Peter T Treadway, PhD
Historical Analytics LLC
September 23, 2010


The legendary Muhammad Ali developed a style of boxing whereby he lay on the ropes and let his opponents swing away at him. The idea was to duck his opponents’ punches and let them tire themselves out. He called it the “rope-a-dope.”

The United States dollar plays an analogous role in the international monetary system. Which country is the “dope” in this process history will decide. But take the latest major event in the markets. Japan, a country running a strongly positive current account and with over a trillion dollars in foreign reserves, decided unilaterally last week to intervene in the foreign exchange markets and buy dollars and sell yen. The Japanese Prime Minister, having come close to being tossed out of office by his own party, decided the yen was getting too expensive for Japanese exporters.

And what does the United States do? Nothing. The United States does not intervene in the currency markets. It doesn’t “hit back.”

Think about it. Supposing the US decided the dollar was too expensive against the yen and went into the markets and sold dollars and bought yen. Maybe the US could have sold the dollars directly to the Japanese. Why not?

Of course if the US did that the international monetary system would quickly collapse into utter chaos. I am certainly not recommending this course of action. The dollar performs the role that gold used to in the international system. The dollar is the global reserve currency, although as an aside it is no longer convertible into gold and unfortunately not subject to supply constraints as was gold. The growth in the gold supply was constrained by how much gold could be mined each year. The growth of US dollar reserves is constrained by how much the Fed wants to print. And as its embrace of quantitative easing shows, there is no limit as to the Fed’s ability or willingness to create reserves.

But the point is, for better or for worse, the US is the world’s banker. It has to follow different rules of behavior than other countries. It cannot unilaterally intervene in the currency markets. If the US is opposed to another country “manipulating” its exchange rate, it must cajole, beg or bully that country to raise the value of its currency. That is what the US is trying to do with China right now. The Japanese, to use an American baseball expression which should be understandable in the land of the Tokyo Giants, came out of “left field” and surprised everyone. A gift to China for the moment. The Chinese can say that the Japanese are the bad guys. (Saying that of course will come easily to the Chinese.)

In 1985 the US convened the major trading nations of the world and the result what was called the Plaza Agreement. Those were the “good old days” when the US could get its way by bullying and persuasion. As the result of that meeting Japan agreed to allow the yen to strengthen against the dollar which it proceeded to do over 1985-90. Japan now cites that appreciation of the dollar as a major reason for its years of stagnation starting in 1990. The Chinese, not normally sympathetic to Japanese complaining, cite the Japanese experience as a reason not to revalue the renminbi.

Times have changed since 1985 with the major changes being the rise of a “not-so-easy-to-bully” China and with the US with its huge debt now viewed in some quarters, rightly or wrongly, as a global mendicant. Chinese Premier Wen Jiabao in a speech just given in the United States said that a rise of the renminbi of 20% would cause severe job losses and social instability. President Obama could have given the same speech, only saying that without a 20% rise of the renminbi and the other Asian currencies the US will experience further job losses and social instability. (And ensure that the Democrats lose the midterm elections.)

What is wrong with this system is that there is no automatic economic adjustment process as there was under the pre-1914 gold standard. Economists and politicians can argue all day long about what the correct level of exchange rates is. Or how many jobs, if any, will come back to the United States were the renminbi to be revalued. Nobody really knows the answers. The point is that only a system where adjustments are compelled by market forces can come up with the real answers. In today’s world where no one country can force its will on others, political resolution of economic decisions is a highly imperfect solution. Politicians will always argue their own country’s perceived interests. Under the pre-1914 gold standard, the so-called advanced world had one currency—gold. All major currencies were freely convertible into gold at rates that did not change. Economies did the adjusting. Capital flowed freely. The markets ruled. Inflation was almost nonexistent. Prosperity reigned.

Meanwhile, today export surplus countries keep right on exporting and buying dollars. Even worse, inflows of dollars into China, as the Wall Street Journal pointed out in a recent op-ed piece, are too often sterilized. In other words, the Peoples Bank of China offsets the increase in Chinese bank reserves caused by buying dollars. That long lost world of David Hume’s price-specie-flow model, where gold flows automatically forced both surplus and deficit countries to adjust, is but a memory.

To a large extent, all of Asia (India and Vietnam excepted) and perhaps Brazil as well have undervalued their currencies against the dollar so to promote their own exports. In doing this they have created excess global liquidity by buying dollars and inflating their own money supplies, funding one bubble after the other and damaging the US’s own manufacturing and export industries. The US of course has “benefitted” from cheaper imports and lower interest rates as foreign dollars have flowed in. Economic historians will argue who the “dope” is, the country that got all kinds of cheap money and goods at the expense of its own industries or the countries that built up their export capacity and in part “gave away” their exports through undervalued currencies.

This system cannot go on forever. Domestic consumption and not exports have to drive Asian economies in the future. The US cannot continue to be the global consumer of last resort. How this system will end is anyone’s guess. Gold bugs want to see gold replace the dollar and a return to the pure pre-1914 gold standard. Meanwhile investors are almost forced to own some gold and Asian currencies in one form or another. And American politicians are trying to come with ways to bully China and in the process risk a global depression.

In the post-Bretton Woods era after 1973 (sometimes called Bretton Woods II), unchallenged US global political hegemony forced a certain modicum of exchange rate adjustments. Those days appear to be over. We are entering uncharted waters. Barring a return to the pre-1914 gold standard which I regard as unlikely, the only possible solution will be a gradual revaluation of other major currencies against the US dollar. The major currencies, including the renminbi, must float against the dollar. The solution is not for the US to intervene in the exchange markets. The solution is for the other major powers to stop intervening and for all major currencies to float freely against one another.

Keep a few things in mind:

– Quantitative easing and zero interest rates do not bode well for the dollar.

– Gold may yet assume a new role not yet envisioned in the global monetary system. It may replace fiat currencies as a store of value for investors and central banks although punitive measures by Western governments against their citizens holding gold are possible.

– Asian currencies as a group will be under continued upward pressure.

– China will not be able to continue to hold its domestic interest rates below the rate of inflation.

– A rise in Chinese interest rates will bring about an inflow of funds into China and further increase pressures for a revaluation

– The Hong Kong US dollar peg is keeping interest rates in Hong Kong far below where they should be. Hong Kong has a special problem. Of course to a lesser extent this applies to all countries which in reality maintain a highly managed rate against the dollar.


Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong
Historical Analytics LLC
pttreadway -at- hotmail -dot- com

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852 94091186
September 12, 2010

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