(Brendan Brown) What Drives Global Capital Flows

What Drives Global Capital
Flows?
Myth, Speculation, and Currency Diplomacy
Brendan Brown
What Drives Global Capital Flows?
Also by Brendan Brown
EURO ON TRIAL
THE YO-YO YEN
ECONOMISTS AND THE FINANCIAL MARKETS
THE FLIGHT OF INTERNATIONAL CAPITAL (1931–1986)
MONETARY CHAOS IN EUROPE (1914–1931)
THE DOLLAR-MARK AXIS
MONEY HARD AND SOFT
What Drives Global Capital
Flows?
Myth, Speculation, and Currency Diplomacy
Brendan Brown
© Brendan Brown 2006
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Brown, Brendan, 1951–
What drives global capital flows? : myth, speculation, and currency
diplomacy / by Brendan Brown.
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ISBN 1–4039–4757–0 (cloth : alk. paper)
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Contents
List of Tables viii

List of Figures ix
1 Main Currents 1
2 Black Money 38
3 Driving Forces 65
4 Short Circuits 94
5 Sustainability 120
6 Currency Diplomacy 146
7 Dysfunctional Union 182
8 Currency Speculation 215
Bibliography 251
Index 256
vii
List of Tables
1.1 World Current Account Balance, 1975–90 4

1.2 World Current Account Balance, 1995–2005 5
1.3 Euro-area Capital Account, 2001–5 10
1.4 UK Capital Flows, 2002–4 10
1.5 UK International Investment Position, 1993–2003 12
1.6 Yen External Flow of Funds, 2005–6 13
1.7 Chinese Yuan External Flow of Funds, 2005–6 14
1.8 Small Advanced Asian Economies – External Flow
of Funds, 2005–6 30
1.9 Non-EU Savings Surplus Countries – External Flow
of Funds, 2005–6 30
1.10 Mid-East Oil Exporters (High Savers) – External Flow
of Funds, 2005–6 31
1.11 Tax Havens and Offshore Financial Centres – External
Flow of Funds, 2005–6 31
1.12 Sterling Flow of Funds, 2005–6 32
1.13 Euro Flow of Funds, 2005–6 34
1.14 US Dollar Flow of Funds, 2005–6 35
2.1 Total Errors and Omissions, 2005–6 48
2.2 Analysis of the Global Current Account Gap, 2005–6 54
2.3 Tracing Trade Balance Divergences to Global Tax
Havens, 2005–6 55
8.1 US Savings and Investments, 2001–5 227
8.2 Japan Savings and Investments, 2000–8 229
viii
List of Figures
1.1 Foreign holdings in Japanese equity markets 27

3.1 US$ vs. Euro, 2-yr and 10-yr swap rate spreads 72
3.2 China – foreign exchange reserves, 2002–5 76
3.3 Hong Kong, Taiwan and S. Korea – foreign exchange
reserves, 2002–5 77
3.4 Switzerland – current account and net investment
income, 1980–2004 81
3.5 Japan – current account and net investment income,
1980–2004 83
4.1 OPEC countries – current account balance, 1974–2004 102
4.2 Japan – JGB 10-yr yield vs. overnight rate, 1990–5 104
4.3 Exchange rates, US$ vs. yen and euro, 1999–2005 107
4.4 US Treasury Bonds – conventional vs. inflation linked
yield 108
4.5 US inflation vs. swap rates, 1999–2005 109
5.1 US current account and investment balances, 1980–2004 121
5.2 US exports and imports of goods and services, 1980–2004 137
5.3 US, Germany and France – imports from Asian developing
countries, 1980–2004 138
5.4 Latin America and Asian developing countries – current
account balances, 1980–2004 141
7.1 Germany – savings, construction and investment,
1995–2005 188
7.2 Germany and France – CPI levels, 1998–2005 189
7.3 Spain, Netherlands, Portugal and Greece – CPI levels,
1998–2005 190
7.4 Germany, France and Netherlands – current account
balances, 1998–2004 190
7.5 Italy, Spain, Greece and Portugal – current account
balances, 1998–2004 191
7.6 Germany, France and Spain – national indices for house
prices, 1996–2005 198
8.1 Real effective exchange rates – US$, euro, yen and Swiss
franc, 1971–2005 216
8.2 Swiss franc exchange rate, 1975–2005 236
8.3 Canadian dollar vs. oil price, 2003–5 238
ix
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1
Main Currents
The unprecedented force of capital inflows to the USA which built

