Robert Skidelsky
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US Current Account Deficit and Future of the World Monetary System
Robert Skidelsky
'Sixty Years After Bretton Woods: Developing a Vision for the Future' - Reinventing Bretton Woods, Rome Conference 2004 | Thursday, July 22, 2004

This paper seeks to challenge the conventional view that generalised floating is the desirable and inevitable goal of the international monetary system.
It argues that the breakdown of 20th century fixed exchange-rate systems was due more to the privileged position of the United States in the system than to inherent weaknesses arising from domestic political pressures or financial liberalisation. Specifically, the position of the dollar in the world economy has enabled the USA at various moments to print dollars without limit to finance its preferred pattern of spending. This has created unsustainable imbalances whose liquidation requires periodic changes of regime. The problem of adjustment is not solved by generalized floating, as the question of who adjusts to whom remains.
The paper challenges the view of Dooley et al. that the pegging of East Asian currencies to the dollar, like the earlier pegging of European currencies to the dollar, represents a deliberate policy of export-led growth by means of currency undervaluation and capital controls; and that, like the earlier European episode, must be considered as part of a progressive global evolution to floating systems. I argue that this distorts history and simplifies the motives of those who believe in fixed-exchange rates as a public good.
In the light of these considerations, the paper considers the issue of the sustainability of the current US account deficit.
It concludes that the deficit is sustainable in the very short run, but not in the medium-term when adjustment will occur through various ad hoc measures.. But the long-run liquidation of the unbalanced creditor and debtor positions requires a redefinition of the geopolitical role of the US. This will occur naturally as the incentives for other countries to accept this role (and the dollar seignorage which goes with it) are much reduced. The liquidation of unbalanced positions will in turn enable a system of stable currencies to re-emerge, with institutions which improve on those agreed at Bretton Woods.
It was to avoid a repetition of the currency wars of the 1930s that the Bretton Woods system of fixed exchange rates adjustable by agreement was set up in 1944. This still seems to be the best model for a globalizing economy.
1. Fixing and Floating
Economists are almost unanimous in preaching the virtues of floating –and its logical inevitability. Yet many, perhaps most, countries remain attached to some form of fixing. Is this a case of economists being out of touch with reality? Or is it that reality is out of touch with economics?
The post-Bretton Woods world is far from being one of generalized floating. The countries of the world present a kaleidoscope of currency arrangements, ranging from ‘hard’ fixers to ‘pure’ floaters, with a large variety of intermediate arrangements. It is said that the floaters are gaining over the currency fixers and managers. There is wide academic acceptance of Stanley Fischer’s argument [Stanley Fischer (2001), “Exchange Rate Regimes: Is the Bipolar View Correct?”, Journal of Economic Perspectives 15, 3-24] that soft pegs are unsustainable –that we are moving towards a bipolar world where most currencies float freely and a minority adopt hard pegs.
The evolution of the European monetary system from a ‘mini-Bretton Woods’ in 1978 into a currency union seems a convincing example of the latter development. But how to explain the emergence of an a ‘revived’ or ‘new’ ‘Bretton Woods’ centred on the US-East Asian nexus? Dooley, Folkerts-Landau and Garber try to do this: the East Asian countries are simply following in the footsteps of European countries, who, in the 1960s, undervalued their currencies relative to the dollar and controlled capital movements in order to grow, and having ‘caught up’, liberalised their capital accounts, which required them to float. ‘The Bretton Woods system does not evolve; it just occasionally reloads a periphery’. [Michael P Dooley, David Folkerts-Landau, and Peter Garber, ‘An Essay on the Revived Bretton Woods System’, NBER Working Paper No 9971, September 2003]
There are at least three problems with this developmental perspective on monetary evolution. The first is that the incentives of the ‘fixers’ are described solely in terms of their desire to maintain competitive exchange-rates with the dollar, whereas fixed -and not undervalued –rates may be preferred for macroeconomic stability and to facilitate inter-regional trade expansion. Growing financial maturity did not lead the European countries to float against each other: rather it led them towards an extreme version of hard fixing. This brings out the point that the theory and advocacy of floating is predominantly American phenomenon, the latest manifestation of a long-standing US monetary unilateralism.
