The attention being paid to exchange rates and to utterances about them by finance ministers and central bankers is misplaced. It is distracting policymakers from tending to more serious issues such as global excess capacity and attendant deflation risks.

The emergence of China as a source not just of rapid supply growth but also of rapid demand growth has provided some relief to countries in Asia and Europe that are currently relying almost exclusively on export growth to avoid recession, especially as the weakening dollar has blunted the growth of exports to the United States--the world's other growth engine. But China is a risky place. A policy misstep with shaky banks or a serious infrastructure bottleneck could precipitate a bursting of a Chinese bubble. Even if, as is more likely, China continues to grow, other global risks could be exacerbated by a preoccupation with exchange rates.

In the United States, the Federal Reserve is walking a fine line between keeping prices from falling and employment rising while simultaneously avoiding an asset bubble. If U.S. growth actually lives up to expectations and excess capacity is absorbed, the resultant much-anticipated reflation will force the Fed to raise rates and disrupt the asset boom. Alternatively, and more likely, if demand growth slows in the second half of this year as stimulus is withdrawn, global deflationary pressures will intensify. The need for exchange-rate flexibility will increase. So may the will to oppose it.

Fixed versus Flexible Exchange Rates

The exchange-rate obsession, like that displayed at the last G7 meeting in Boca Raton, is dangerous in this unusual cycle. It really does not matter whether a country decides to pursue fixed or flexible exchange rates as long as it understands the rules. Few do.

A country that chooses to peg its currency value must allow its money supply to be raised by a current account surplus and cut by a current account deficit.  A country that allows its currency to float freely retains control of its money supply by relinquishing control of exchange rates.

Currency regimes, fixed or floating, depend on a number of features, and countries select--or say they select--a regime on the basis of consideration of such as the size of the economy, its openness, and other factors. A relatively small, open economy like that of Canada, with close trading ties to the United States, faces considerable challenges regarding its currency regime. If its currency were pegged to the U.S. dollar, Canada would become the thirteenth Federal Reserve district; in other words, its monetary policy would be determined by the Fed if Canada intervened to peg its exchange rate. Consequently, Canada has opted for some exchange-rate flexibility in order to maintain some independence of its monetary policy.

Sterilization of the impact of intervention in currency markets to peg an exchange rate is an act of denial. If a non-sterilizing surplus country resists currency appreciation by purchasing an excess supply, at a target exchange rate, of foreign exchange, that intervention in the currency market boosts the money supply, pushes up prices, reduces interest rates, and thereby cuts the surplus and the attendant upward pressure on the currency.

If that same country with a current account surplus sterilizes currency intervention and does not allow a rise in the money supply or lower interest rates and higher prices to emerge, it prevents adjustments that would cut the surplus. As a result, it is forced to intervene again. Usually in such circumstances (Japan is a classic example) the intervening country's policymakers complain of "excessive volatility of exchange rates" or "currency movements that do not reflect fundamentals." They then march to G7 meetings and try to craft a statement complaining about exchange rates to cover their tracks in hopes of getting other countries to adjust their policies in order to relieve pressure on their currency.

Exchange Rates and Global Excess Supply

In a world of excess supply such as we are now experiencing, no country wants a stronger currency, U.S. statements to the contrary notwithstanding. That is because countries with deflation and weakening employment (Japan) or with slowing growth (Europe), all of which are dependent on exports to China and the United States for continued growth, want to shift demand toward their own producers of goods and services.

As it happens, the United States has an advantage at this currency-weakening game, with a half a trillion-dollar current account deficit that spews out $1.5 billion per day of dollar supply into global currency markets. Beyond that, the U.S. central bank has elected to hold interest rates very low in order to alleviate its own symptoms of excess supply, intensifying deflation, and weak employment growth. Indeed, U.S. stimulus efforts have started to show modest positive results. About 10 percent of fourth-quarter demand growth was due to rising external demand, and U.S. employment has begun to rise modestly--by about 70,000 per month in the three months ending in January, compared to an average drop of 47,000 per month during all of 2002.

