Armageddon Can Wait
CAMBRIDGE – Where are global currencies headed in 2011? After three years of huge, crisis-driven exchange-rate swings, it is useful to take stock both of currency values and of the exchange-rate system as a whole. And my best guess is that we will see a mix of currency wars, currency collapses, and currency chaos in the year ahead – but that this won’t spell the end of the economic recovery, much less the end of the world.
Let’s start by acknowledging that the modern system of floating exchange rates has, on the whole, acquitted itself remarkably well. True, given complex risk factors and idiosyncratic policy preferences, it has been particularly challenging of late to divine the logic underlying big exchange-rate swings. For example, even though the United States was at the heart of the financial crisis, the dollar initially soared.
But, even if exchange rates work in mysterious ways, their cushioning effect is undeniable. The sharp depreciation of the euro after the crisis helped sustain German exports, thereby keeping the eurozone afloat.
Emerging markets’ currencies also collapsed, even in economies with huge foreign-exchange reserves and relatively little debt. Since then, most emerging-market currencies have rebounded sharply. In hindsight, these exchange-rate swings mirrored the initial collapse and subsequent rebound in global trade, helping to mitigate the recession.
By contrast, the financial crisis was hardly an advertisement for expanding the scope of fixed exchange rates. The eurozone’s peripheral countries, including Greece, Portugal, Ireland, and Spain, found themselves pinned to the mast of the common currency, unable to gain competitiveness through exchange-rate depreciation.
The intellectual father of the euro, Columbia University’s Robert Mundell, once famously opined that the optimal number of currencies in the world is an odd number, preferably less than three. It is hard to see why right now.
Perhaps when we have one world government, it will make sense to have one world currency. But, even setting aside the equilibrating benefits of flexible currencies, the prospect of a single, omnipotent central bank is not particularly appealing. Witness the vitriol and hysteria that accompanied the US Federal Reserve’s policy of so-called “quantitative easing.” Imagine the panic that would have ensued in a world where gold, storable commodities, and art were the only ways for investors to flee from the dollar.
But the continuing success of the floating exchange-rate system does not imply a smooth ride in 2011. For starters, we can certainly expect a continuation of the so-called currency wars, in which countries strive to keep their exchange rates from appreciating too rapidly and choking off exports. Asian governments will probably gradually “lose” their battle in this war in 2011, allowing their currencies to appreciate in the face of inflationary pressures and threats of trade retaliation.
As for currency collapse, the most prominent candidate has to be the euro. In an ideal world, Europe would deal with its excessive debt burdens through a restructuring of Greek, Irish, and Portuguese liabilities, as well as municipal and bank debt in Spain. At the same time, these countries would regain export competiveness through massive wage reductions.
For now, however, European policymakers seem to prefer to keep escalating the size of bridge loans to the periphery, not wanting to acknowledge that private markets will ultimately require a more durable and sustainable solution. No risk factor is more dangerous for a currency than policymakers’ refusal to face fiscal realities; until European officials do, the euro remains vulnerable.
The dollar, on the other hand, looks like a safer bet in 2011. For one thing, its purchasing power is already scraping along at a fairly low level globally – indeed, near an all-time low, according to the Fed’s broad dollar exchange-rate index. Thus, normal re-equilibration to “purchasing power parity” should give the dollar slight upward momentum.
Of course, some believe that the Fed’s mass purchases of US debt poses an even bigger risk than Europe’s sovereign debt crisis. Perhaps, but most students of monetary policy view quantitative easing as the textbook policy for pulling an economy out of a zero-interest-rate “liquidity trap,” thereby preventing the onset of a sustained deflation, which would exacerbate debt burdens.
As for China’s renminbi, it is still supported by a highly political exchange-rate regime. Eventually, China’s rapid growth will have to be reflected in a significant rise in its currency, its domestic price level, or in both. But, in 2011, most of the equilibration will likely take place through inflation.
Finally, currency chaos is the safest bet of all, with sharp and unpredictable swings in floating exchange rates around the world. During the mid-2000’s, there was a brief window when some argued that currencies had become more stable as a corollary of the “Great Moderation” in macroeconomic activity. Nobody is saying that now. The floating exchange-rate system works surprisingly well, but currency volatility and unpredictability look likely to remain an enduring constant in 2011 and beyond.
Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.