The story of a disillusion.

• Author: Kessler, Martin

A review of The Unloved Dollar Standard: From Bretton Woods to the Rise of China, by Ronald I. McKinnon, Oxford University Press, 2012

Ronald McKinnon's book, The Unloved Dollar Standard, is the story of a disillusion. The post-Bretton Woods system backed by a dollar anchor freed from its gold link could have ensured global monetary stability--or so thought the author as a young economist in the late 1960s.

Forty years later, looking back at this period, McKinnon blames the repeated failures of the system on American policymakers who have systematically "bashed" other countries for their exchange rate policies instead of realizing their own monetary shortcomings. Overall, this stimulating book gives McKinnon scope to fully explain his iconoclastic arguments, some of which will already be familiar to readers of this magazine. While mainly a collection of shorter and longer already-published articles, The Unloved Dollar Standard reveals a story spanning from the demise of the Bretton Woods system to our paradoxical times, where dollar domination seems to linger stubbornly while many expect its decline in the face of Chinese ascension. The crux of McKinnon's argument is that given the dollar's role as the world's key currency, domestic policy mistakes have global consequences. A weakening dollar triggers "hot money" outflows to other countries--whether Europe or Japan in the 1970s or emerging market countries in the last decades. Faced with upward pressures on their exchange rates, countries resort to intervention and increase their dollar reserves, thus raising the domestic money supply--along with domestic inflation. In the end, according to McKinnon, inflation becomes global whether through the two oil shocks of the 1970s or the global commodity price bubble of 2007.

Why did the United States fail to play its role as guardian of the key world currency? Why did American policymakers repeatedly target a lower dollar, whether by directly intervening on the foreign exchange markets or by "talking it down"? McKinnon's main answer to that question is that economists and policymakers, worrying about growing trade deficits, held the wrong belief that correcting the exchange rate can play a role in adjusting the trade balance. Why is that? Following the so-called "absorption approach," the trade balance is first and foremost the result of saving and investment decisions--both of which could move in a different direction than desired by economists...