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Our Dollar, Your Problem

In his new book, The Unloved Dollar Standard: From Bretton Woods to the Rise of China, McKinnon explains some uncomfortable truths. The dollar standard is unloved because of what one US Treasury secretary told his foreign critics of US exchange rate policy - "our dollar, your problem."

McKinnon argues that US monetary policy has been highly insular, despite globalisation making such insularity obsolete, and that three macroeconomic fallacies were responsible - the Phillips curve fallacy; the efficient market fallacy; and, the exchange rate and trade balance fallacy.

In the 1960s, the US belief in the Phillips Curve - that higher inflation generated lower unemployment - resulted in the US pushing the Europeans and Japanese to appreciate their currencies. When they refused, Richard Nixon broke the link with gold in 1971. In the Alan Greenspan era (1987-2008), there was a strong belief in efficient markets, which encouraged global foreign exchange liberalisation, despite high volatility. But the most enduring fallacy is the belief that the exchange rate's role is to correct trade imbalance, hence the Japan-bashing in the 1980s and the China-bashing now to push for their exchange rates to appreciate, to reduce the US trade deficit. McKinnon considers the third fallacy the most pernicious conceptual barrier to a more internationalist and stable US monetary policy.

The central thesis of this book is that the US should recognise that the dollar standard is actually a global standard, with privileges and responsibilities. Dollar depreciation is not to America's advantage, because it would only lead to future inflation. Instead, the US should concentrate on improving its competitiveness and manufacturing prowess. This requires having positive real interest rates.

The logic of the McKinnon thesis is irrefutable, although his US colleagues may find the conclusions unpalatable. The logic is that whoever maintains the dominant currency standard must maintain strong self-discipline; the benchmark standard cannot be on shifting sands. If the dollar is weak because the US economy is weak, then all other currencies will be volatile, because they float around an unsteady standard. For small, open economies that maintain large trade with the US, having a dollar peg requires them to keep their economies flexible and they must maintain fiscal and monetary discipline. This is Hong Kong's experience.
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