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Monday, July 27, 2009
Dollar beauty may be fading but it still tops currency pageant list
The Group of Eight countries and the outreach participants in the July 8-10 summit in L'Aquila, Italy, discussed promotion of an international currency system that is stable and functions well. But it remains an elusive goal to find concrete ways of reforming the system.
Economist John Maynard Keynes once likened the currency exchange market — a key to an international currency system — to a vote in a beauty contest. Exchange rates reflect the relative comparison of the currencies involved.
Beauty contest judges pick who they perceive as the most beautiful contestant. Just as the criteria for judging a beauty contest includes height, weight as well as bust, waist and hip measurements, market participants have a set of criteria in choosing from among various currencies.
They will be looking at the economic growth rate of the nation where the currency is based, the inflation rate, interest rate, employment conditions, balance of external accounts, and so on. Aside from these factors, they will also judge the currencies by the political stability and international leadership of the countries involved.
The winner of a beauty contest is chosen by several judges. Judges in the currency exchange market come from an extremely wide range of backgrounds, including export-import traders, people who raise and manage funds across national borders, government officials responsible for managing their countries' foreign currency reserves, and speculative traders.
Their decisions are influenced not just by economic factors, but political ones, military power, language as well as regional proximity. One reason financial engineering based on the latest information technologies helped exacerbate the financial industry turmoil is that people applied the same probability theory in dealing with probability in natural sciences and that for economic phenomenon, which are heavily influenced by qualitative elements, particularly human judgment.
After World War II, the dollar — backed by the overwhelming economic and military power of the United States as well as its status as the sole currency convertible with gold — dominated the international currency contests. The International Monetary Fund regime was also called the gold-dollar regime.
However, the economic reconstruction of Japan and Europe led to competition with currencies that included the yen and German mark. Following various developments, including the Nixon Shock, the Plaza Accord and the birth of the euro, the dollar's exchange rate has declined to around ¥90 — about a quarter of the ¥360 set under the IMF-led fixed-rate regime.
Recent developments in the foreign-exchange market give the author the impression that it has shifted from a "beauty contest" to something like a "contest not to choose a nonbeauty."
Rather than opting for a "beauty" currency backed by good economic fundamentals, market participants appear intent on avoiding nonbeauties that have uncertainties, like the risk of a depreciation.
What are the political-economic conditions of the major powers? After being hit by the financial crisis triggered by the subprime mortgage woes, the U.S. has seen changes in its excess consumption but still relies heavily on capital inflows from overseas.
Japan continues to depend on export demand to support its economic growth and is saddled with massive public debts. Now it faces political uncertainties.
In the euro-zone countries, monetary policy functions have been integrated into the European Central Bank. However, some countries have experienced asset bubbles more serious than those in the U.S. in per-GDP terms, and it cannot be said that fiscal policies of the individual member countries are being properly coordinated.
The BRICs economies continue to grow despite the global recession, but international trust in their currencies remains insufficient, with the Chinese yuan, for example, still lacking convertibility in the international market.
On the other hand, there is little prospect that market transactions in the artificial international currency, the Special Drawing Rights, would sharply increase. As a result, it looks likely that the market will continue to lack a "beauty" currency with strong international support, and that market participants will have to focus on avoiding risky currencies.
In Japanese politics, people tend to focus on the decline of the Liberal Democratic Party, but uncertainties linger over the opposition camp's ability to run the government, given that the Democratic Party of Japan's foreign policy goals have yet to be spelled out.
In short, Japan's political and economic infrastructure has not caught up with the rapid changes in the international situation. Given these circumstances, big hurdles remain before an international currency system can be rebuilt.
Teruhiko Mano is chairman of the Mano Economic Intelligence Forum.