Resident Fellow  Desmond Lachman

Today's international payment system is very much out of kilter. The clearest sign that this is the case is the fact that global payment imbalances between the United States and the Asian economies are now at their widest level in the past sixty years. And these imbalances show no sign of narrowing anytime soon. This is giving rise to ever louder calls for trade protection in both Europe and the United States against China and Japan, both of which countries are charged with manipulating their currencies for competitive advantage.

Even more troubling than today's growing payment imbalances is the fact that, the IMF notwithstanding, there appear to be no rules as to what countries might do with their exchange rates. Some countries seem free to fix their exchange rates at levels that are patently undervalued, while others seem free to actively manage their floating exchange rates in a manner that maintains for them an unfair international competitive edge. In this currency free for all, currencies are simply not moving in the direction that might offer hope that today's global payment imbalances might be attenuated anytime soon.

Currency management in China and Japan, the two countries with the world's largest external current account surpluses, vividly illustrate the lack of order in the global currency market. Despite very public assurances in July 2005 that it would float its currency, China's central bank continues to intervene heavily in the foreign exchange market to prevent the Chinese currency from appreciating. It does so despite the fact that China's current account surplus has now widened to around 9 percent of its GDP and its international reserves have now surpassed the $1 trillion mark.

As a result of this heavy foreign exchange intervention, China's exchange rate today is at very much the same level as it was eighteen months ago against a basket of its main trade partners' currencies. And this is the case despite China's ever-widening balance of payments surplus.

Whereas China effectively fixes its exchange rate, since March 2004 Japan has maintained a freely floating currency without any official intervention. Yet despite the Bank of Japan's hands-off foreign exchange policy, the Japanese yen has depreciated by almost 20 percent over the past two years as the Bank of Japan hews to its low interest rate strategy. This has taken the yen to its most depreciated level in almost twenty years at a time when Japan's external current account surplus has remained in the vicinity of $150 billion.

The correction of today's global payment imbalance problem will require a marked reduction in the United States external deficit. It is widely recognized, however, that currency movements alone will not correct the large U.S. balance of payments deficit even were those currency movements to be in the right direction. Rather the correction of the large U.S. payment imbalance would also require a major increase in U.S. household and government savings from their presently very low levels. This would be needed to make the room for the increased production of traded goods required to reduce the external deficit

In an ideal world, the United States dollar would depreciate most against the countries of those countries like China and Japan, which have the world's largest current surpluses. This would allow the U.S. to reduce its payments imbalance without putting undue pressure on economic regions like the European Union, which has an appropriate balance of payments position and which is not part of the U.S. balance of payments problem.

Sadly, over the past two years, exchange rate movements have been in anything but in the right direction. Instead of the Asian currencies appreciating as they should have against the U.S. dollar, it has been the Euro that has taken most of the strain. Little wonder then that cries for trade protection are growing louder each day in European capitals.

It is against this background that one has to regret the conspicuous silence on these matters by the International Monetary Fund. For after all, the IMF was set up in 1944 as the international organization that was charged with the specific mandate of preventing any return to the economic mayhem of the 1920s and 1930s. One also has to regret that the IMF has all but given up on its proposed multi-lateral surveillance exercise, which was announced with much fanfare last year and which was supposed to have paved the way for a collaborative solution to today's payment imbalance problem.

Economic policymakers have been fortunate to date that today's very large global payment imbalances have not been tested in an economic downturn. If past experience is any guide, it would be a grave mistake for these policymakers to keep counting on their luck and to keep avoiding addressing the issue of how we are to move to a more stable international currency system.

Desmond Lachman is a resident fellow at AEI.