America and its exchange rate!

Dr. Walker, what was your reasoning for why America would never set an exchange rate? And, can we use that as leverage over the rest of the world to get ourselves out of a hole economically? And, you were right this summer when you said the economy would take a serious nose dive! 

The idea is very simple.

If you have two countries trading with one another, you have one exchange rate between them.

If you have three countries, you have two exchange rates.

There is always one less exchange rate than the number of countries engaged in trade.

This means there must always be one country that accepts the exchange rates set by others. 

Today (and in the past) the United States has accepted the exchange rate to the dollar set by all its trading partners, i.e., it accepted the role of the so-called n-country, the one that does not set its exchange rate.

It does this to avoid the inevitable fights that would occur if the U.S. were to impose an exchange rate on other countries.  Besides, it puts the burden for maintaining the exchange rate on the other countries.  In the past, it has been so big (at the end of WWII it accounted for almost 40 per cent of gross world product) it felt, no doubt correctly, that other countries would try and balance their trade, so there would be no reason for great trade imbalances.  In any event, any trade imbalance with the U.S., given its size, would be small.

 Now, however, the U.S. is only about 20 to 25 per cent of gross world product and some countries (notably China) has insisted on having a large trade surplus, which translated into a large American deficit.  Now we are not so agreeable to the idea that others can do what they want with the exchange rate.  But were we to insist on imposing a different exchange rate, we would be in a big fight with the Chinese and others.  Also, many in the U.S. have benefited from the Chinese surplus (think Wall Street) and do not want our exchange rate to change.  Finally, we now live in a world of floating exchange rates (better: managed exchange rates), so the setting of exchange rates has become less of a policy question.  Hence, our policy position has been ambiguous:  At times, we would like a lower exchange rate to help our exports and limit imports.  At other times, the reverse.

 I don't think it's a good idea for the U.S. to set an exchange rate with a foreign currency.  We do it with one currency; we will have to do it with many.  It isn't worth the headaches.  Better is to say to the Chinese (or any other country where we have a large trade deficit), you can set it where you want but if the deficit gets too big we will implement capital controls against you.  Not current account controls; capital account controls. 

 A better set of exchange rates would be helpful to the U.S.  I would threaten the use of capital controls but I suspect the deficits will be coming down anyway.

 Right now, we are in trouble and the world is in worse trouble.  Common sense says to you that the outsized imbalances -- budget as well as trade -- have contributed to our troubles and those of the rest of the world.   Once we have recovered from the present mess, in several years, the entire matter can be re-considered.  And it will be in the context of the ongoing discussions about reform of the international monetary system.

 On the mess were in, I fear it will get worse before it gets better.