up in the early years of the 21 st century provoked awe, bewilder-
ment, resentment, and intense anxiety. In order to understand
the wide range of reaction amidst the universe of international
investors, currency diplomats, international bureaucrats, and eco-
nomic commentators, it is necessary to delve far into the subject of
what drives the global flow of capital. That is the main theme of the
present volume.
Global capital flows have a power to fascinate. There are many
reasons for this. Foremost is sheer size. According to Commerce
Department estimates, the current of capital inflow into the US in 2005
registered a force of around $800bn p.a., near 6.5% of US GDP. Beyond
size there is the whole imagery of what lies behind this gigantic flow –
including teams of faceless officials pouring over their desks in the
Japanese and Chinese Finance Ministries and managing the world’s
largest foreign exchange reserves (each around $800bn at end-2005), a
nebulous commonwealth of private investors operating in the secrecy
provided by offshore tax havens, and bold gamblers in the hedge fund
industry intermittently making huge gains or losses.
Indeed it is the roller coaster waves in the currency markets, on
which a few successful speculators surf with success for periods of vari-
able length, that grab the international financial headlines. Editors
realize that many readers (or listeners) are absorbed in the quest for
high return. Extremely low transaction costs make foreign currency
speculation the cheapest form of gambling. Some knowledge of what
drives global capital flows combined with market-timing skills might
actually tip the scales so that the player could expect over the long-run
to make net gains at the expense of less talented or more constrained
1
2 What Drives Global Capital Flows?
competitors (for whom limits might apply, for example, to the time
over which they can maintain positions).
Money equals power, not just at the micro level of the fortunate
speculator but also at the macro level populated by governments.
Global capital flows bestow influence on both the borrower and
lender. For example, the US, as a massive global borrower, would be at
risk from any sudden loss of momentum by capital inflows. Hence
maintaining the strength of flow, or preventing any abrupt shut-off,
has become a potential objective of US foreign policy – akin to secur-
ing sources of essential mineral wealth. In practice, as we shall see in
Chapter 6, Washington has shown only scant and intermittent con-
cern about this issue, perhaps persuaded of its own more than coun-
tervailing powers as the world’s largest and most eligible debtor.
Borrowers can inflict large losses on the lender (in the US case most
plausibly via the unleashing of unanticipated inflation). The whole
subject of global capital flow is intimately connected with that of
international relations between sovereign states.
At the level of the individual citizen, global capital flows are an
expression and condition of personal liberty. The option of putting
some wealth outside the political jurisdiction in which one lives or in
foreign currency assets expands the scope for individuals to reduce
their exposure to various shocks – whether emitted by government or
by nature. The constraints are tighter on the power of sovereign gov-
ernments to impose penal tax regimes or inequitable laws. None of this
is to deny that there might be losers as well as gainers from an increase
in capital mobility across the globe. Nor are the gains equally spread.
Arithmetic and geography of net capital flow

As a general principle, capital flows out of countries where there is a
surplus of saving over domestic investment opportunity into countries
where there is a deficit (savings less than investment).
Through most of the past three decades, for example, Japan has been
a large exporter of capital and the US a large importer (see Tables 1.1
and 1.2). That is consistent with the observation that in Japan the
savings rate is high whilst in the US it has been low. And for most of
the time (with the main exception of the late 1980s), apparent invest-
ment opportunity (measured by expected rate of profitability) has been
relatively thin in Japan.
It is an identity of national income accounting that the difference
between saving and investment equals the balance on the current
Main Currents 3
account of the balance of payments. (More exactly, the surplus of

savings over investment spending equals the surplus on the current
account of the balance of payments, or the deficit of savings below
investment equals the current account deficit).
And if measurements are correct, the current account balance should
be equal and of opposite sign to the capital account balance. (A current
account surplus is matched by net capital exports of the same amount,
a current account deficit by equal net capital imports).
Hence in principle a surplus of savings over investment should equal
net capital exports. By contrast a deficit of savings below investment
should equal net capital imports.
At a global level, current account balances should add up to zero.
Equivalently, savings surpluses and deficits, added up across all coun-
tries, should sum to zero. (All net lending internationally must be
matched by net borrowing).
In practice there are large errors in measurement which mean that
equality is not observed in the actual data. The savings-investment balance
registered in the national income data is typically somewhat different from
the current account balance found in the balance of payments statistics.
(In turn, that difference equals exactly the residual error in the national
income accounts, as discussed further in the next chapter – see p. 56). And
as we shall see, when we add up the current account balances across all
countries the result is a huge negative amount rather than zero.
If measurement techniques were perfect, and all the relevant eco-
nomic transactions were traceable by the official statisticians, there
would be no errors. It is important to realize, however, that these
saving and current account surpluses, even perfectly measured, would
be quite different for much of the time from the equilibrium concepts
in which economists are interested.
There is no mechanism which ensures perpetual general equilibrium
characterized by the level of economic output equal to productive
potential in each country and the difference between intended savings
and investment equal to actual net capital exports (or to the actually
realized savings balance) and subject to the constraint that for all coun-
tries together these must add up to zero. That is an equilibrium out-
come, dependent on the operation of a complex array of forces which
operate over usually lengthy periods. Much of the time, disequilibrium
rather than equilibrium pertains (where equilibrium in its fullest sense
embraces all markets, including labour and capital).
Households and corporations, for example, might have budgeted to
save a given amount (for corporations, target savings means expected
Table 1.1 World Current Account Balance, 1975–90
(US$ bn) 1975 1980 1985 1990

