Questioning the Currency Float
Jude Wanniski
April 11, 1995


For the first time since September 30, 1987, one of the world’s most important finance ministers has seriously questioned the system of floating exchange rates. This time it is Japan’s Masayoshi Takemura, who is exasperated by the persistent skyward float of the yen, which threatens international trade in general and the Japanese economy in particular. Takemura told the Japanese parliament yesterday that he wanted the United States “to feel responsible and make a clear stance to defend the dollar.” He then asserted: “We also need to think whether we can leave the current exchange-rate system as it is now.” Takemura has it almost right. It is time to replace the float with a fix. If the system were properly fixed, though, it would be clear the Bank of Japan is for the moment the source of the problem. 

It was in ‘87 that U.S. Treasury Secretary James Baker III told the IMF’s annual meeting in Washington that it was time to reform the international monetary system. His intent was to institutionalize the Louvre Accord of the previous spring, which set informal currency bands for the dollar, yen and Deutschemark. To solve the sovereignty problem, Baker used my concept of a reference point that would enable the major central banks to stabilize “the relationship among our currencies and a basket of commodities, including gold.” Two weeks later, on Tuesday, Oct. 13, 1987, I met with Baker at Treasury, carrying the message from Robert Mundell that the Louvre Accord would soon be tested, and that the government should defend the dollar by selling assets, even if it meant selling gold out of Fort Knox. At that time, the upward drift of the dollar gold price made it clear that the Fed was at fault, not the Bank of Japan or the Bundesbank. Baker, alas, was pulled in the other direction, picking a fight with the Bundesbank over the sovereignty issue that was reported in the Sunday New York Times. The Great Crash occurred on Monday, the 19th, and down the drain went the Louvre Accord and the proposed IMF reform. 

In the absence of a reference point, Mr.Takemura now assumes the United States must be responsible for the weak dollar. Insofar as overnight interest rates are a mere 1.75% in Tokyo and 6% in New York, the Japanese can make the argument that the Federal Reserve should be raising interest rates to offset the U.S. trade deficit. Unhappily, neither the Bank of Japan nor the Federal Reserve see the problem. We have tried to explain it to Fed Chairman Alan Greenspan, but have not yet been persuasive. The solution would require the Bank of Japan be prepared to see overnight interest rates rise and the Fed be prepared to see them fall. Conventional wisdom says exactly the opposite. By the same token, we also believe it would be bad for the financial markets of both countries if interest rates were lowered in Japan and raised in New York.

The Bank of Japan errs in trying to prevent its currency from appreciating by keeping the overnight rate at 1.75%. Overnight rates, after all, are determined by the market. Neither the BoJ or the Fed “fix” them, the way they do the discount rates they administer. They can only force the markets toward the overnight rate they prefer by buying or selling assets according to formulae worked out by their technicians. If an overnight rate higher than 1.75% would be optimum in Japan, it could not get there if the Bank of Japan did not want it to -- which it does not. In the last three weeks, since March 20, the Bank of Japan has drained Y6.4 trillion from the pool of yen in order to hit the 1.75% target. At an average exchange rate of 87 yen to the dollar, this amounts to $73 billion drained from the nation’s monetary base, which at year’s end was worth $494 billion at an exchange rate of 100 to the dollar. On April 10, when the yen scraped 80, the bank had just completed a drain of Y2.36 trillion! That’s almost $19 billion, folks. This is utter madness, yet when we mentioned this to a senior international bureaucrat at the Fed, we were told they did not concern themselves with such information, as the amount of yen liquidity was Japan’s domestic concern. 

The Fed has more than 300 such Ph.D. economists responsible for keeping Chairman Greenspan in a constant state of confusion. Treasury only has a few, but it only takes one, Larry Summers, to baffle Secretary Rubin. It was Summers who ultimately persuaded Rubin to reject the arguments of the Senate Republican leadership vis a vis Mexico’s peso. Conceptually, the problem is of course the same as we encounter in Japan. On CNN’s Evans & Novak two weeks ago, Rubin said Mexico had no choice last December. It was either devalue or raise interest rates, he said. The no-other-choice problem goes beyond neo-Keynesians such as Summers. Allan Meltzer of Carnegie-Mellon, who is Milton Friedman’s most important student, says the same thing. By December, the Bank of Mexico had exhausted its foreign-exchange reserves, he points out. It does not occur to him that the Bank of Mexico could sell domestic assets from its bulging portfolio to bid up the peso.

The interest-rate infernal machine driving Japan is akin to that which drove the U.S. in 1981-82, when the Volcker Fed was trying to hit money-supply targets. In the process, the gold price was halved to $310 from $625 over an 18-month period. The monetary deflation thus induced brought dollar debtors around the world to their knees. The crisis ended only when the creditors, not getting paid, faced bankruptcy. It was the Mexican government that could not pay U.S. banks the money it owed, forcing Chairman Paul Volcker to scrap the money-supply targets and reliquefy the U.S. banking system. Japan is not likely to get off its deflation treadmill unless it encounters a similar internal crisis. The idea that a fiscal stimulus will somehow help it avoid recession makes little sense. This would only further boost the demand for yen, put up pressure on the overnight rate, inviting the BoJ to drain again. 

Surely Alan Greenspan knows this would be the perfect time to echo Takemura’s call for an end to the floating regime -- the source of almost all the financial turbulence of the last quarter century. Alas, to say the BoJ should not be targeting overnight interest rates, he would have to explain why he continues to do so, and why it would be better to target gold. If he had help at the White House and Treasury, he might do so. 

Were the Baker “reference point” system in place, we would assume Greenspan would suggest the dollar at $350 gold. The yen should be back at 100 per dollar, where it was at the beginning of the year, to get the Japanese economy reliquefied. This would mean the BoJ would target the yen at 35,000 per ounce. Here’s what would happen: The Fed would put aside the 6% overnight rate and drain liquidity until gold, now at $390, would hit $350. The BoJ would put aside the 1.75% overnight rate and add liquidity until the yen, now at 31,000 per ounce, were at 35,000. What would happen to interest rates when both dollar and yen were fixed at this reference point? They would converge. Let’s say that again: They would converge! Insofar as one currency is fixed to another over time, their interest rates would of course be roughly the same. Overnight and short rates would occasionally diverge to handle domestic variations in demand, which smooth out over longer periods. Long-term rates also converge toward the same rate, with minor variations among mature industrial powers with a history of paying their debts. 

The idea that the only defense of a currency is an interest-rate increase is on its face a silly one, which Alexander Hamilton would laugh out of town. The 1.75% overnight rate in Tokyo is an annual rate, after all. The market of yen debtors and creditors is far more interested in the principal of a debt than the interest rate. A 1% overnight decline in a currency’s value against gold is a 365% annualized loss. Japan’s Takemura, who, like Jim Baker, has no economic credentials, seems to have figured this out. It is definitely a good sign.