The usual counter-cyclical remedies of monetary and fiscalpump-priming accomplish little as long as interest rates are stucknear zero. And against the background of financial contraction,little can be done to reduce the overhang of bad bank debt. As werecognize that the Japanese stagnation has external origins, anddoes not represent some peculiar, made-in-Japan policy failure, weare on the way to a systemic solution. Breaking the pattern ofJapanese deflation will require breaking the expectation that theyen in the future will appreciate, fluctuate sharply, or both.Then, yen interest rates would rise to dollar rate levels,financial sector recovery could begin and the deflation trap wouldbe sprung.

China as Stabilizer

While the Japanese economy has been a trigger of instability,the Chinese economy has helped to stabilize others in the region.Where other Asian economies have been whiplashed by yenappreciations and depreciations, most of their currencies have beenpegged to the dollar and, hence, to the renminbi. By notdepreciating its currency during the 1997-99 crisis, China avoidedsetting off a new round of competitive devaluations. More recently,a stable renminbi has been the anchor for a revived Asian dollarstandard. Through a series of constitutional changes beginning in1999, property rights have gathered much greater legal protection,and a more transparent regulatory framework has been adopted, whichtogether have given a strong boost to private-sector-led growth.Some price controls have been lifted (although many remain), soresource allocation has become more market-driven than in the past.China is now expanding faster than the United States as a source ofdemand for every economy in the East Asia region.

Chinese reserves by mid-2005 exceeded $650 billion--only Japan'sare higher--and grew by about $200 billion in 2004, $95 billion ofit in the fourth quarter alone. Unlike the case in Japan recently,capital inflows into China have boosted both asset prices anddemand generally. They have funded lending pools to take advantageof high interest rates in the "informal sector." Inflows alsoreflect speculative demand for renminbi, in anticipation of itspossible appreciation. Some of the new reserves are "sterilized",that is, prevented by deliberate central bank interventions fromaffecting the domestic money supply, aggregate demand and pricelevel. Sterilization succeeded to the point that growth of basemoney actually slowed during 2004 relative to 2003, despite theextraordinary increase in the People's Bank of China's (PBC)foreign reserves.

The evidence of sterilization makes it likely that the renminbiat 8.28 or even 8.11 to the dollar is somewhat undervalued.However, it is normal practice for central banks to sterilize whatthey perceive as speculation-driven inflows. The Chinese currentaccount surplus typically runs in the range of 1 to 2 percent ofGDP and moved to over 3 percent during 2003 and 2004, which maysuggest that domestic cost structures are somewhat low. On theother hand, most countries now run trade and current accountsurpluses--the inverse of huge U.S. deficits. China may producemore than it consumes because domestic savings are high; indeed,the savings habits of Chinese peasants are legendary. Alternately,savings (and the trade surplus) may be high because of a cyclicalslowing of the Chinese economy--that is, the trade surplus may havelittle to do with the exchange rate. With inconvertibility andquantitative restrictions on capital inflows, the usual marketsignals are muddled.

In any event, Chinese costs may adjust through internal priceinflation as well as through external appreciation of the currency.This is not hypothetical--from 1994 to 2003, money wages inmanufacturing in China grew by about 13 percent annually and byonly about 3 percent annually in the United States. A MorganStanley report calculates that domestic price changes led therenminbi to rise in real terms by 40-50 percent against both thedollar and the euro from 1993 to 2004, despite fixed nominalexchange rates. Assuming stable exchange rates, domestic priceswould again increase relative to prices in the United States if thePBC sterilized less.

Notwithstanding assertions to the contrary, there is littleevidence that the Chinese economy is overheated, or that it needs achill from a rising exchange rate. While the consumer price index(CPI) increased by over 4 percent during 2004, the highest increasesince 1997, the price increase for non-tradable goods was onlyabout 2 percent. The non-food, non-energy CPI rose by less than 1percent, after three consecutive years of decline. Labor costs havegrown more slowly than sales or overall GDP. Financial sectorobservers now forecast that Chinese growth will slow greatly during2006 and 2007. Stock market performance has been subdued. During2004 and the first few months of 2005, however, higher importedcommodity prices put a further squeeze on manufacturingprofits.

While foreign manufacturers complain that the renminbi is toolow relative to the dollar, the problem in part may be that theeuro is too high relative to both the dollar and to the renminbiand that the Japanese economy is too depressed to absorb imports.Were the euro lower, Europe might export more goods and services toChina, and were it also to absorb more capital inflow, it wouldbecome a larger market for imports. Were the Japanese economy morebuoyant, it might absorb more imports from China, Europe and theUnited States, thus reducing its trade surplus and its absorptionof dollars.

