Reflections on currency regimes: the uncertainty of the dollar's future role.

• Author: Clarida, Richard H.

Ten years ago, in the aftermath of the Asian-Russian-LTCM crisis, I was invited by Paul Volcker to prepare a report for the Group of Thirty on "G3 Exchange Rate Relationships: A Review of the Record and of Proposals for Change." Readers of TIE will recall, during that turbulent time, there was widespread (but certainly not unanimous) dissatisfaction with the prevailing regime of managed floating exchange rates among the G3--comprised of the United States, Germany (now the eurozone), and Japan. It was said by many that G3 exchange rates were not well-anchored by fundamentals and were excessively volatile.

As a consequence, the critics believed, the post-Bretton Woods status quo for G3 exchange rates contributed to, rather than stabilized, the turbulence of the global financial system of the late 1990s. Defenders of the status quo did not, in general, suggest that G3 exchange rate relationships were ideal but rather that the leading alternative proposals--essentially variants of a target zones with hard or soft commitment to narrow or wide bands--were likely either to be inferior or, if superior in the abstract, not feasible (time inconsistent) in practice.

In this article, I reflect on what has been learned about G3 exchange rate relationships that was not clearly foreseen or fully appreciated (including by myself) ten years ago.

CAPITAL ACCOUNTS NOW DRIVE CURRENT ACCOUNTS--G3 EXCHANGE RATES AND THE SAVING GLUT

Some things never seem to change, but our interpretation of them can and should as the underlying circumstances do change. The United States ran large current account deficits in the 1980s, in the 1990s, and will for the entire first decade of the twenty-first century. In the 1980s and 1990s, large U.S. current account deficits were correlated with high real interest rates in the United States. Low U.S. saving relative to average or better U.S. investment generated a current account deficit which required a capital inflow attracted by these high real interest rates. The U.S. current account deficits of the present decade widened (from an already elevated reading of 4 percent of GDP in 2000) in large part because of the global saving glut--more precisely the excess of desired saving relative to desired investment at unchanged global interest rates. (1) The global saving glut brought down global real interest rates, both spot and forward, and this encouraged consumption and residential investment not only in the United States, but in other countries as well (such as the United Kingdom and Spain).

Initially the driving source of the global saving glut was Asia. China and other emerging Asian countries joined Japan which has had its own structural saving glut (and the current account surpluses to show for it) since the Carter administration. Notwithstanding all the focus on China, and its undervaluation- and export-based...