The U.S. trade deficit currently runs at the unusually highlevel of 5 percent of GDP, and something like 80 percent of the netdeficit has recently been funded not by private capital flows, butby foreign central bank purchases of dollars. U.S. netinternational indebtedness, which summed to less than 10 percent ofGDP in 1998 or 1999, now exceeds 25 percent of GDP and continues togrow. In late 2004 and early 2005 it became commonplace toanticipate that the dollar would plunge and interest rates wouldrise. Such prestigious figures as Paul Volcker and Joseph Stiglitzhave predicted that a dollar crisis is likely.

As this is written, that has not happened--the dollar hasstrengthened against the euro, the pound and several Asiancurrencies. After much American pressure, the Chinese have revaluedthe renminbi, but, at least initially, only by a minimal 2.1percent. Long-term dollar interest rates remain higher than euroand yen rates, but they were boosted only slightly by the Chineseaction and have continued to decline to their lowest levels indecades.

The trade balance is overrated as a driver of currency values;consequently, allowing currencies to float usually has littleimpact on trade deficits or surpluses. The market value of thedollar is driven also by all sorts of other factors, includingsupply and demand for its use as a national monetary reserve, as ashort- and long-term store of value, as an investment vehicle, ascirculating currency, and for facilitating trade between countrieseven where U.S.-produced goods are not involved. By emphasizingspecific national trade deficits or surpluses, we are led topropose the wrong solutions and may indeed aggravate contractionarypressure from elsewhere in the world economy--what I would term theslow-growth trap.

In part a consequence of the popularity of flexible exchangerates among economists, the post-World War II Bretton Woods regimeof fixed exchange rates was allowed to break down in phases duringthe early 1970s. Yet, despite many economists' embrace offree-floating currencies, Europeans and Asians subsequently movedin the opposite direction and sought to stabilize exchange ratesand re-establish currency blocs. The euro was introduced in 1999but was preceded by European exchange rate mechanisms dating backto the 1970s. By 1980 Hong Kong, Korea, Malaysia, Singapore, Taiwanand Thailand had more or less fixed their currencies to the dollar,creating a regional dollar standard, until the "Asian crisis" of1997 led some of them to devalue or float. The value of the Chineserenminbi hardly budged against the dollar from 1994 to 2005. Sincethe end of the 1997-99 crisis, a number of Asian governments andcentral banks have attempted to restore pre-crisis dollar pegging,this time using softer, changeable pegs. In the wake of the crisis,and facing opposition from the U.S. Treasury and the InternationalMonetary Fund (IMF)--both of which embrace flexible exchange ratesas doctrine--few would attempt a harder fix. Japan has joined thestabilizers in an effort to limit yen appreciation against thedollar.

Whatever floating-rate advocates may propose, there are avariety of reasons why developing countries often choose to pegtheir exchange rates, of which two stand out. First, mostdeveloping countries lack forward markets, which allow importersand exporters to hedge exchange exposure. A dollar peg provides apractical hedge, as it reduces the exchange risk in cross-bordertransactions. Second, many governments limit foreign exchangeexposure by domestic banks, for good, prudential reasons, but doingso prevents banks from being active dealers to stabilize theexchange rate. In this circumstance, floating would likely lead todisruptive volatility.

Much of the recent discussion about U.S. trade deficits hasfocused on fiscal deficits and inadequate U.S. savings. But growingtrade deficits and downward pressure on the dollar in part reflectcontractionary pressure arising outside the United States. U.S.exports may be low because of weak demand for consumption andbecause of investment, and consequent oversaving, elsewhere. U.S.capital inflows may be high because other economies providerelatively few opportunities for direct or portfolio investment. Weneed to consider the systemic consequences--that is, theconsequences for the world economy as a whole--of any measuresintended to address deficits. It is in this context that allowingother currencies, including the yen, renminbi and euro, to driftupward becomes problematic. By reducing the cost of imported goodsand materials, higher currency value puts relative downwardpressure on domestic prices. Where systemic price inflation ismodest, as has been the case for most of the past couple decades,downward price pressure in countries where currencies appreciatemight generate actual deflation.

Concern that the dollar may continue to decline, or, in anyevent, be volatile, leads investors to expect higher interest rateson dollar assets than on assets of surplus-country currencies.Where dollar rates are themselves declining toward low singledigits--that is, toward 4, 3 or 2 percent annualized--then interestlevels in trade surplus countries fall to close to zero percent,too low to make lending profitable. An illiquid financialenvironment constrains investment in both export and home sectorsand reinforces patterns of underspending and oversaving.Consequently, the U.S. trade deficit and overborrowing andoversupply of dollars are aggravated, which leads to furtherdownward pressure on the U.S. currency.

