The Unloved Dollar Standard

Ronald McKinnon

23 January 2013
This illustration is by Paul Lachine and comes from <a href=""></a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

PALO ALTOSince World War II’s end, the US dollar has been used to invoice most global trade, serving as the intermediary currency for clearing international payments among banks and dominating official foreign-exchange reserves. This arrangement has often been criticized, but is there any viable alternative?
The problem for post-WWII Europe, mired in depression and inflation, was that it lacked foreign reserves, which meant that trade carried a high opportunity cost. To facilitate trade without requiring payment after each transaction, the Organization for European Economic Cooperation created the European Payments Union in 1950. Supported by a dollar-denominated line of credit, the EPU’s 15 Western European member states established exact dollar exchange-rate parities as a prelude to anchoring their domestic price levels and removing all currency restrictions on intra-European trade. This formed the keystone of the hugely successful European Recovery Program (the Marshall Plan), through which the US helped to rebuild Europe’s economies.
Today, most developing economies, with the exception of a few Eastern European countries, still choose to anchor their domestic macroeconomic arrangements by stabilizing their exchange rates against the dollar, at least intermittently. Meanwhile, to avoid exchange-rate conflict, the US Federal Reserve typically stays out of the currency markets.
But the dollar’s role as international anchor is beginning to falter, as emerging markets everywhere grow increasingly frustrated by the Fed’s near-zero interest-rate policy, which has caused a flood of “hotcapital inflows from the US. That, in turn, has fueled sharp exchange-rate appreciation and a loss of international competitivenessunless the affected central banks intervene to buy dollars.
Indeed, since late 2003, when the Fed first cut interest rates to 1%, triggering the US housing bubble, dollar reserves in emerging markets have increased six-fold, reaching $7 trillion by 2011. The resulting expansion in emerging markets’ monetary base has led to much higher inflation in these countries than in the US, and to global commodity-price bubbles, particularly for oil and staple foods.
But the US is also unhappy with the way the dollar standard is functioning. Whereas other countries can choose to intervene in order to stabilize their exchange rates with the world’s principal reserve currency, the US, in order to maintain consistency in rate setting, does not have the option to intervene, and lacks its own exchange-rate policy.
Moreover, the US protests other countries’ exchange-rate policies. Two decades ago, the US pressed the Japanese to allow the yen to strengthen against the dollar, claiming that Japan’s unfair exchange-rate policies were responsible for America’s ballooning bilateral trade deficit. Likewise, today’s China-bashing” in the US which has intensified as China’s contribution to America’s trade deficit has soared – is intended to force the Chinese authorities to allow faster renminbi appreciation.
Herein lies the great paradox. Although no one likes the dollar standard, governments and private market participants still consider it the best option.
In fact, US trade deficits are primarily the result of insufficient, mainly government, saving not a misaligned exchange rate, as economists have led policymakers to believe. Large US budget deficits during Ronald Reagan’s presidency generated the famous twin fiscal and trade deficits of the 1980’s. This, not an undervalued yen, caused the bilateral deficit with Japan to widen in the 1980’s and 1990’s.
The much larger US fiscal deficits of the new millennium, courtesy of Presidents George W. Bush and Barack Obama, portend large – and indefinitetrade deficits. But American policymakers continue to blame China, claiming that the renminbi has been undervalued for the last decade.
The claim that exchange-rate appreciation will reduce a country’s trade surplus is false, because, in globally integrated economies, domestic investment falls when the exchange rate appreciates. So the ill will that China-bashing is generating is for nothing. Worse, it detracts political attention from America’s huge fiscal deficit$1.2 trillion (7.7% of GDP) in 2012 – and thus impedes any serious effort to rein in future spending for entitlements, such as health care and pensions.
Some contend that large fiscal deficits do not matter if the US can exploit its central position under the dollar standard –& that is, if it finances its deficits by selling Treasury bonds to foreign central banks at near-zero interest rates. But America’s ongoing trade deficits with highly industrialized countries, particularly in Asia, are accelerating de-industrialization in the US, while providing fodder for American protectionists.
Indeed, America’s trade deficit in manufactures is roughly equal to its current-account deficit (the amount by which domestic investment exceeds domestic saving). So those concerned with job losses in US manufacturing should join the chorus lobbying for a much smaller fiscal deficit.
Can large US fiscal deficits and near-zero interest rates be justified because they help to revive domestic economic growth and job creation? Five years after the credit crunch of 2007-2008, it seems that they cannot. And, without even that justification, the latest wave of criticism of the US dollar standard appears set to rise further – and to stimulate the search for a “newarrangement.
But the best new arrangement – and possibly the only feasible one – would follow an old formula: as in the 1950’s and 1960’s, the US would set moderately positive and stable interest rates, with sufficient domestic saving to generate a (small) trade surplus. The cooperation of China, now the world’s largest exporter and US creditor, is essential for easing and encouraging the transition to this nirvana. Apart from the ongoing euro crisis, a stable renminbi/dollar exchange rate is the key to renewed (dollar) exchange-rate stability throughout Asia and Latin America – as envisaged in the original 1944 Bretton Woods Agreement.
Ronald McKinnon is Professor Emeritus of International Economics at Stanford University, and the author of The Unloved Dollar Standard: From Bretton Woods to the Rise of China.