North America
USA 18 2 –118 –79
Canada –5 –6 –6 –20
Europe
ERM* 5 –35 24 13
Switzerland 1 0 4 9
Norway –3 1 3 3
UK –4 4 –1 –40
Sweden 0 –4 –1 –7
Japan –1 –11 51 43
Asian Tigers** –2 –8 11 17
Australasia –2 –4 –8 –16
Total Advanced 7 –61 –41 –77
Developing
China 0 0 –11 10
Other Asia –7 –5 –8 –25
Middle East/Turkey 27 60 –8 –5
Western Hemisphere –13 –20 –5 0
Africa –10 0 –5 –10
Total Developing –3 35 –37 –30
URSS & E. Europe –18 –2 –4 –18
Aggregate Global Gap –14 28 82 125
Memo: US GDP ($ bn) 1638 2790 4220 5803
* Germany, France, Italy, Spain, Netherlands, Belgium

** Hong Kong, Singapore, South Korea, Taiwan
retained profits less intended capital expenditure including planned

inventory building) in a given year. But the actual result is often very
different from budget. In particular, realized income, corporate or
household, (out of which investment spending and savings occurs) can
turn out very different from anticipated income. One factor respons-
ible could be a dip in output below full potential level, perhaps due to
an exogenous shock. Another factor could be the economy unexpect-
edly hitting capacity constraints. On top there are the whole range of
possible shocks from the side of the government’s budget (which is an
important part of the overall savings-investment balance).
As illustration of a disequlibrium outcome, take the case of the given
economy beginning to overheat (as would happen if cyclical slack dis-
Main Currents 5
Table 1.2 World Current Account Balance, 1995–2005
(US$ bn) 1995 2000 2005

North America
USA –105 –414 –810
Canada –4 20 35
Europe
Euro-area 40 –20 10
Switzerland 21 31 45
Norway 5 26 50
UK –14 –27 –60
Sweden 8 10 20
Japan 111 125 170
Other Asia 0 42 65
Australasia –22 –18 –45
Total Advanced 40 –225 –520
Developing
China 0 20 105
Other Asia –40 26 20
Middle East/Turkey 0 45 215
Western Hemisphere –30 –45 10
Africa –15 –5 0
Total Developing –85 41 350
Transition economies –5 10 20
of which Russia (n/a) (44) (80)
Aggregate Global Gap 50 174 150
Memo: US GDP ($ bn) 7398 9817 12300
appears whilst aggregate demand growth continues unabated). Real

income growth – profits and wage incomes – might suddenly slow
because capacity limits have been reached. Productivity growth decel-
erates. It takes time for businesses and households to realize the new
situation. Investment spending runs ahead. As consumer spending
expands on the basis of anticipated rather than actual income growth,
savings slows and savings relative to income falls. Inflation picks up
unexpectedly. The current account deficit and savings deficit widens.
But this is a disequilibrium outcome.
By the same token actual spending, whether by households or busi-
ness, can differ considerably from budgeted spending. This is most
obvious in the case of inventory-building, which to a large extent
reflects unanticipated fluctuations in sales volumes or the hitting of

