Chairman LAFALCE. Well, we will revisit that afterward. Mr. MCKINNON. OK. If you had a fixed nominal exchange rate in this small open economy and you have a fiscal deficit, you will show up with a trade deficit with no change in exchange rate. But that is a point that is not generally realized by most people here. We have the immediate problem of getting the dollar down and then it is of course necessary to manage the system into the more distant future. But I would like to return to one point that Representative Reuss raised about the inflationary consequences of this one-time depreciation of the dollar. When we had the big dollar devaluations of the 1970's, in 1971 and 1973 and again in 1977 through 1979, there was a monetary explosion in the rest of the world from people who have looked at the statistics. You can see that the money supplies of European countries greatly increased in the 1971, 1972, and 1973 period and again in 1977 and 1978. Because they were trying to keep the dollar from depreciating, foreign central banks intervened by buying dollars and selling their own currencies. So there was a monetary explosion in the rest of the world. Therefore, those dollar depreciations were associated with a great deal of international inflation. Now if we have the kind of agreement that I have in mind here where are going to nudge the dollar down to 2.2 deutsche marks, the important element in that agreement is that the other central banks sit on their money supplies and they don't expand as they did in the 1970's. Now if we have that agreement, then we can get the one-time depreciation without the mass of inflationary consequences that we experienced in the 1970's. Thank you. [The prepared statement of Prof. Ronald I. McKinnon, entitled "What To Do About the Overvalued Dollar," follows:] March, 1985 WHAT TO DO ABOUT THE OVERVALUED DOLLAR* by Ronald I. McKinnon Reneging on the long-standing American commitment to maintain fre free international trade would undermine the economic basis for the postwar prosperity of the noncommunist world. Yet, the grossly overvalued dollar--as much as 40 to 50 percent when measured against European currencies and about 25 percent against the Japanese yen--is imposing undue competitive pressure and great distress across a broad spectrum of American farming, mining and manufacturing activities. restrict imports is rapidly increasing. And pressure to However, a return to protectionism is no solution at all. Restricting imports entering the United States would drive the dollar up further, causing even more misfortune for American exporters. But to thwart protectionism, the financial imbalance between the United States and the industrial countries of Western Europe and Japan must be righted. The large U.S. fiscal deficit is commonly (and correctly) blamed for much of the trade deficit--but it cannot explain the present extraordinary exchange-rate misalignment. I hypothesize that monetary coordination among the United States, the European bloc, *Much of the empirical and theoretical support for the proposals advanced in this paper can be found in the author's recent book, An International Standard For Monetary Stabilization, the Institute for International Economics, (Washington D.C.) and the M.I.T. Press, 1984. Some of these materials are included in the supporting tables and figures, all of which appear at the end of the paper rather than being inserted into the text. and Japan is the only practical way of correcting dollar overvaluation while at the same time preserving longer-run price and exchange-rate stability. The Fiscal Conundrum An obvious target for reform is American fiscal policy. Huge budget deficits, which the Federal Reserve properly refuses to monetize-increase American real interest rates (those calculated after expected future price inflation is discounted) and attract capital from abroad. The dollar is then bid up in the foreign exchange markets--overshooting its long-run equilibrium--as foreigners rush to take advantage of the high yields on U.S. government bonds and corporate securities. Apart from exchange-rate overshooting, however, the trade deficit simply cannot be eliminated while the fiscal deficit remains SO large and raises the country's.expenditures above its income. But fiscal policy is not the whole story. After all, the large dollar depreciations of the 1970s were not caused by U.S. budgetary surpluses! Indeed, in the 1970s, some commentators at the time pointed one reason why foreigners to the much smaller U.S. fiscal deficits as felt nervous about holding on to dollar assets. Moreover, much of the recent increase in the foreign exchange value of the dollar has been associated with falling nominal interest rates. From August 1984 to early February 1985, American interest rates fell 2 to 3 percentage points relative to those in Germany (see Figure 4), while the dollar was rising from 2.88 to 3.25 marks (Figure 2). Although interest rates remain important, expectations of future political safety, price inflation, and other sources of future exchange rate movements often dominate the portfolio preferences of international investors. The gnomes of Zurich, Luxembourg, and Singapore continually look for the safest haven (currency) in which to place their internationally liquid assets. Suppose the American government moved seriously towards cutting expenditures. U.S. interest rates would fall immediately in anticipation of lower future fiscal deficits, and this effect by itself would tend to depress the dollar in the foreign exchanges. Against this, people might expect that the resulting reduction in the projected national debt would lessen the chances of price inflation in the distant future. Similarly, other taxes on the holders of dollar assets become less likely. The United States could then seem like an even safer haven for international capital. Because of these opposing considerations, even resolute action by the American government to eliminate its unsustainable fiscal deficit need not bring the dollar down in the foreign exchange markets--although it probably would. (The one dramatic exception is a general withholding tax on interest and dividend income--including all those American securities owned by foreigners. That certainly would bring the dollar down.) At best, fiscal policy is a blunt instrument, subject to long delays and uncertainties, for influencing the exchange rate. Enter Monetary Policy In contrast, monetary policy is immediately flexible and can be made to influence the exchange rate unambigously. In the asymmetrical Bretton Woods system, countries other than the United States were directly responsible for maintaining their exchange rates within one percent of either side of their formal dollar parities. For example, from 1950 to 1970, the Bank of Japan kept the yen within 3/4 of one percent of 360 yen to the dollar by raising yen interest rates and contracting when international payments were in deficit, and expanding the yen money supply when the Japanese currency tended to appreciate. Japanese monetary policy, based on this fixed exchange-rate rule, led to stable yen prices for the broad range of internationally traded goods and contributed to Japan's extraordinary postwar recovery. Similarly, in these same two prosperous decades, European governments generally subordinated their monetary policies to preserve stable exchange rates for long periods--with small, infrequent adjustments in their dollar parities. Only Britain continually resisted the necessary internationalization of its domestic monetary policy with deficits and numerous "sterling consequential balance-of-payments crises" throughout the 1950s and 1960s. And Britain had the least |