22, 2013 6:13 pm
Healthcare is America’s real problem
Improved value would have more fiscal impact than any policy change, says Peter Orszag
Healthcare costs are the core long-term fiscal challenge facing the US – and yet also the best hope for cushioning workers from globalisation. This is why the recent deceleration of these costs is so encouraging – and why we should double down on them. Given the fragmented medical system in the US and its financial incentives for more rather than better care, health costs dominate the long-term fiscal picture.

Official projections show federal health expenditure rising between now and 2050 from 5.5 per cent of gross domestic product to more than 12 per cent. Social Security spending, by comparison, is predicted to rise in the same period from 5 per cent of GDP to 6 per cent.

It is not hard to work out what is driving our long-term fiscal gap. President Barack Obama is right. We do not have a spending problem – we have a healthcare problem.
Improving value in healthcare will not just deliver benefits to our public finances, it will also help America’s wage-earners who have lost out in recent years. Thanks mostly to globalisation, labour income’s share of GDP has fallen 5 percentage points in the past three decades.

This decline has reduced labour compensation by about $750bn a year, and no one has a credible set of policies for offsetting it. Yet estimates also suggest about $750bn a year in US health spending does not improve outcomes. Both economic theory and evidence suggest workers pay for this waste, either through reduced wages or higher taxes. If we could get rid of it, take-home pay would ultimately rise by the difference offering the best hope of filling the globalisation hole.

The good news is that recent developments in health costs are better than many appreciate. Cost growth has slowed dramatically, and spending on the Medicare programme for the elderly and disabled has led the way. Last year Medicare spending rose by 3.2 per cent, compared with 4 per cent for total national health spending. With such slow growth rates, health spending as a share of GDP has remained flat in the past three years.

A weak economy in which people do without unnecessary care partly explains this. Yet if it were entirely cyclical, it would be odd for Medicare to slow more than other health spending. Most beneficiaries have some form of supplemental insurance and so face very low out-of-pocket costs. Also, for most, their primary source of income is Social Security, which is protected from economic downturns.

Medicare covers a disproportionately high share of expensive cases – and we would expect structural change to affect such cases most, which would explain the pattern we have seen. Three shifts support this idea: a move to value-based payments; digitisation and associated management changes; and better-informed consumer behaviour.

To see what a big deal slower growth in health costs could be, consider this: if they rose 50 basis points faster than income each year, they would still be rising much faster than the growth rate of the past three years. And yet, with that more moderate growth assumption, our long-term fiscal gap would look almost manageable.

Last year, the Congressional Budget Office estimated that the gap between revenue and expenditure in the next 75 years would amount to 8.7 per cent of GDP. Since then, enacted revenue increases and an improved underlying budget outlook have reduced the gap to perhaps 7.5 per cent.

Achieving the lower health-cost growth would knock another 2.5 per cent of GDP off, bringing the long-term fiscal hole down to 5 per cent of GDP – a greater impact than any policy change currently being debated in Washington. Moderate revenue increases and Social Security reform could then reduce it further, bringing us within reach of long-term fiscal balance.

How do we do this? Three steps would be particularly helpfulstarting with the acceleration of the shift from paying for specific services to paying for “value”. Second, promote evidence-based medicine by connecting electronic health records with patient registries and by prohibiting malpractice suits when doctors follow professional guidelines.

Finally, we should require any patient admitted to a hospital to fill out an advance directive about their end-of-life care preferences. This reduces costs as some patients choose to skip expensive, often painful procedures towards the end of their lives.