capacity limits.. But it also applies to spending which is constrained by,
for example, lengthening delivery periods (leading to so-called “forced”
saving or dissaving).
The observed current account balance equals the difference between
realized savings and investment, not between the planned savings and
investment totals which would coincide with the economy operating
at (but not above) its full potential (defined as consistent with no
inflationary pressure). There is equilibrium only when planned out-
comes, based on income levels equivalent to full productive potential,
turn out to be actual outcomes. And for global equilibrium to hold,
that condition must hold in each economy (or currency areas). In addi-
tion, savings deficits and surpluses, so defined, must sum to zero across
the globe.
A possible example of disequilibrium at the global level where
nonetheless one large economy is in equilibrium (with respect to
planned savings and investment being in line with actual outcomes
and with the given economy operating at full potential – but not
above) was the US situation in late 2004. At that point the gap of US
savings below investment (the savings deficit) and the current
account deficit were estimated at around 6% of GDP. But also at that
time, the second and third largest economies (Japan and Germany
respectively) slipped unexpectedly into a growth cycle downturn.
Slowed US export growth was the obvious immediate factor behind
the widening of the US current account deficit. Slower exports coin-
cided with a strong upswing in (US) business investment.
In turn, there was a corresponding shift in the realized US savings
deficit which moves in continuous identity (subject to measurement
error) with the current account deficit. The weakened export demand
(in the US) meant that interest rates there (US) remained lower than
otherwise, helping to underpin asset values and contributing to a
further fall in the US household savings rate (to near zero in net terms).
By contrast the German and Japanese downturns went along with
some rise in their savings rates. The internal disequilibrium in Japan
and Germany (below-potential level of economic output) had a corol-
lary in the US savings deficit being greater than what it would be if
global equilibrium held.
Economists and market analysts (they may be the same people!) are
usually more interested in finding out the global equilibrium path
rather than simply monitoring observed most-of-the time disequilib-
rium outcomes. The actually observed current account balances (and in
Main Currents 7
principle equal net capital flow balances) and their direction of change
might provide clues to the equilibrium path (determined by the differ-
ence between planned savings and investment).
If that path is far distant from present observations, then large cor-
rective forces are surely operating. These are most likely going to have
serious consequences for the course of economic growth and of
financial market prices over time.
Plotting an equilibrium path involves making estimates of the given
balances both now and at various points (for which forecasts are avail-
able) sequentially into the future. In the jargon of analysts, such flow
charting can be re-cast in stock terms. Instead of seeking to estimated
planned savings and capital spending rates over given discrete time
intervals the focus could be on the level of wealth and physical capital
which various economic agents intend to hold at given dates in the
future.
Typically a country with a persistently large savings surplus would be
characterized by a resident public which is seeking to accumulate
wealth (measured net of government debt) at a faster pace (in absolute
terms) than the expansion of the domestic capital stock. By implica-
tion, the amount of net external assets (measured after deducting lia-
bilities to foreigners whether in the form of debt or equity) in the
international balance sheet of the given country would be increasing.
By the same token, a country with a persistently large savings deficit
would be characterized by a domestic capital stock growing faster than
wealth of domestic residents. The total of net external assets of the
given country would be decreasing.
In practice, the rate of net foreign asset accumulation is not deter-
mined simply as a residual as in the simplified description above but
can stem from definite portfolio preferences on the part of domestic
and foreign investors. That becomes clear as soon as we introduce the
real world assumptions of currency risks and political (or credit) risks.
Suppose, for example, resident investors in country A have a long run
target of increasing the amount of wealth which they hold abroad,
perhaps so as to reduce their exposure to various domestic political
(including taxation) risks. This requires either the generation of a
domestic savings (and current account) surplus to match, or a coinci-
dental emergence of a foreign demand for assets in country A. The
same conclusion applies in the case of foreign investors in A deciding
to run down their net assets there. Either country A’s savings surplus
must increase or residents of country A decide simultaneously to run
down their foreign asset holdings.
The point here is that in the equating of savings surpluses and

