FIX GOLD TO ESTABLISH A FAIR DOLLAR LEVEL / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

February 11, 2013 12:24 pm

 

Fix gold to establish a fair dollar level

 

By Komal Sri-Kumar

 

Currency exchange needs to be established at realistic values

 

 

In a global economy still recovering from the 2008 crisis, boosting economic growth has become a key priority. The discussion among central bankers has focused on using currency depreciation to boost export competitiveness, production and employment.


This is by no means a novel idea. Competitive devaluations were repeatedly used during the 1930s to gain competitive advantage – until the trading partner also devalued, negating the impact of the first devaluation. Such currency wars, or “beggar thy neighbour” policies, prolonged and deepened the Great Depression. More recently, incremental resort to quantitative easing by the US Federal Reserve has weakened the dollar on a trade-weighted basis.


In 2010, Brazil’s finance minister Guido Mantega complained about the massive capital inflows resulting from the US measures, strengthening the real and making exports expensive. Cuts in interest rates by Brazil’s central bank since mid-2011 to weaken the currency ended up increasing inflationary pressures.


Bank of England governor Mervyn King warned about currency wars last month, but said at the same time that the pound has to depreciate to foster growth. Shinzo Abe, Japanese prime minister, has also pushed his country’s central bank to target a doubling of the inflation rate to 2 per cent by weakening the yen.


The ongoing exchange rate battles run counter to a basic concept in mathematical logic. When n numbers add up to a specific target, only n-1 of them can be independently determined. The nth figure is the anchor that gives the remaining numbers the flexibility to vary and be set at desired levels. With the exchange rate itself having little intrinsic value, fixing it would allow governments to use monetary and fiscal measures to target desired levels of employment and inflation.


In the post-second world war era, it was the exchange rate that served as the anchor enabling western market economies and Japan to facilitate a greater role for the private sector domestically, and to pursue freer trade externally, reviving the global economy. The desired goals were growth (raised to an acceptable level), global trade (returned to normality after war-related disruptions), and inflation (kept low). Similarly, despite the eurozone’s imperfect structure, the single currency encouraged the free flow of capital across national borders, boosted growth prospects and kept inflationary pressures low.


While adherence to the discipline of fixed exchange rates was a major factor in the global prosperity of the 1960s, breaking the rules ended in disaster. US president Richard Nixon’s decision in August 1971 to delink the dollar from gold allowed global inflation to surge and precipitated a recession. Nixon had set the nth input adrift, leaving the global economy without an anchor.

 

The pursuit of an exchange rate level as a target in itself has also resulted in misplaced priorities. The US Treasury and Senate have spent the past 15 years criticising Chinese authorities for not permitting a bigger appreciation of the yuan.


This was time wasted. Foreign exports to China did gain competitiveness in recent years, but due to increased Chinese wage costs rather than from a stronger yuan.

Instead of focusing on the yuan’s exchange rate with the dollar, foreign negotiators should have pushed China to open its markets to foreign competition, and to reduce restrictions on foreign capital inflows. Trying to force Chinese monetary authorities to move the exchange rate faster shifted the focus of western governments from the need for structural reforms in the Chinese economy.


As central banks in the US, Europe, Japan and China wrestle with recession or slower growth, they will find that competitive monetary easing measures, and uncertainty about exchange rates, hold back rather than promote recovery. Providing the security that comes from fixed exchange rates, and pursuing policies compatible with those rates, would be more effective in reviving growth.


In a move away from the current situation of extreme currency volatility to one involving fixed exchange rates, global markets would gain most benefit from the rates being set at appropriate levels.


A first step would be to fix the price of gold in dollar terms at near its current level of $1,675, with assured convertibility. To ensure that currencies are neither over- nor undervalued, the consumption basket (or the hypothetical loaf of bread) should be valued at roughly similar levels in different currencies at fixed rates against the dollar.


When currencies are established at realistic values, investors and exporters will see the exchange rates as durable. This will promote increased capital flows across financial markets, and encourage longer-term investment in projects such as infrastructure.



Komal Sri-Kumar is president of Sri-Kumar Global Strategies

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Copyright The Financial Times Limited 2013