Secondly, it assumes that the motives of the ‘fixers’ have been predominantly economic, whereas in the 1960s at least they were partly geopolitical. The Western European countries accepted dollar seignorage in return for military protection against communism. This incentive is evidently lacking today, and the ‘war against terrorism’ is a lame substitute. Acceptance by the eurozone countries of an upward float against the dollar is as much an assertion of political independence as an ineluctable consequence of financial liberalisation.
Finally, the developmental perspective in concentrating on the incentives of the ‘periphery’ to keep their currencies undervalued against the dollar ignores the incentives for the monetary hyper-power, the USA, to live beyond its means. Both in the 1960s and today, the USA took advantage of the world appetite for dollars to print as many as it wanted. That is, in both periods it placed the onus of adjustment to its self-chosen spending patterns on other countries. These could either revalue their currencies or accept dollars without limit. The latter was the chief mechanism by which unbalanced creditor and debtor positions arose and persisted in the postwar world, irrespective of whether exchange-rates were fixed or floating. The alternative would have been for the United States to reduce its own consumption. It is just as accurate, then, to say that other countries’ acquiesced in US overspending as that the US acquiesced in their currency undervaluation.
The central monetary fact of the 20th century, it seems to me, was not the alternation of fixing and floating, but the failure to develop generally accepted rules of adjustment for either. Floating does not obviate the need for such rules: it is simply the most obvious consequence of not having them.
The unilateral US attitude to monetary adjustment has its parallel in the ‘unilateralism’ of US foreign and security policy. At bottom it is the attitude that the USA is powerful enough to do whatever is in its own interest, and it’s up to other countries to adjust to what it does. There is no hope of bringing the European and East Asians together into a single agreed system of monetary rules as long as the United States remains indifferent to the external value of the dollar, and indifferent to the consequences of its indifference. Even worse: in the long-run its unilateralism is destructive both of economic globalization and of any orderly system of international relations.
Is the US Deficit Sustainable?
The main contemporary example of America’s monetary unilateralism is its indifference to its burgeoning current account deficit. Driven by a widening trade deficit, it stands at $531 bn., or 4.9% of GDP, its highest ever as a share of the American economy.
The deficit has two sources: the government spends more than it raises in taxes, and the US imports more goods and services than it exports-hence the ‘twin deficits’. Currently the US government accepts no internal limits on the growth of either public or private spending. It’s up to other countries to adjust their economies to the rate of US spending by allowing their countries to appreciate against the dollar.
This attitude is based on the view that the US deficit is not the result of any profligacy by US consumers, but of the ‘undervaluation’ of East Asian currencies against the dollar in order to secure an ‘unfair’ trade advantage. This is a recipe for currency wars.
Traditional economics teaches that deficits of this magnitude are unsustainable –foreigners will not go on financing them. Kenneth Rogoff, Chief Economist of the International Monetary Fund (IMF) put it this way: “Suppose for a moment we were talking about a developing country that had a gaping [trade] deficit year after year as far as the eye can see, budget ink spinning from black into red, open-ended security costs, and an exchange rate that has been inflated by capital inflows. With all that I think it’s fair to say we’d be pretty concerned”. [Wall Street Journal, April 10th 2003] To oversimplify, foreigners will withdraw their capital for fear of a default.
Catherine Mann wrote in 2000 that ‘Absent structural reforms in the United States and abroad, a large devaluation of the dollar, or significant changes in the business cycle, both the trade and the current account deficits will continue to widen until they become unsustainable, perhaps two or three years out’. [Writing in ‘Finance and Development’, IMF Quarterly, March 2000] Four years on, the deficit has widened and continues to be sustained.