capital flows, there is a two-way causality possible. Excess savings (rel-
ative to domestic investment opportunity) tend to drive a current of
capital outflow. But also an increasing net demand for foreign assets or
a long-run reduction in foreign net demand for domestic assets (in the
given country) can be the driving force behind an emerging or actual
savings surplus.
Turn-tables
Indeed without introducing some real world facts such as currency risk,
political risk, and other heterogeneous factors, we would have a hard
job in explaining a salient feature of global capital flows – the turntable.
In a world where all assets were identical in characteristic across
national boundaries, net and gross capital flows would be identical.
Why would residents of country A invest in country B simultaneously
with residents of country B investing in country C or A?
A considerable amount of two-way capital flows can be explained by
the simple arithmetic of diversification. If there were no home biases
(preference to hold domestic rather than foreign assets) investors in
any country would tend to hold the same portfolio of assets drawn
from all over the world. That would mean large inflows and outflows
of capital being the norm for each country as part of the process of
wealth accumulation. Relative to national income these would be
greater for small countries (whose assets formed only a small part of
the world portfolio) than for large.
The concept of a turntable in the global flow of funds refers to some-
thing different from simultaneous inflow and outflow of capital attrib-
utable to investors accumulating wealth in the global portfolio of
assets. Rather a turntable describes the phenomenon of a country (or
group of countries forming a currency area) importing capital on a net
basis from one region of the world and exporting it (net) to another.
Typically the turntable would import capital from the savings surplus
countries and re-export (capital) to the savings deficit countries. But
turntables can also have relationships with each other.
For example, turntable A could import large amounts of capital from
the savings surplus countries and turntable B and re-export this
(capital) in large part to a huge savings deficit country and also to
turntable C. Moreover the roles of turntable and savings deficit or
surplus country are not mutually exclusive. A country can be in large
savings surplus and also perform a turntable role.
Main Currents 9
Some illustrations help demonstrate these points.

First, in 2003–4, huge Asian savings surpluses (mainly concentrated
in Japan and the small advanced economies in East/South East Asia)
and mid-East savings surpluses (in the oil exporting countries) coin-
cided with a huge US savings deficit. But the Asian and mid-East
investors were set on accumulating not just US but also a substantial
amount of euro-assets. And some euro-area residents (whether corpora-
tions or hedge funds, for example) were keen to borrow low or zero
rate yen to finance euro-assets. (In so far as euro-area residents bor-
rowed yen to finance non-euro-assets, mainly US dollar, they were not
generating any turntable role for the euro-area, but adding power to
the main current of global capital flow – out of the savings surplus
countries in Asia – especially Japan – into the biggest savings deficit
economy, the US.)
The euro-area was itself in small savings surplus. And so the inflow of
Asian funds (whether powered by Asian investors or euro-area borrow-
ers) was in fact matched by outflows of capital from the euro-area.
These included in particular borrowing in euros by non-residents of the
euro-area (whether in the form of loans by banks in the euro-area or
issuing bonds to euro-area residents). Of some importance here were
borrowers in the UK and in Eastern Europe – both areas of savings
deficit. But the UK was itself a turntable, drawing in capital to finance
its large direct investment in the US (see below).
Second, in 1999–2000, European portfolio and corporate investors
became very enthusiastic about US equities and companies (more so
than did investors in other parts of the world). If that had occurred
in isolation and had been sustained, euro rates would have risen and
the euro fallen to a level such as in the medium term a savings and
current account surplus would have been generated in the euro-area
equal to the ongoing rate of accumulation of US assets. And it is
arguable that to some extent this process got under way. This was
the period of the cheap euro. Anecdotal evidence however suggested
that there was also a simultaneous emergence of global investor
demand (from outside the euro-area) for euro money and fixed-rate
assets (ignited by the birth of the new European currency and the
emergence of new deep money and capital markets in it). In effect
inflows into euros from the savings surplus countries (including
Asia, the mid-East, and Switzerland) played a large role in financing
euro-area outflows of capital into the US which in turn filled
the shortfall of US domestic savings below boom-time levels of
investment spending.
Table 1.3 Euro-area Capital Account, 2001–5
(€ bn) 2001 2002 2003 2004 2005H1*

Direct Investment –103 0 5 –78 –68
equity out –235 –180 –113 –164 –84
equity in 149 125 124 75 34
intercompany –17 55 –6 10 –16
Portfolio Investment 68 128 43 76 238
Equities –128 48 52 50 62
–EURO out –105 –38 –65 –73 –82
–foreign in 233 86 117 123 144
Debt Instruments –61 82 –10 26 176
–EURO out –184 –135 –213 –206 –324
–foreign in 123 217 203 232 500
Credits & Loans –15 –170 –78 –32 –40
Banks 3 –143 –18 –15 4
Other –18 –27 –60 –17 –44
Errors/Omissions 32 –30 –28 –59 –132
Official transactions 18 –2 30 12 15
* annualized rate
Table 1.4 UK Capital Flows, 2002–4
(£ bn) 2002 2003 2004

Direct Investment –18 –28 3
equity outwards –34 –41 –25
equity inwards 17 13 27
Portfolio Investment 50 58 –13
Equities out 3 –19 –65
Equities in 3 10 10
Bonds out –4 –17 –60
Bonds in 48 84 102
Financial Derivatives 1 –5 –13
Other Investments –24 –11 64
Reserve Assets 1 2 1
Errors/Omissions 6 3 4
Third, in the early and mid-1990s, investment opportunity in the