The Case of Japan

The nearly decade-and-a-half Japanese tailspin is usuallyassumed to have origins in some national economic malfunction--evenby financial sector economists who should know better. In fact, thecontractionary mechanism outlined above is most clearly at work inthe case of Japan, which has in turn been a trigger for East Asianinstability. The yen strengthened from 250 to the dollar in 1985 to80 to the dollar in 1995 before weakening. Since 1985, Japan hasexperienced mild but persistent deflation of wholesale prices. Thecombination of price deflation and an often-rising yen forcedinterest rates down, usually to several percentage points belowdollar rate levels. In a deflationary environment, firms do notwant to borrow for expansion, nor do they want to owe money in acurrency that has tended to gain external value. Bankers do notwant to lend at interest rates too low to generate profits or tocompensate for the risk of default. Investors prefer not to buylong-term bonds at very low interest rates; simple bond mathematicsindicates that their principal values would collapse if interestrates were some day to rise.

But despite the sharp depreciation of the yen from 1995 to 1997,and its essentially trendless behavior since, yen interest ratestypically remained 2 or 3 percent below dollar rate levels, whichsuggests that Japanese institutional investors now attach a largevolatility premium to holding dollar-denominated paper. In the faceof ongoing U.S. borrowing, dollar holdings in the portfolios ofJapanese financial institutions have inevitably risen. Importantempirical data indicate that the negative risk premium on yeninterest rates has increased as foreign assets become a largerportion of total financial-sector balance sheets. Since liabilitiesare in yen--in the form of bank deposits and pension and insurancepayout obligations--increased dollar holdings place at risk thesolvency of many institutions and even of the financial system as awhole. Japanese borrowers are thus inclined to convert dollarholdings into yen, and, in environments of low internationalinflation, demand for yen keeps Japanese interest rates close tozero.

A first consequence of Japanese instability is that the floatingyen has often been out of step with other currencies in East Asia,most of which have soft or hard pegs to the dollar. A decline inthe exchange value of the yen during the sharp dollar recovery of1995-97, for example, upset trade and investment patterns andhelped trigger the regional financial crisis that began in 1997. Italso forced several Asian countries either to devalue or to floatdownward against the dollar. The yen in the past was often forcedupward, not for market-induced reasons, but because U.S.politicians were exerting pressure to pry open Japanese trademarkets. During the past half-decade, Japanese authorities havemade an effort to manage the yen so that it tracks the dollarsomewhat more closely, so disruption from yen exchange ratemovements has been less. Even so, the yen appreciated sharplyduring the fourth quarter of 2004, and concern about futureappreciation and price deflation are embedded.

A second effect followed from the domestic deflation in Japan.Much of the trade advantage U.S. manufacturers would theoreticallygain through yen appreciation has been offset by lower Japanesedomestic prices. From 1950 through about 1977, Japanese wage levelsincreased far faster in nominal terms than did wage levels in theUnited States--reflecting greater Japanese productivity growth.Deflationary pressure, induced by yen appreciation, then led to anabrupt reversal so that, since 1977, U.S. nominal wage growth hasexceeded that in Japan in all but a few years. After decades of yenappreciation, Japan continues to run large bilateral tradesurpluses with the United States, which are the flip side ofongoing capital outflow. The underlying dynamic for capital exportshas gradually shifted from providing finance abroad for boomingexport-driven growth in Japan to (more recently) sending moneyabroad because of a lack of investment opportunities in Japan. Buteven this channel of adjustment is becoming blocked as manyJapanese investors now prefer to hold yen assets; hence, a growingportion of dollars are instead bought and held by the Bank ofJapan. Without the Bank of Japan's intervention, Japanese capitalsurpluses would be larger, and the logic of economic slowdown wouldagain push the yen higher, and domestic prices lower, in aself-amplifying way.

A third effect of the instability has been Japanese reluctanceto deregulate. In the face of rising exchange rates and shrinkingdemand, legislators and officials have not been willing to reducethe safety nets implicit in maintaining protected industries.Indeed, it is hard to identify important economic benefits gainedby either Japan or the United States from decades of flexibleexchange rates--exchange markets have driven fundamentals, ratherthan the other way around. The Japanese economy appears to havefallen again into recession during the fourth quarter of 2004, andthe volume of bank lending has contracted every year since1998.

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.

The stakes are high. Indications suggest that the United Statesand IMF prefer to address financial imbalances by encouragingexchange rate adjustments that will have the effect of inducing orextending the slow-growth trap in major countries. Most likely, theoutcome would fall short of the deflationary depression of theearly 1930s or the stagflation of the 1970s, and the situationmight not be perceived as a crisis, especially not to Americanvoters. But it would bring large-scale economic underperformanceand represent serious policy failure.

There are grounds for skepticism about how much the BushAdministration might accomplish or wish to accomplish. First is theadministration's obvious lack of interest in negotiations withallies and international organizations over a wide range of issues.Second is the respect still accorded to flexible exchange ratemechanisms as reflecting economic principle. Third is the tendencyof those in the American "heartland", well represented in the BushAdministration, to embrace "soft" money, which, in an internationalcontext, means a willingness to let the dollar sink. This tendencyhas deep historical roots, as many heartland farms and businesseswere often in debt to creditors in East Coast cities. But thebenefits from a different approach to managing international moneyshould be clear.