There is little prospect that exchange rate adjustment cangenerate the kind of financial shifts that would end the threat ofsystemic disruption; indeed, a lower dollar might attract capitalinvestment to the United States, which would increase U.S.indebtedness and possibly increase the trade deficit. Similarly, arise in dollar interest rates might draw more capital to the UnitedStates, which would be offset by more imports of goods and servicesand would probably lead the dollar to appreciate.

The pressure on the Chinese to float their currency against thedollar seems especially misdirected. Beyond the case of Japan(above), Taiwan, Singapore and even Korea now have very lowinterest rates, reflecting fear of appreciation and the stagnationof financial-sector intermediation. China's dollar-linked exchangerate anchor has constrained such appreciation for much of theregion, but during the last few months of 2004 several Asiancountries allowed their currencies to float upward against thedollar. Were the renminbi to spiral upward, the pattern ofsoft-dollar pegging in East Asia would be jeopardized, and Chinacould itself experience deflationary pressure. Reports suggest thatChinese officials are themselves concerned that ongoinganticipation of a higher renminbi could set up a Japan-styledeflationary trap. Further, were China to float its currency andmove it toward convertibility--floating requires market-makers and,hence, the right to freely buy and sell the currency--then itscommitment to purchasing the dollar at specific levels would belessened. The United States would find it harder to borrow fromAsian countries in order to finance purchases of Asian exports.Contractionary pressure would then have spread to parts of theworld that had previously avoided it.

By early summer 2005, as it appeared that China would rejectpressure to appreciate its currency more than minimally, the Koreanwon, Thai baht, Indian rupee and Singapore dollar fell back, closerto their earlier soft-peg levels against the dollar. This isstriking evidence of the stabilizing role of a steady Chinesecurrency in Asian trade and investment. When the Chinese proceededto revalue slightly, early indicators were that other Asianeconomies would buy dollars or take other action to prevent theircurrencies from rising any more than the renminbi had.

As opposed to floating the renminbi, there is a good argumentfor a one-time revaluation--which could more easily be combinedwith ongoing PBC purchases of U.S. treasury securities. Because therenminbi has been fixed to the dollar, higher imported oil andcommodity prices have led to a profit squeeze on manufacturing forthe Chinese domestic market. Far from cooling an "overheated"Chinese economy, a revaluation could actually increase enterpriseprofits! Also, a one-off revaluation might be coordinated withother Asian governments to ensure that they maintainedapproximately stable exchange rates among themselves. But we shouldunderstand any revaluation as a paradoxical, "second-best"solution--because it might otherwise reinforce the mistaken premisethat the dollar should be encouraged to drift lower. In fact, theopposite is the case: Had the dollar not depreciated since 2002,the recent upward pressure on world commodity prices would beless.

Another frequent suggestion is that the United States shouldreduce its international borrowing by reducing its fiscal deficit.Certainly, an improved U.S. fiscal position should be part of anypro-growth package, but taken in isolation it might bringdisappointing results. If the United States reduces spending butthe rest of the world does not see an offsetting increase, thengrowth of the world economy will slow. Fewer U.S. imports wouldmean less demand for producers in European and Asian economies. Itis not even clear that a smaller U.S. fiscal deficit wouldstrengthen the dollar; indeed, less borrowing by the U.S. Treasurymight lower U.S. interest rates, which would reduce capital inflowto the United States. And it might do little to allay concerns thatcurrency volatility would continue.

To spring the slow-growth trap, we need a systemic remedy. Thekey is not to make debtor countries (like the United States)contract, but to enable creditor countries to expand. A lessvolatile, growth-oriented world framework must begin with exchangerate coordination. Even better would be an effort to hammer out along-term agreement among U.S., European, Japanese and Chinesecentral bankers and treasury or finance ministry officials aboutappropriate exchange rate levels, combined with understandingsabout trade, capital movements and financial sector regulation. Ifmarket participants believed dollar-yen and dollar-eurorelationships would stabilize, then inflation expectations indifferent countries would settle at similar levels, and interestrate differentials would vanish.

Fixed exchange rate systems broke down during the 1920s and the1960s because central bank reserves were inadequate and nationalmacroeconomic policies were not coordinated, not because they couldnot have worked. The current floating-rate framework has aggravatedslow-growth tendencies in Japan and in the euro bloc and could dothe same in China and other parts of Asia. In an integrated worldeconomy, there is no good alternative to monetary coordination, notif we wish to optimize welfare.