In practice, the United States gets away with it for several reasons. The demand for a country’s currency is not closely tied to its current account balance. This is particularly true of a currency which plays a key role in world trade and finance. The usefulness and reputation of a currency, that is, can survive the relative economic decline of the country which issues it-especially in the absence of viable alternatives. This was true of sterling in the early 20th century [R. Skidelsky, Capital Regulation: For and Against, Social Market Foundation, 1999] and is true of the dollar today. [For a good account of the contemporary role of the dollar as a unit of account, a medium of exchange, and a store of value, and the structural characteristics of the US economy which sustain this role, see Patricia Pollard, “The Creation of the Euro and the Role of the Dollar in International Markets”, The Federal Reserve Bank of St. Louis, September / October 2001]
A different approach to the problem of the sustainability of the US deficit emphasises the structural difference between the US economy and the rest. The US is essentially a productivity growth economy; the rest rely on export growth. The US therefore sucks in capital which forces up the value of the dollar. ‘There have been complaints from US industry about the strong dollar, but overall the US has been happy to invest now, consume now, and let investors worry about its deteriorating international investment position’. [Michael P. Dooley, David Folkers-Landau, and Peter Garber, ‘An Essay on the Revived Bretton Woods System’, NBER Working Paper No.9971] This mechanism has been used to explain US success in financing its current account deficits in the boom years of the late 1990s.The role of the USA as ‘consumer of last resort’ imparted an economic virtue to this unbalanced position. But European investors care about returns, and as the American economy started to stagnate, the inward flow from Europe shrivelled, and the dollar started to depreciate against the euro. This was a sign of the classic adjustment mechanism at work.
By contrast, this adjustment mechanism has been blocked on the Asian side. The widening US current account deficit is being financed by purchase of Treasuries by the Central Banks of Japan, China, India, and other East Asian countries. The dollar’s predominant weight in East Asian currency baskets has returned to its pre-1997-8 crisis levels. Most East Asian economies are becoming dollar creditors. [See Ronald McKinnon, Gunther Schnabl, “The Return to Soft Dollar Pegging in East Asia Mitigating Conflicted Virtue”, Forthcoming in International Finance]
The hypothesis is that their governments are accumulating dollar assets as a by-product of a strategy of export-led growth. East Asia is prepared to forgo better returns in order to keep its exchange rates down and export demand up, allowing the region's industries to compete on world markets and attract foreign investment. This explains the emergence of a ‘very asymmetric version of a fixed exchange rate system in which, for some time, periphery countries are willing to underwrite future deficits of the United States’. [Michael P. Dooley, David Folkers-Landau, and Peter Garber, ‘An Essay on the Revived Bretton Woods System’, NBER Working Paper No.9971] This is not the only explanation. McKinnon says: “The microeconomic rationale for stabilizing dollar exchange rates in East Asia stems from the need to limit foreign exchange risk in intra-regional trade and capital flows that are mainly invoiced in dollars […] The macroeconomic rationale stems from the monetary need for a nominal anchor for domestic price levels – more against the threat of inflation before 1997, and now against threatened deflation in the new millennium”. [McKinnon and Schnabl, “A return to exchange rate stability in East Asia?”, October 2003, p.4]
Most academic economists and Washington-consensus officials deplore the East Asian strategy of sterilising dollar holdings rather than allowing their currencies to appreciate. The Americans forced through a G7 statement in Florida calling for ‘more flexibility in exchange rates’. [Financial Times, 8 February 2004] Martin Wolf thinks that East Asian reserve accumulations ‘will prove seriously destabilising…it would be better to let exchange rates move upward’. [Martin Wolf, “Asia: A New Economic Powerhouse”, Asian Development Bank Annual Meeting, Jeju, Republic of Korea, May 14th 2004]
Others emphasise the costs of the system. Lal, Perry and Plant have argued that by accumulating foreign exchange reserves to keep the rupee competitive with the dollar, rather than investing the money, India sacrificed 2.7 per cent annual growth in the 1990s, i.e., its growth would have been 2.7% p.a. higher had it let its currency float. Joshi and Sanyal have shown that this argument rests on a simple analytic mistake. (It assumes non-absorption of all capital inflows and remittances, rather than just those represented by the reserve accumulation that actually took place.) In practice, India’s growth rate was probably higher under exchange rate management than it would have been under floating. A clean float can enable a country to do without reserves. But the cost is an exchange rate which