff, other trade deficit countries would soon follow suit. The result would balance trade worldwide.

Disclosure: I own Chinese yuan through CYB