Exchange Rates

For the second time in a generation, the US dollar has experienced serious overvaluation. In the first instance, in the 1960's, the result led to Nixon Shock , i.e., wage and price controls, a removal of the dollar as a gold-backed currency and a de facto devaluation, especially against the Japanese yen. In 1971, the yen was Y360 to one US dollar; at the end of 1987, the dollar declined below Y125 on its way to parity at Y100. The more recent experience of the dollar's devaluation stems directly from the unsustainable American combination of huge government deficits, persistent trade deficits and a low domestic savings rate. The trade deficits alone in the past three years were $113 billion in 1985, $137 billion in 1986 and $146 billion to October 1987.

The serious policy dilemma stems not from these annual current account deficits in and of themselves, but the larger issues of the US external debt, the sources of funds needed to finance the debt, i.e., foreign and primarily Japanese money, and the relative interest rate spreads between the US and its major trading partners, with the resulting international pressure on the exchange rate. As Britain found to its cost after the 1967 devaluation of the pound, slow and piecemeal adjustments only exacerbate the need for even more severe policy measures, leaving the dollar open to continued pressure and speculation in the foreign exchange markets. In fact, accepted wisdom in Tokyo is for dollar-yen parity, i.e., 100 yen to the dollar the largest single currency realignment, and thus shift in real wealth, in modern history (see Exhibit I).

Evidently, the most startling result has been the reversed position of the United States as the world's biggest international debtor nation, with liabilities greater than the combined debts of Mexico and Brazil. For the US, Japan's position as financial superpower has an historical precedent in Britain s portfolio of investments in the US just before the turn of the last century. Linked to Britain by the operation of the international gold standard, and heavily indebted for railway construction and for the financing of seasonal agricultural commodities, the US viewed her Atlantic trading partner more as a sinister commercial rival and indeed financial scapegoat, stemming from the perceived policy divergences of their respective debtor and creditor positions.

While the historical parallels are not exact, there can be little doubt that both American and non-American sentiments towards Japan have turned Japan-bashing into a growth industry. Bilateral resentment on trade has extended to investment, to technology, to monetary issues and, especially among Americans, to Japan's role as a Western ally carrying a small defense burden. Conspiracy theories abound about "Japan, Inc." , about the "Japan Problem" and, more ominously, given the racial overtones, about "The Danger from Japan".⁽²⁾ The overwhelming economic evidence shows that despite the manifestations of the Japan problem whether that of market access or simply protectionism it is the exchange rate issue and the macroeconomic imbalances that explain both global and US-Japan deficits.

According to one study,⁽³⁾

...virtually the entire growth in the bilateral imbalance, from about $12 billion in 1980 to about $40 billion in 1984, can be explained by the onset of exchange rate misalignment and differences in economic growth rates.

Feldstein ⁽⁴⁾ is more specific:

The principal reason for the substantial and sustained rise of the dollar was undoubtedly the rise in US real interest rates that resulted from the massive increase in projected budget deficits in a monetary environment that aimed at preventing a return to high inflation.

Normally, currency realignment would be the obvious policy approach to market equilibrium, but for the United States, this approach poses particular difficulties, not the least being the role of the dollar as an unofficial reserve currency, and its impact on the American economy as the locomotive for world trade. Moreover, in an increasingly open economy, continued devaluation as a route to equilibrium acts as a spur to higher inflation rates and thus higher interest rates. In the absence of effective international coordination, extreme and continued pressure on the dollar has led to a flight of capital by foreigners out of American currency into other currencies or into precious metals such as gold. Further, there is no obvious break or leveling mechanism to support the US dollar since so little of the assets of US pension fund money is held in foreign securities, scarcely five per cent by some estimates. With the US dollar depreciating about 45 per cent in the past three years, the tendency would be for US investors to move out of foreign markets to take advantage of improved US competitiveness.

The Tokyo Economic Summit, ironically, advanced the international policy coordination process through a system of multilateral surveillance as a potential mechanism to stabilize exchange rates through Objective economic indicators. A more extreme approach, given the market pressures on the dollar during 1987, is one advanced by some economists, namely, to establish targets for real exchange rates, possibly based on measures of purchasing-power-parity rates. Under this approach, where exchange rates would be based on measures which equalized price levels for goods and services across countries, the US dollar would be subject to a target zone wherein domestic policy fiscal and monetary would be subordinate to international constraints.