may be highly unstable or inappropriate. ‘Without the cushion of adequate reserves, the shelter of capital controls and the reassurance they provided to the authorities and the market, the exchange rate could have spun out of control and caused severe damage to companies and the private sector’. Exchange rate management kept the rupee ‘mildly undervalued’ in real effective terms, which is good for GDP growth via growth of exports. Appreciation of the exchange rate would have discouraged export growth and made it more difficult to liberalise the capital account and imports and achieve productivity gains’. [D.Lal, S. Bery and D Pant, ‘The Real Exchange Rate, fiscal deficits and capital flows – India:1981-2000, Economic and Political Weekly, XXXVIII (47), 4965-4976; Vijay Joshi and Sanjeev Sanyal, ‘Foreign Inflows and Macroeconomic Policy in India’, May 2004. This paper will be published by Brookings NCAER in the first issue of the new journal, India Policy Forum, vol.1]
The debate over the sustainability of the US current account deficit has strong echoes of earlier debates about how the duty of adjustment should be shared between creditor and debtor countries. The orthodox view was that it was the duty of debtor countries to curtail their spending as a condition for the receipt of new loans. Keynes emphasised the duty of creditors to expand their spending so that debtors could earn the foreign exchange to repay their loans. This debate is not resolved by floating. How much appreciation or depreciation of one’s currency is ‘accepted’ by one’s trading partner depends on some prior agreement between them on how the costs of adjustment should be shared –in other words, what the appropriate internal policies for both should be. Without such generally accepted ‘rules of the game’ floating can produce currency wars as readily as fixing can give rise to trade wars.
On the hypothesis that the US deficit is the counterpart to a rational export-led growth strategy by East and South Asian countries, it can be sustained until the limits of their growth are reached. But this hypothesis is flawed. Currency stability is desired for many reasons, of which maintaining competitive exchange-rates with the dollar is only one. If we take the European precedent seriously, a group of East Asian countries (possibly together with India) will liquidate their creditor position with the United State over time by allowing their currencies to appreciate against the dollar, but will organise a regional zone of currency stability. With the elimination of unbalanced creditor and debtor positions in the major monetary centres, there is no inherent reason why a new and superior Bretton Woods system should not be constructed.
The competitive motive for accumulating dollar reserves blocks the global adjustment process allowing the USA to continue to run large current account deficits. But it is not the only motive East Asian countries have for managing their exchange-rates. The importance of stable currencies within the region will grow with the expansion of inter-regional trade. So a double process of liquidating creditor balances and regional monetary consolidation is probable.
In the very short-run the deficit is evidently sustainable. In the medium-term it will be shrunk by ad hoc measures. The strong recovery of the US economy may well restart private foreign investment in the US economy, thus lessening the exposure of East Asian Central banks. Unlike in the ‘classic’ Bretton Woods system, there is an alternative store of value to the dollar (the euro) and other currencies will follow. The US will also in due course bring its domestic deficit under control.
In the long-run, the curing of monetary imbalance depends on restoring global political balance – a position which David Calleo has long argued in eloquent, if somewhat solitary, splendour. If the US wants to run an empire it has to be in position to tax rest of world. Running up debt is a shadow tax, but payment is voluntary and depends at minimum on acquiescence in US foreign policy, or to put it another way, in the perception that, via the deficit, the US is providing public goods for the whole world. This is far from evident. Specifically, the geopolitical reason for accepting the seignorage of the dollar has become less important since the fall of Communism. Its puny substitute ‘the war against terrorism’ is insufficient.
If US empire rejected, then other economic power centres have to assume responsibility for their own protection, the EU and Japan in particular. This is ‘burden sharing’, but others must help define how the burden is to be shared, and for what purposes.
If the imbalances caused by geopolitics are eliminated, then currencies will become more stable. That floating enjoys its present vogue is not because of theoretical arguments in favour of floating but because US policy precludes the elimination of imbalances which are required to re-establish a global system of stable exchange rates.
It was to avoid a repetition of the currency wars of the 1930s that the Bretton Woods system of fixed exchange rates adjustable by agreement was set up in 1944. This still seems to be the best model for a globalizing world.
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