Can the dollar devalue?

It is a common feature of international economics that countries with persistent balance of payments deficits are advised to depreciate their exchange rate; if they fail to heed to this advice they are eventually compelled to do so as they run out of sufficient international liquid resources to pay for the goods and services.

The only country that does not face this dilemma is the reserve nation whose currency is accepted by all trade surplus countries.

Thus America is unable to devalue the dollar in spite of mounting trade deficits as other countries choose to deposit their surpluses in America.

For, in contrast to America, countries that run persistent balance of payments surpluses do not need to change their exchange rate.

They can go on accumulating reserves indefinitely without having to revalue their currency. Unfortunately, this asymmetry between deficit and surplus countries nearly always leads to tensions between the two blocs.

Deficit countries object to the burden of adjustment falling wholly on them, while surplus countries can choose to ignore the issue.

Of course commentators and analysts do not fail to point out that the surplus countries are following sub-optimal policies but as countries so frequently choose to follow sub-optimal economic policies, no particular regard is given to this inefficient behaviour in policy making.

Yet at the global level one country's surplus must be at the cost of another country's deficit. In recognising this dual aspect of the balance of payments Keynes had in an ignored proposal at the time of Bretton Woods suggested that both persistent deficit and persistent surplus countries should be penalised by having to pay an interest rate charge for failing to rectify the imbalance in their Balance of Payments account.

The Americans, who had rejected the idea at that time, might have welcomed it now when the Asians are running the surpluses against American deficits.

In the normal course, one should expect an outcry that the Americans should depreciate their exchange rate but unfortunately this has technical difficulties as the nominal value of all currencies is measured against the dollar.

The dollar cannot be devalued against itself, hence the proposal that other currencies like the Chinese should revalue against the dollar.

This requires the Chinese and other East Asian surplus countries to take the initiative to change their exchange rates, which they are unwilling to do.

They can see no reason to take deliberate steps to change policies that are accumulating for them reserves.

The history of developing countries with trade surpluses that turn to deficits by deliberate policy has not been a happy one. When the authorities are unable to stem the tide of deficits, the consequences for the persons held to be responsible can be severe.

Recently, for example, the governor of the Central Bank in Thailand was legally charged for frittering away $ 5 billion by allowing foreigners to convert their baht holdings into dollars.

Presumably, the governor had thought that if he showed sufficient confidence in the Thai currency he could stop a run on his reserves but when that ploy failed the anger of the people fell on those in authority.

One must assume that it is incidents like these that prevent the Chinese authorities from taking such discretionary action as would be involved in re-valuing the yuan.

If there were some automatic rules generally accepted by the sovereign state of China, and if such rules resulted in a re-valuation of the Chinese currency, no one would particularly care.

It is not out of careful economic planning that the Chinese currency has emerged strong. It is primarily a consequence of historical events and a policy commonly favoured by many experts all over the world in export-led growth.

Some analysts could now accuse the Chinese of mis-handling their finances by accumulating high reserves with no immediate or visible benefit to the Chinese people.

But such arguments of sub-optimal behaviour are not very convincing and unlikely to persuade the Chinese or any other Asian authorities that their currency needs to be re-valued.

Thus internationally the financial system faces an impasse. Everyone recognises that American deficits ought to be reduced by a suitable change in relative exchange rates but no one knows how to initiate the change.

Further, the dollar's position as the reserve currency seems to hinder a devaluation of the dollar as an immediate necessity.  On the other hand, the economically equivalent action of a re-valuation by other currencies is hampered by the success of their export policy.

The worst case they face is an accumulation of reserves in dollars, which though harmful in some complex economic way, is not immediately obvious.

The initiative for a change should come from the Americans, who would like to see an improvement in their trade deficit but are they able to change the relative exchange rates so long as surplus countries accumulate reserves in dollars.

One somewhat laborious solution might be a world conference on currencies to produce an agreement whereby East Asian currencies might agree to be re-aligned simultaneously but such an initiative would require the sort of tedious negotiation that could not promise a solution.

Certainly, it could be initiated under the aegis of the International Monetary Fund but the chances of success are not immediately self-evident.

The initiative required to achieve a desired result would have to contain more than logical discussions. Dominance by a few countries would help but it is not clear that in trade matters any set of nations are particularly strong.

If the task of determining its exchange rates is primarily the business of each sovereign power to decide for themselves on fixing their central rate, the likely outcome of a successful determination is doubtful.

One possible technical but highly speculative solution that could be considered by the Americans on their own initiative would be to choose any one international currency against which they would formally devalue.

If, for example, they chose to declare that they would sell any number of dollars against, say, the Japanese yen at a rate of $1 against 100 yen, this would amount to an effective devaluation of 10 per cent of the American dollar against the yen.

Such a step cannot be prevented because just as other countries are free to price their currencies against the dollar, the American authorities are free to price the dollar against other currencies.

Markets would arbitrage the yen against the dollar. They could purchase the yen at 110 (the present market price of the yen) and sell it at 100 to the Americans. Clearly such an arbitrage would not last long as the market price for the yen would rapidly rise to 100 yen and presumably cross-currency rates between the yuan and the dollar would rapidly adjust the new exchange rates.

The merit of such an initiative would be a devaluation of the dollar through an effective revaluation of the yen and hopefully of other strong currencies.

In other words, the Americans could ensure the revaluation of other currencies if they take the initiative of pricing up other currencies in terms of the dollar not just by persuasion but by action in the markets.