Of course in a static world U.S. gains in demand growth would come at the expense of losses in Asia and Europe. Fortunately, overall global growth is positive, thanks to rapidly accelerating growth in China and the United States that is creating rising exports in Asia and Europe. The rising euro threatens sustained European growth of exports going forward, so European policymakers should press further for a boost to domestic demand--perhaps by lowering interest rates in the spring. In Japan, domestic demand growth remains weak. Japan has elected to purchase U.S. securities at a rate of $250 billion per year, with that purchase rate rising to an extraordinary $750 billion annual rate in January, to slow appreciation of its currency. That problem would end if Japan's policymakers at the Bank of Japan and the Ministry of Finance announced jointly that sterilization would end, thereby boosting Japan's money supply massively and turning expectations of deflation into expectations of price stability and, yes, even a little inflation.

Why Aren't Asia and Europe Boosting Demand?

 Why don't the central banks of Asia and Europe act to boost demand growth? One view has it that they fear an asset bubble--especially in the United States--will arise from further monetary easing. This is a legitimate fear, but it represents a wrong choice in a difficult situation. The asset bubble argument states that keeping interest rates low (the Federal Reserve's approach) to stabilize falling prices and boost lagging employment also encourages too much borrowing to finance purchases of riskier financial assets like low-grade corporate debt, emerging market debt, and real estate. A building asset bubble created by unusually narrow spreads between risky assets and treasury securities creates a high degree of vulnerability to a rise in interest rates, which, in the anticipated-asset-bubble view, must come when inflation finally picks up and central banks must tighten.

The possible asset bubble story is complicated by the emergence of China as a major economy growing at 10 percent a year, soaking up raw materials as well as sophisticated manufactured goods from Europe and Asia as production platforms are relocated in that labor-rich country. The urgency for European and Asian central banks to respond to the pressure from a weaker dollar with easier monetary policies is reduced since exports to China from both regions are rising.

The painful truth is that the alternative to risking an asset bubble--tighter monetary policy in the United States--is even more dangerous than the asset-bubble risk itself. Those who advocate a tighter monetary policy by the Fed claim that raising short-term interest rates by 100 or 200 basis points to around 3 percent would, in effect, move those rates to "neutral" while still being accommodative. This is a very risky claim. Suppose the Federal Reserve raises rates this spring, as "neutrality" advocates suggest. If employment is rising, while inflation is stable or rising, such a move would make sense. But with employment rising at just 3,000 a month on average over the past twelve months and core inflation at or below 1 percent, such a step is just too risky. Federal Reserve Chairman Greenspan in effect said as much in his February 11 Humphrey-Hawkins testimony to Congress.

A premature tightening by the Fed would cause asset markets to plunge, while U.S. growth would slow rapidly, with negative consequences for growth in China and the rest of the world. Neutrality advocates might claim such a reaction would be painful but less painful than the reaction that would follow in a year or so after a long-delayed tightening was forced by reflation or higher growth. This need not be the outcome. If, a year from now, Europe and Asia have boosted domestic demand and moved toward absorbing global excess capacity, and, as inflation stabilizes and starts to rise while U.S. employment rises, a Fed tightening will make sense. But the boost to domestic demand in Europe will require letting interest rates fall there--a constructive response to the message from an ever-strengthening euro that ECB monetary policy is too tight. And Japan needs to stop sterilizing its growing intervention in currency markets so that deflation is brought under control. Both areas need to focus on growth and forget about exchange rates.

Meanwhile, we must hope that the U.S. expansion holds up and that there are no accidents in China before Europe and Asia refocus on growth. Perhaps that is what Chairman Greenspan and the Federal Open Market Committee mean when they talk about "patience."

John H. Makin is a resident scholar at AEI.