Can changes in exchange rate valuations affect trade imbalances? A collection of noted experts tackles McKinnon's thesis.

• Position: A SYMPOSIUM OF VIEWS - Ronald McKinnon

In his new book, The Unloved Dollar Standard: From Bretton Woods to the Rise of China, Stanford economist Ronald McKinnon argues that the "China bashers" have been captured by a false theory of the U.S. trade balance. That theory argues that exchange rate changes can compensate for large discrepancies in saving behavior. McKinnon counters that the United States has had a large trade deficit for an extended period directly as a result of a major saving deficiency which America finances with a long dollar line of credit with the rest of the world. No exchange rate change, McKinnon argues, can compensate for, or alleviate, this trade imbalance when investment is globalized and is itself dependent on the exchange rate.

DIANA CHOYLEVA

Director, Lombard Street Research, and co-author, The American Phoenix (2011) and The Bill from the China Shop (2006)

Ronald McKinnon's fascinating new book, The Unloved Dollar Standard: From Bretton Woods to the Rise of China, is right in drawing attention to the interaction between global saving and investment in creating the global financial imbalances. But McKinnon gets the direction of causation between savings and investment in the Sino-U.S. dollar zone wrong. As a result, he advocates the continuation of China's dollar peg and closed capital account--the very mechanism which greatly contributed to the global financial crisis.

Economics is not a precise science. The direction of causation between economic variables can switch, leading to diametrically opposite outcomes. McKinnon argues that America's saving deficiency caused its large current account deficit. But for American profligacy, or in other words its desire to invest in excess of its national savings, to have caused China's excessive saving, interest rates would have needed to rise to induce the extra saving.

The opposite has happened. Interest rates have progressively fallen to test the zero bound. This proves that the key driving force in the dollar zone, created by Beijing's exchange rate policy, has been China's desire to save excessively. If the desire to save and lend is higher than the desire to borrow and spend, the rate of interest falls to create better prospects for investor returns.

High savings become excessive when the desire to save out of income exceeds the economy's need for productive investment. Excess savings are malign, because by definition they depress demand, causing income to fall in order to equate the absolute level of savings and investment.

China's excess savings phase started with its entry into the World Trade Organization in 2001 and coincided with the same dynamic in Japan, Germany, and north-central Europe to produce a global savings glut. If not for the borrower economies, in particular America, being willing to rack up debt to finance their excessive spending, the global economy would have been depressed much earlier.

Instead, China poured its excess savings into risk-free U.S. dollar assets, stoking America's consumer boom which itself fueled China's export-led growth machine. But the symbiotic relationship was broken once the U.S. private sector exhausted its ability to take on debt and the excesses in its housing and financial sectors became visible, triggering the seize-up of global liquidity and the near-collapse of the global financial system.

Contrary to McKinnon's assertion, China's mode of development has made the global economy more unstable, and the yuan-dollar peg has been the chief mechanism through which China's desire to save excessively has spawned America's credit-fueled asset price bubbles. Four years on from the start of the global imbalances workout, the global status quo is little changed. The borrower economies are still borrowing excessively, but this time it is their public sector. Overall growth has been depressed due to the huge private sector deleveraging. The saver economies, China in particular, continue to save excessively and to rely on exports or investment to pull their economies through.

The problems of our globalized world need a global solution. McKinnon is right to point out that if China were to save less and spend more and America were to save more and spend less, the Sino-American financial imbalances would disappear. But he doesn't provide a credible policy solution of how to enforce such simultaneous changes. Worse still, he tries to discredit the ability of a fundamental market mechanism--the change in real exchange rates--to achieve the necessary adjustment.

Underlying his model is the unsubstantiated assumption that domestic savings are relatively insensitive to the exchange rate even though investment in a globalized world is. But China's dollar peg and its closed capital account, together with its warped domestic financial system, are key reasons behind China's excess savings. Chinese people save excessively, among other things, because the real return on their assets, which have to be invested largely at home, is paltry. An open capital account and a market-driven exchange rate would ensure Chinese people get the best real rate of return on their assets, driving down their desire to save.

Luckily for America, whether by design or not, the Federal Reserve's easing policy has already forced the necessary real exchange rate adjustment in the dollar zone by exacerbating the natural tendency towards inflation of China's undervalued economy. The chief obstacle preventing a sustainable improvement in U.S. growth prospects has now been removed. America has made substantial progress rebalancing its economy, while China has deepened the excesses on which its growth model is built.

JEFF FRANKEL

James W. Harpel Professor for Capital Formation and Growth, Harvard University

Ron McKinnon has made many important contributions to international macroeconomics over the years. But on this issue, he is simply wrong.

It goes without saying that the current account is equal to the difference between national saving and investment. But it does not follow that we should try to improve the current account by increasing national saving. Under current conditions, that would send the United States back into recession.

The national saving identity is a tautology: it does not in itself imply causation. True, many of the big movements in the U.S. current account deficit can be explained by changes in national saving: the fiscal expansion of the early 1980s, the investment boom of the late 1990s, and the new fiscal expansion of the 2000s. But the important point is that we care about a lot more besides external balance (the trade balance and current account). We care at least as much about internal balance (growth, employment, and inflation). To say that an increase in the budget balance and national saving would improve the trade balance does not imply that this would be good policy or that it is the only way to improve the trade balance. Under current circumstances--a still-weak economy, high unemployment, low inflation, rock-bottom interest rates--a reduction in public or private spending would send the economy straight back into recession. That is why the fiscal cliff of January 1, 2013, was such a danger. To observe that the trade balance would improve would be small consolation.

The U.S. trade deficit is not the problem it was five years ago. But if improving the trade balance is considered an important goal, then a devaluation or depreciation of the currency is a better tool for the job. (This proposition does not violate the national saving propositions. Nor, on the other hand, does it justify China-bashing.) Because a real devaluation would also raise demand for U.S. products--admittedly with a lag--and thus move us closer to internal balance, it would be a far more appropriate tool for improving the current account under present-day conditions than cutting national spending.

JIM GLASSMAN

Managing Director and Senior Economist, JPMorgan Chase & Co.

Ron McKinnon's thesis, that a yuan appreciation would do little to balance the U.S.-China trade flows, is persuasive and consistent with some notable experiences. Japan comes to mind. McKinnon argues that, because the trade imbalances are a reflection of fundamental "saving discrepancies," efforts to rebalance trade flows by forcing a currency adjustment are ineffective and likely would do more harm than good by intensifying deflationary forces. McKinnon's case is even stronger when the causes of the U.S.-China "saving discrepancies" are exposed. Are these a U.S. problem? Are they China's problem? Are they a problem at all?

Popular views about international imbalances, and in particular about the U.S.-China trade imbalance and calls for China to appreciate the yuan to restore balance, are shaped by the simple textbook story that offers few insights about the U.S.-China relationship. The textbook story asserts that persistent trade imbalances are red flags, because they eventually lead to currency crises and punishing spikes in interest rates. International investors grow reticent about accumulating ever-larger holdings of the deficit country's currency without adequate compensation. So, restoring balance by whatever means trumps most other considerations. Many believe that a currency depreciation offers one way to rebalance international trade accounts. Perhaps in a regime of fixed exchange rates, such as the Bretton Woods fixed exchange rate system adopted after World War II, when exchange rates are set at artificial levels, a currency realignment might make sense. But the story is not very convincing today when exchange rates are free to float or impoverished economies are managing their currencies to promote development. In fact, the textbook story has few insights to offer on the U.S.-China trade relationship.

McKinnon correctly argues that, because trade imbalances, like that between the United States and China, are the result of fundamental saving discrepancies between the two countries, they...