Musing exchange rates and all that jazz

Most people tend to forget that the exchange rate is an asset price, because holding a foreign currency is exactly like holding stocks, bonds or real estate. You switch in and out foreign currencies to maximize your portfolio value. Investment is now global in life, but to paraphrase Mervyn King, the costs are local. In an environment of freely flowing capital, everyone including the locals love the asset prices to go up, including the exchange rate. So asset bubbles have become the norm in an age of global capital flows.

Unfortunately, when asset bubbles deflate, it is mostly the locals who pay, because domestic governments are the ones who have to pick up the pieces of failed banks, depressed markets, unemployment and deflation. There is no free lunch. So we have the current situation where everyone blames the central banks, the regulators or the government for allowing the bubbles to happen, but no one wanted to stop the bubble on its way up.

The real problem with exchange rates is that we have not solved the fundamental of exchange rate standards. Gold was not thought to be a good standard, because if its supply was limited, then hoarding gold could be highly deflationary. This was the lesson of the 1930s.

Having the U.S. dollar as the reserve currency solved the problem of expanding the monetary base to fit global liquidity needs, but when the United States (U.S.) monetary policy was too loose for its own needs, with low interest rates, the world went into a leverage frenzy, helped by financial engineering. The Samuelson-Balassa effect says that when the world is growing faster than the reserve currency country, world currencies would have to appreciate in real effective terms. Namely, inflation should be higher than the U.S., either in consumer prices or in asset prices.

This is exactly what we are witnessing in emerging markets. Due to good weather, cheap labor and excess capacity, consumer prices have not increased so much, but there is no doubt that real estate prices in emerging markets are rising much faster than income.

So, we are all facing the music of our own creation. Next, I shall consider whether we can jazz our way out of this mess.

Andrew Sheng is the author of the book “From Asian to Global Financial Crisis.”

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