Exchange Rates under the East Asian Dollar Standard: Living with Conflicted Virtue - by Ronald I. McKinnon
Exchange Rates under the East Asian Dollar Standard: Living with Conflicted Virtue , by ( The MIT Press , Cambridge, MA , 2005 ), pp. ix + 279 .
Managing the exchange rate has been a controversial subject in East Asia since the financial crisis in 1997–1998. Opinions range from supporting fully floating exchange rates to adopting currency boards, and all other types of regimes that fall in between the two. This book adds to the controversy by suggesting an adoption of a dollar standard for the countries in the region.
The book discusses exchange rate policies and the structure of the financial system in East Asia. It contains eight independent essays written by McKinnon and his co-authors and ties them together into a coherent analysis of the region's exchange rate policies. It argues against traditional theory, which favours a flexible exchange rate, by building the case for the region to coordinate their exchange rates, with the US dollar as an anchor.
The book is divided into two parts. The first part provides a simple but fairly comprehensive analysis of the region's financial structure and its consequences for exchange rate policy. Therein lies the book's strength. Although sometimes too simplistic, it is helpful for understanding the complicated issue faced by the region without having to go through difficult technical jargon often associated with the issue. However, the second part of the book, which contains the policy implications and recommendations, is lacking as it does not offer a balanced analysis of alternative policies.
Chapter 1 argues that the economic surprises experienced by the East Asian economies in the 1990s are linked to the adoption of the dollar standard in facilitating cross-country trade and capital flows. Authorities in these countries pegged their exchange rate to the US dollar mainly because their trade and debt are largely invoiced in US dollars. The latter is widely known as the ‘original sin’ problem. These countries were virtually unable to borrow internationally in their own currencies due to their relatively inefficient capital markets. Given this heavy dependence on the US dollar, the governments of these debtor countries often pegged their exchange rates to the US dollar to stabilise market expectations of the exchange rate.
This chapter offers a nice examination of why an uncoordinated dollar standard is problematic. The decision to peg the exchange rate could lead to over-borrowing in the domestic financial sector, which potentially invites both currency depreciation as well as domestic inflationary pressures. The book also provides a careful analysis of this mechanism in Chapter 6.
Chapter 2 provides statistical evidence for growing economic integration in the region. It shows how fluctuations in the yen–US dollar exchange rate have a negative impact on the other East Asian economies. The argument provided in this chapter serves as the basis for the author's coordinated dollar standard policy suggestion for the region.
Chapters 3 and 4 introduce a new concept to the literature, termed the ‘syndrome of conflicted virtue’. This concept is a mirror image of the ‘original sin’ problem for a debtor economy. Under the syndrome, a creditor country is unable to lend internationally using its own currency, hence forcing the country to accumulate currency mismatches, which puts upward pressure on the domestic currency and potentially leads to runs onto the currency. Once the latter takes place, the domestic economy's authority faces a dilemma because appreciation may induce deflation and lead to a liquidity trap. Using Japan's experience, the two chapters neatly explicate how this syndrome emerges.
The book then argues that the syndrome of conflicted virtue may also threaten the other East Asian economies since most of them became dollar creditors after the 1997–1998 crisis. For that reason, along with the growing economic integration, McKinnon strongly argues that the region will benefit from coordinating their policies to keep their exchange rates stable against the US dollar. Such coordination is supposed to achieve three objectives: (i) to provide greater long-run exchange rate security in dollar exchange rates among all East Asian economies, including Japan; (ii) to offer a credible anchor in the region; and (iii) to enhance a mutual understanding of more appropriate policies for regulating the financial sector in the region.
While the above reforms are indeed necessary, McKinnon seems to advocate a particular exchange rate regime for East Asia: a dollar standard in East Asia through collective rather than individual action by national governments in the region. The book explicitly acknowledges that a coordinated exchange rate policy, and not independent individual pegs, is of core importance in guarding against the risk of devaluation and inflation in debtor economies and appreciation and deflation in creditor economies within the region. Unfortunately, the book does not elaborate on why the suggested dollar standard should dismiss the other possible alternatives, such as having a common basket currency or other forms of coordinated policies. The author does recognise the difficulties of adopting a common currency in East Asia. However, the same difficulties also apply to achieving an agreement for having a common dollar standard in the region. How to overcome these difficulties is not adequately discussed.
Overall, the book offers an excellent analysis of the current exchange rate dilemma confronting the region. It provides thorough explanations of the failures of past exchange rate management in the region. Based on these contributions, this book is too important to be neglected by either policy-makers or scholars who are studying the East Asian economies.