The next decade in healthcare is crucial. Aggressive action today could help to perpetuate slower cost growth and make the system a more effective, efficient onehelping both the budget and our pay cheques.

The writer is Citigroup vice-chairman and a former budget director

Copyright The Financial Times Limited 2013.

The Eclipse of British Reason

Joschka Fischer

23 January 2013
This illustration is by Paul Lachine and comes from <a href=""></a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

BERLINWhen placed under too much strain, chains tend to break at the weakest link. Figuratively speaking, the same applies to the European Union. So the entire world quite naturally assumed that any process of EU disintegration would start primarily in the crisis-ridden European south (Greece, first and foremost). But, as British Prime Minister David Cameron has now demonstrated, the European chain is most likely to break not at its weakest link, but at its most irrational.
The United Kingdom – the homeland of pragmatism and realism, a country of unflappable principles and unmatched adaptability that stoically gave up its empire after successfully defending Europe’s freedom against Nazi Germany – has now lost its way. More precisely, it has been led astray by the Conservative Party’s ideological fantasy that certain EU powers can and should be returned to British sovereignty.
The UK’s national interests have not changed, and no fundamental shifts within the EU have worked against those interests. What has changed is Britain’s domestic politics: a prime minister too weak to control his roughly 100 anti-European backbenchers (call them the “High Tea Party”) in the House of Commons, and a Conservative establishment wary of the UK Independence Party’s rise, which could cost the Tories enough votes on the right to give Labour an electoral advantage.
Cameron claims that he does not want the UK to leave the EU. But his strategy – “renegotiation” of EU membership, followed by a British referendum on the new agreement – is the product of two illusions: first, that he can ensure a positive outcome, and, second, that the EU is able and willing to give him the concessions that he wants.
In fact, there is good reason to believe that such a course would take on a dynamic of its own, possibly leading to an unintended British exit from the EU. That would be a severe setback for the EU; for the British, blundering through history, it would be a veritable disaster.
While Britain surely would survive outside the EU, the quality of its existence is another matter. By exiting the EU, the UK would severely damage its economic interests, losing both the single market and London’s role as a financial center. An exit would also harm Britain’s geopolitical interests, both in Europe (where, ironically, it favors EU enlargement) and, worldwide, in its global standing and special relationship with the United States (which has made clear its preference for a European UK).
Unfortunately, Cameron’s track record in European politics does not inspire confidence in his ability to manage a different outcome. When, in 2009, he ordered the Conservative MEPs to withdraw from the European People’s Party, the Europe-wide grouping of center-right political forces, he merely deprived the Toriesnow consigned to sit with the sectarians and obscurantists – of any influence in the European Parliament. By weakening the UK’s position within the EU, he ended up strengthening the Euro-skeptics within his party.
But, while Cameron should know from grim experience what is looming, it seems that he has abandoned rational considerations. Indeed, the belief that the EU would renegotiate Britain’s membership terms – which assumes, further, that Germany would not objectborders on magical thinking. Such a precedent would be applicable to the other member states, which would mean the end of the EU.
With all due respect to the UK, dismantling the EU as the price of its continued membership is an absurd idea. Cameron should recognize that his strategy cannot be allowed (even if he fears that a few cosmetic corrections to the treaty won’t help him at home).
In the meantime, the Tories risk losing their way on a crucial issuereform of the relationship between the eurozone and non-euro EU members – if they try to use it as leverage to renegotiate the various European treaties. Britain knows that the euro’s survival requires much closer political integration, and also that London’s role as a financial centeras important for the UK as the nuclear industry is for France and the auto industry is for Germany – would be greatly damaged if the euro should fail.
Although no one should expect the British to join the euro any time soon, political leadership within the EU requires the acumen to take account of the central interests of one’s own country and those of the other member states without indulging in threats. This, however, requires an adequate understanding of those interests and a willingness to cooperate on the basis of mutual trust, which should be a given within the European family.
Speeches, particularly when delivered by leaders of great nations, can be useful, irrelevant, or dangerous. Cameron’s long-planned speech on Europe was postponed time and again. Perhaps he should have taken that as a sign that he should rethink his position.
He still can, before it is too late. The best starting point would be a re-reading of Winston Churchill’s famous speech in Zurich in 1946. “We must build a kind of United States of Europe,” urged Britain’s greatest twentieth-century statesman. That remains our task – and Britain’s – to this day.
Joschka Fischer was German Foreign Minister and Vice Chancellor from 1998-2005, a term marked by Germany's strong support for NATO’s intervention in Kosovo in 1999, followed by its opposition to the war in Iraq. Fischer entered electoral politics after participating in the anti-establishment protests of the 1960’s and 1970’s, and played a key role in founding Germany's Green Party, which he led for almost two decades.

