Avoiding a currency war: how a new "dual-key" exchange rate system could help the United States, Japan, the eurozone—and China—find a way out

International Economy, The, Summer, 2004 by Adam S. Posen

A conflict over exchange rates is brewing. The burden of adjustment the United States needs to close its trade deficit has fallen mostly upon the euro-dollar exchange rate, to the tune of 30 percent versus eighteen months ago. Meanwhile, the yen-dollar exchange rate has moved only 17 percent in the same period, largely because the yuan-dollar rate has not moved at all. The weak and, in part, export-driven recovery in Europe makes the eurozone governments antsy about further rises in the euro against the dollar. And U.S. presidential candidates are formulating legal challenges to those countries that are seen as blocking the orderly decline of the dollar. Governments and interest groups do not like feeling as if they are being taken advantage of by foreign economic policies.

Outright "management" of exchange rates, however, is not in the offing-none of the major governments are willing to subordinate domestic monetary or fiscal policy to achieve exchange rate goals, and they would have to do so in order to actively manage exchange rates. This external laissez-faire stance is justified economically for each of the three major currency issuers--the United States, Japan, and the eurozone--since the exchange rate does not have a significant effect on domestic price levels or growth rates until large misalignments are sustained. Politically, though, this is not a sufficient argument to stave off either self-serving arguments from import-competing sectors or more valid government-to-government complaints about burden-sharing and exchange rate manipulation.

A system of dual-key exchange rate intervention agreed to by the United States, Japan, and the eurozone should be adopted in response to this situation. The governments would agree that they would not intervene in foreign exchange markets to affect the value of their home currencies against either of the remaining two, unless one of the other two players agreed to intervene as well. No more unilateral intervention would occur, as for example done on an enormous scale by Japan over 2003 and the first quarter of 2004.

Were one of the three currency issuers to engage in unilateral intervention, presumably to weaken its home currency versus one or both of the others, the other two would commit to offsetting that intervention. Since issuers can always weaken their own currency by simply selling more of it on world markets, the threat to offset is credible and no prior agreement about reserves would be necessary. In the improbable situation that one of the three currency zones wished to appreciate its currency against the other two, and neither of the other two would agree to coordinate on that direction of intervention, they could combine reserves to sell on the market (in all likelihood, they could expect the market to join them in opposing the appreciation, for the unilateral intervener could only strengthen its currency to the extent it had foreign exchange reserves with which to buy up its own currency).

The first obvious advantage of this dual-key arrangement would be the calming of political pressures over apparent competitive depreciations--none of the big three issuers could be accused of exchange rate manipulation, and that accusation no longer could be used as a rallying cry for protectionism or nativist complaints about burden-sharing. Further advantages would accrue as well:

* Exchange rate interventions would become far more credible since they would only be undertaken when coordinated, and thus backed by all countries involved (we already know that coordinated interventions are more effective when known to be joint).

* Information disclosure and sharing about economic situations and exchange rate goals between the three issuers would be reinforced, since a government wishing to intervene would have to persuade the other issuers of the benefits of so doing.

* Independent central banks would be reassured about external pressures on price stability, since this would restrict an elected government's use of its control over exchange rate intervention to offset monetary policy.

* Exchange rate expectations would be better anchored since the outer limit of how far a major currency could depreciate would be the lower of whatever the other two issuers would be willing to accept at a given time.

* There would be diminished incentive for ally of the major economies to accumulate vast reserves of either of the other two major currencies, which would in turn reduce uncertainty about, and potential cross-border politicization of, capital flows.

The governments involved would give up very little in practice to gain these benefits by agreeing to a dual-key system. The United States essentially ceased to intervene unilaterally over a decade ago, believing that only coordinated intervention has sufficient beneficial impact; to date, the eurozone member governments have largely displayed the same sentiment, and the European Central Bank certainly feels that way. Unless one is engaged in competitive depreciation, there is little reason to keep a country's intervention plans secret from the governments responsible for the other major currencies. This plan does nothing to compromise governments' ability to surprise markets with their exchange rate interventions, should that prove tactically useful (which is not always the case in any event).