Ronald I. McKinnon and Kenichi Ohno
MIT Press. Cam bridge. Massachusetts, 1997. x + 266 pp., $39.50 (cloth).
The 1990s have not been kind to advocates of managed exchange rates. A series of exchange market crises—beginning with the currencies participating in the exchange rate mechanism of the European Monetary System during 1992-93, and continuing with the speculative attacks against the Mexican peso in 1994-95 and East Asian currencies in 1997 and 1998— have poured cold water on the notion that pegged exchange rate arrangements are sustainable in a world of high capital mobility.
One of the most prominent proponents of managed exchange rates over the years has been Ronald McKinnon, and in this provocative book, he and his co-author, Kenichi Ohno, resuscitate the case for target zones among the key currencies within the context of the post-1973 trade disputes between the United States and Japan. The emergence of these trade disputes coincided with the adoption of managed floating rates among the major currencies, which was supposed to facilitate balance of payments adjustment and reduce protectionist pressures. As twenty-five years of post-Bretton Woods experience has shown, managed floating did not deliver what its advocates had hoped it would. Exchange rates have moved mainly to equilibrate asset markets in the short and medium terms, rather than to equilibrate trade flows. Nevertheless, the view persists among economists and policymakers that the exchange rate can be manipulated to produce adjustment in trade flows. McKinnon and Ohno argue that this view has permeated U.S. commercial policy with respect to Japan in the post-Bretton Woods era, with serious adverse consequences for the two countries concerned. Their book is an exemplary blend of relevant theory, empirical analysis, and policy prescription.
According to McKinnon and Ohno, U.S. commercial policy contributed to a 250 percent appreciation of the yen against the U.S. dollar from the early 1970s to 1994, but the magnitude of the U.S. current account deficit in terms of U.S. dollars increased for much of the period. McKinnon and Ohno argue that the U.S. current account deficits are a reflection of that nation’s propensity to invest more than it saves and are not very responsive to exchange rate changes. Chapter 7 is an incisive critique of the theoretical rationale and empirical estimates of the elasticities approach to the trade balance, which the authors believe has been misapplied in the form of a proposition that currency depreciation, somehow engineered, can improve the trade balance.
Dollar and Yen’s authors argue that the policy of what they call “the syndrome of the ever higher yen”—based on the elasticities approach—has trapped both countries in a distinctly suboptimal position. The authors maintain that, over time, the exchange rate reverts to its purchasing power parity (PPP) level. When the nominal exchange rate is used as a policy tool, the exchange rate forces national price levels to adjust in order to restore PPP. The U.S. economy, however, is still a relatively closed economy and, as such, U.S. prices are not very responsive to exchange rate changes. The Japanese economy, therefore, bears the brunt of relative price adjustment, imparting a deflationary bias to Japanese monetary policy. An issue that’ naturally arises in this context is why the Bank of Japan has validated this deflationary bias by tightening its policy stance. McKinnon and Ohno respond that the bank has done so to avoid the wrath of U.S. protectionists, although during episodes of particularly sharp yen appreciations, it has typically responded by easing.
The authors argue that the syndrome of the ever-higher yen and the associated deflationary bias of Japanese monetary policy have had several important implications. First, market participants— projecting that Japanese current account surpluses will persist into the future—have come to expect that U.S. pressure on the yen will periodically reappear and consequently incorporate these expectations into the term structure of interest rates. Thus, market expectations of this syndrome have caused U.S. long-term interest rates to exceed comparable Japanese rates by between 3 and 4 percentage points since the late 1970s. Second, the deflationary policy forced the Bank of Japan into unwanted deflation beginning in the mid-1980s.
McKinnon and Ohno link the Japanese downturns of 1985-86 and 1993-95 to their thesis that U.S. commercial policy exerted unwarranted pressures on the Bank of Japan to maintain overly restrictive policy stances in 1985 and 1993. The asset bubble of 1986-87 represented the bank’s overcompensation in the opposite direction in order to spring the economy loose from the earlier downturn. The collapse of the asset bubble, McKinnon and Ohno argue, contributed to the U.S. credit crunch and cyclical downturn of 1991-92.
In addition to asserting that managed exchange rates imparted a deflationary bias to Japanese monetary policy, McKinnon and Ohno ascribe the slowdown in world economic growth in the managed floating era, relative to that seen under the Bretton Woods regime, to what they perceive to be the excess volatility, misalignment, and long-term drift inherent in floating exchange rates. The solution they prescribe is the adoption of target zones (with ± 5 percent bands) for the U.S. dollar, the yen, and the deutsche mark (or the euro). Unlike John Williamson’s target-zone proposal, which aims to stabilize real exchange rates through frequent adjustments of the nominal exchange rate, McKinnon and Ohno propose to permanently stabilize the nominal rate through sterilized intervention (with some adjustment of relative interest rates). The central rate would be based on the initial purchasing power parity that aligns wholesale price levels. McKinnon and Ohno recognize that a number of conditions, not the least of which is the absence of asymmetric business cycles, need to hold in order for their proposal to be successfully implemented. Chapter 11, written in early 1997, deals with the recent depreciation of the yen against the dollar and asks whether this marks a sustainable departure from the syndrome of the ever-higher yen. The authors think not, but subsequent events will shed much light on the matter of whether the conditions for their target-zone proposal are in place in today’s highly integrated, but diverse world.
George S. Tavlas
Cover concept: Luisa Menjivar-Macdonald; all photographs by Padraic Hughes except for jets by Dan McCoy/Rainbow/via PNI and factory by Erica Lansner/Black Star/via PNI. Left-hand contents page: art (bottom) by Lew Azzinaro, photographs (top) by Padraic Hughes and (bottom) by Denio Zara. Art on pages 26 and 42 by Lew Azzinaro; pages 15 and 40-41 by Luisa Menjivar-Macdonald; page 52 by Massoud Etemadi. Photographs on pages 3, 7,11,34, and 49 by Padraic Hughes; page 23 by Charles Winters/Stock Boston/via PNI; page 38 by Denio Zara.