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

The repeated Japanese unilateral interventions of the last year were often justified in terms of limiting exchange rate volatility, so perhaps a restriction on such frequent intervention could be argued as negative. But the fact is that exchange rate intervention to limit volatility does not work, and volatility has not proved to be so bad. We do not even really understand exchange rate volatility, since in recent decades monetary policy's commitment to price stability and limiting activism has deepened (removing what Milton Friedman thought would cause instability), and the real economies of the major issuers have become more flexible (diminishing what Rudiger Dornbusch thought would cause overshooting), and still exchange rate volatility has increased. Meanwhile, all empirical evidence indicates that the costs to businesses and economies arise from sustained misalignments--not from volatility--of exchange rates.

Such an agreement on dual-key exchange rate intervention would defuse the political pressures on the exchange rate system without promising too much in terms of specific deliverables or requiring too much in terms of specific actions from the major governments. It is damaging to have the strategy of competitive undervaluation seemingly accepted amongst the big three currencies, as now appears to be the case. Making progress on trade or aid could well be sidelined by the conflicts and mistrust that unilateral intervention breeds.

If China were to revalue the renminbi, or even if simply the political winds were to shift in the face of the Japanese recovery, Japan could find itself under harsh attack for its "manipulation" of the exchange rate that had taken place under the cover of China as primary target of U.S. interest groups and politicians. Similar problems could result if the eurozone countries (or some particular member countries of the eurozone) were to unilaterally draw a line on euro appreciation against the dollar in coming months, even if there were a strong "fairness" argument to be made for the eurozone so doing in the face of U.S. fiscal profligacy.

It is worthwhile to compare this dual-key proposal with the older overly ambitious proposals for G3 target zones. Unlike target zones, a dual-key intervention system would not require the major currencies to specify publicly the acceptable range or targets for the exchange rates. Without such specified targets, the governments would not be subject to market attacks or suspicions of their will to defend the targets as the outer bands were approached. Without such specified targets, the governments would be able to, in consultation but in real-time, flexibly change their underlying willingness to intervene as conditions changed. They would not have to pre announce the changes and worry about the credibility and signaling effects of changing targets too often, or the economic difficulties of changing target zones too infrequently.

This dual-key system would have been particularly handy in recent months as Japan went from a period of stagnation and danger of deflationary spiral (which all participating governments would have agreed justified forestalling any rise in the yen exchange rate) to a period of sustained recovery and prospects of future positive inflation (which at least two of the governments and the Bank of Japan would agree is consistent with a modest rise in the value of the yen). It would similarly have been useful to deal flexibly with the concerns about deflation emerging in the United States following the information technology bubble. The major governments would have been forced into a practical discussion of what was mutually acceptable as the limit, making something actionable out of the framework of outlook discussions that already take place in the G7 and OECD.