January 22, 2013

China’s Information Challenge

To maintain monopoly control of political power in a country with a hard-charging economy, fast-growing middle class and the rising expectations they create, party officials will do all they can to monitor and manage the flow of information within the country and across its borders. This is especially important for a new generation of leaders now assuming their posts, officials who know that public expectations for good governance have never been higher. But with more than half a billion Chinese citizens now online, more than 300 million active on Weibo (China’s Twitter) and an increasingly ineffectivegreat firewall,” assertions of control over words and ideas reflect little more than wishful thinking.
The party’s right to rule is predicated on the claim that stewardship of a three-decade-long economic expansion proves that government is run by competent, honest officials who understand the country’s needs. That’s why, in 2012, China’s leaders didn’t want citizens to read and discuss charges that a senior party official and his wife were deeply involved in corruption and murder, or that the family of Prime Minister Wen Jiabao held “billions in hidden riches,” according to The New York Times.
There have been many other such embarrassments. In 2013, new leaders will try to reassert control at a time when an ever growing number of Chinese citizens are using modern communication tools to demand better governance and broader freedoms.
China’s battle with information is not about to give rise to a Tiananmen Square-scale public showdown. Nor is it likely to impact China’s near-term economic growth. Yet, the government’s bid to maintain control of information will have two important near-term consequences for China and the world. It will delay the reforms that China, soon to be the world’s largest economy, needs in order to reach the next stage of its development. And it will encourage China’s leaders to divert public anger toward outsiders, in part by taking more assertive sometimes aggressiveactions in East and Southeast Asia.
In 2007, Wen Jiabao first warned that China’s development path was “unstable, unbalanced, uncoordinated and unsustainable.” As the state embarks on year three of its five-year plan, efforts are ongoing to reduce a growing gap between rich and poor and to build China’s interior to give growth a better geographical balance. But the state’s most important medium-term goal is to reduce reliance on the export of manufactured products to Europe and America by empowering a much broader segment of China’s population to buy Chinese-made products. Getting from here to there will prove a dangerous process, because the restructuring and redistribution of wealth it demands will put tens of millions of workers (at least temporarily) out of work.
China’s leaders need the country’s economy to generate enough jobs to satisfy the rising expectations of the swelling ranks of university graduates. These are the people most active online, those most likely to express opinions and engage in debate. If the party’s inability to control information leads to a go-slow approach on potentially painful reforms, a surge of public frustration might make matters worse — with substantial longer-term implications for the country’s political and economic future.
Fear of public anger might also lead China’s leaders toward a more belligerent foreign policy. Over the past year, we’ve seen rising tensions between China, Vietnam and the Philippines over territorial disputes in the energy-rich South China Sea. We’ve also seen an increasingly hostile confrontation with Japan over a string of contested islands in the East China Sea. Nationalist rhetoric is on the rise in all these countries.
Four months ago, Beijing allowed anti-Japanese protests inside China to burn hotter and longer than usual, and Japanese companies operating there sustained serious damage from boycotts and acts of public vandalism. Party leaders may well decide this year that if new channels of information cannot be shut down, the popular fury they sometimes transmit must be steered toward what the government callsinternational hostile forces.” That’s bad news for Washington, since the U.S. foreign policy pivot toward Asia could leave U.S. diplomats to try to referee some of these disputes at a time when America needs better security and commercial relations with both China and its neighbors.
Whatever happens to its politics, the still-fragile global recovery needs the Chinese economy to continue to expand and mature. Companies around the world need access to China’s markets. The world’s most commercially dynamic region needs a stable China to sustain a peaceful status quo.
That’s why we should worry that China has become the emerging market least likely to develop along a predictable path. In 2013, it will become ever more obvious that the increasingly free flow of ideas and information inside China — and the anxiety it creates for its leaders — has become one of the world’s most important developing stories.
President Xi Jinping has championed what he calls the “Chinese dream.” He may soon discover that defining that dream for a fast-changing society is already beyond the party’s control.
Ian Bremmer is president of Eurasia Group and author of “Every Nation for Itself: Winners and Losers in a G-Zero World.”