Like most policy debates, the debate over exchange rate policy stems in part from conflicts of interest and in part from legitimate disagreements over empirical parameters. However, it also appears to stem to an important degree from confusion, pure and simple, about how the mechanism of international adjustment works. This chapter cuts through as much of this confusion as possible, clearing the way for debate over the truly disputable issues.
The current discussion of the international adjustment mechanism is an unusually murky one because it is not a debate between two coherent positions. Instead, what we have is a coherent, though not necessarily correct, standard view that is under attack from a number of directions. This standard view holds in brief (1) that current account imbalances are the result of divergent fiscal policies, (2) that this fiscaldivergence led to current account divergences via a rise in the relative price of U.s. goods and factors of production (i.e., a real appreciation), and (3) that narrowing the imbalances requires both reversal of the fiscal divergence and a nominal depreciation of the dollar against other industrial-country currencies. Challenges to this view deny that fiscal policy drives the current account, that real exchange rates have anything to do with current accounts, or that nominal exchange rate movements have anything to do with real exchange rates.
These challenges to the standard view do not add up to a coherent alternative; indeed, some of them are mutually contradictory. That is why attempts to squeeze the debate into a Keynesian-monetarist or supply-side/ demandside mold only add to the confusion.
To preview the conclusions: The weakest link in the standard view is actually the part that has achieved the most public acceptance, the link from budget imbalances to trade imbalances. While a plausible case for this link can be made, there is enough contrary evidence to· give us pause. But the other challenges to the standard view are as close to being just plain wrong as any positions in economic debate can be. The view that real exchange rates have nothing to do with trade balances is, in the form in which it is often stated, a confusion between accounting identities and behavior. There are certain cases where, in principle, balance of- payments adjustment need not be accompanied by relative price changes, but these cases can be empirically rejected. Similarly the view that relative price changes would not be facilitated by nominal exchange rate adjustment is often stated in a way that misstates the issue, and a logically coherent statement of the view can be rejected on the basis of the evidence.
Read More: Adjustment in the World Economy
