Avoiding a currency war: how a new "dual-key" exchange rate system could help the United States, Japan, the eurozone--and China--find a way out.

• Author: Posen, Adam S.

A conflict over exchange rates is brewing. The burden of adjustment the United States needs to close its trade deficit has fallen mostly upon the euro-dollar exchange rate, to the tune of 30 percent versus eighteen months ago. Meanwhile, the yen-dollar exchange rate has moved only 17 percent in the same period, largely because the yuan-dollar rate has not moved at all. The weak and, in part, export-driven recovery in Europe makes the eurozone governments antsy about further rises in the euro against the dollar. And U.S. presidential candidates are formulating legal challenges to those countries that are seen as blocking the orderly decline of the dollar. Governments and interest groups do not like feeling as if they are being taken advantage of by foreign economic policies.

Outright "management" of exchange rates, however, is not in the offing-none of the major governments are willing to subordinate domestic monetary or fiscal policy to achieve exchange rate goals, and they would have to do so in order to actively manage exchange rates. This external laissez-faire stance is justified economically for each of the three major currency issuers--the United States, Japan, and the eurozone--since the exchange rate does not have a significant effect on domestic price levels or growth rates until large misalignments are sustained. Politically, though, this is not a sufficient argument to stave off either self-serving arguments from import-competing sectors or more valid government-to-government complaints about burden-sharing and exchange rate manipulation.

A system of dual-key exchange rate intervention agreed to by the United States, Japan, and the eurozone should be adopted in response to this situation. The governments would agree that they would not intervene in foreign exchange markets to affect the value of their home currencies against either of the remaining two, unless one of the other two players agreed to intervene as well. No more unilateral intervention would occur, as for example done on an enormous scale by Japan over 2003 and the first quarter of 2004.

Were one of the three currency issuers to engage in unilateral intervention, presumably to weaken its home currency versus one or both of the others, the other two would commit to offsetting that intervention. Since issuers can always weaken their own currency by simply selling more of it on world markets, the threat to offset is credible and no prior agreement about reserves would be necessary. In the improbable situation that one of the three currency zones wished to appreciate its currency against the other two, and neither of the other two would agree to coordinate on that direction of intervention, they could combine reserves to sell on the market (in all likelihood, they could expect the market to join them in opposing the appreciation, for the unilateral intervener could only strengthen its currency to the extent it had foreign exchange reserves with which to buy up its own currency).

The first obvious advantage of this dual-key arrangement would be the calming of political pressures over apparent competitive depreciations--none of the big three issuers could be accused of exchange rate manipulation, and that accusation no longer could be used as a rallying cry for protectionism or nativist...