from Follow the Money

James Dorn leaves me confused -

October 25, 2006

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CATO’s Dorn attacks a coordinated policy response to global imbalances on the grounds that it presumes that governments have a better sense of the “right” exchange rate than the markets:

A negotiated approach to resolving trade imbalances presumes that “experts” know the relevant market-clearing exchange rates and that governments can agree to enforce them – neither of which has proved to be true. Any exchange rate that was fundamentally misaligned would eventually be attacked and governments would be ill-equipped to prevent it. Moreover, the longer that adjustment was delayed, the higher the cost would be in terms of resource misallocation.

But doesn’t the current system hinge on “experts” rather than markets setting key exchange rates?   In this case, the key experts are China’s State Council (which seems to make Chinese exchange rate policy), the central banks of the GCC countries and the heads of all the other emerging market economies intervening in the fx market at an unprecedented rate.  And hasn’t a key lesson of the past few years been that governments are a bit more able to ward off attacks if they are defending an undervalued exchange rate than if they are defending an overvalued exchange rate?   Particularly if they have somewhat effective capital controls in place ...  

And, viewed, from Dorn’s perspective, doesn’t delaying the end of the current system  only increase the misallocation of resources created by central banks massive intervention in markets and the resulting deviation of key exchange rates from market levels?

It seems to me that a big part case for policy coordination is precisely that current emerging market exchange rates are so far from market clearing exchange rates – look at the current scale of reserve accumulation in the emerging world – that any changes needs to be both gradual and coordinated.   Ending the United States bond markets dependence on its central bank fix by going cold turkey wouldn’t be fun.   

Another part of the argument for coordination is that absent a bit of coordination, everyone will continue intervening at the current – or perhaps an even bigger rate.  Coordination is needed to convince folks to change.  And a final part of the argument for coordination is that adjustment would be a lot easier if everyone was confident that steps to reign in US demand growth were matched by steps to spur demand growth outside the US.    See Larry Summers.

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