Asian developing countries blossomed. One important element was the
(post-bubble) depression of rates of return to business capital in Japan
partly as a result of the sky-high yen and the related scope for firms in
Main Currents 11
the Asian developing countries to replace Japanese production,

whether aimed at export sales to the US and Europe or at domestic
consumers. The fall in investment opportunity in Japan and rise in
Asia could have led simply to a corresponding direct investment flow
(from Japan to Asia), which would have largely matched the rise in
Japan’s overall saving surplus and the shift of developing Asia into
deficit. And there was indeed a big increase in direct investment flows
as described. But in some part Japan’s raised savings surplus flowed
into portfolio-type assets (mainly bonds) in Europe and the US, whilst
companies there joined in taking advantage of the new opportunities
for direct investment in the Asian developing countries. Thus the US
and Europe performed a (modest) turntable role between Japan and the
other East or South East Asian economies.
Fourth, in various episodes through the past three decades there
have been huge outflows of flight capital from Latin America mainly
into the US. The financing of the capital flight has largely taken the
form of Latin American governments borrowing in Europe, Asia and
the US. In so far as the borrowing was in the US, the phenomenon can
be described as a round-trip rather than a turntable. The incentive
behind the turntable flows was usually that yen and Deutsche mark
interest rates were well below US rates, and governments (in Latin
America) sought to keep down their current debt servicing costs.
Round-trips
Round-tripping is a pervasive feature of the global flow of funds. This
describes where a country or currency area imports capital in one form
and exports it in another form – both flows occurring with the same
group of countries. Round-tripping depends on various forms of asym-
metry, whether between assets in different countries or between risk
preferences of investors (or borrowers) across countries. Again, some
examples help to demonstrate the concept.
First, equity markets are more highly developed in say the UK or
Switzerland (relative to size of GDP) than in other European countries.
Correspondingly, companies in the UK or Switzerland become con-
duits of capital flow. Global investors buy shares in UK or Swiss com-
panies which themselves make large direct investments in the world
outside. In effect the UK or Switzerland become equity intermediation
centres – some direct investment outside the UK or Switzerland that
first passes through a British or Swiss multinational has ultimate
equity owners also outside. In practice, Switzerland and the UK both
have large net international liabilities in the form of equity (foreigners
Table 1.5 UK International Investment Position, 1993–2003
(£ bn) 1993 1998 2003

Direct Investment abroad 172 299 632
Direct Investment in 136 214 377
Net Direct Investment 36 85 254
Portfolio Investment abroad 469 704 969
(Equity) 194 304 420
(Bonds) 275 400 549
Portfolio Investment in 306 692 1054
(Equity) 133 402 490
(Bonds) 173 290 564
Net Portfolio 163 11 –75
Other Investments –198 –253 –256
Reserve Assets 30 23 23
hold more equities in these countries than residents there hold

outside) matched by net assets in the form of direct investment.
A further factor in the importance of direct investment outflows from
the UK is the comparative advantage (based largely in language)
enjoyed by UK corporate managers in undertaking and administering
business in the English-speaking world outside (especially the US). A
naturally high level of direct investment outflow from the UK could in
itself put some upward pressure on UK interest rates and that would
play a part in bolstering the UK savings rate so as to match the capital
exports. In turn higher-than-otherwise UK rates would attract global
capital into Sterling money market and fixed-rate assets. In effect, the
UK could have a turntable role (in addition to the round-tripping role
already described). Net business assets abroad – largely in the US and
other English-speaking countries – would be matched in part by net lia-
bilities in the form of money and bonds held by investors in Asia and
Continental Europe. Alternatively, if global investors are keen to buy
equities in UK companies which have this comparative advantage in
making direct investments in the US, the UK’s turntable role would take
the form of running up equity liabilities (to foreigners worldwide)
matched by direct investment in the US. Then there might be no
interest rate effect or influence on the savings rate.
Fourth, an unusual amount of home bias by Japanese investors with
respect to equity investment means that over time inflows of foreign
Main Currents 13
funds into Japanese equities far exceed outflows of Japanese funds

into foreign equities (both these items are highly volatile!). But in
turn foreign corporations are typically more reluctant to acquire
Japanese assets – or constrained by structural factors – than are
Japanese corporations to acquire foreign assets. One such structural
factor is the lack of a well-developed Japanese market in corporate
control. (Its under-development is widely attributed in part to the still
considerable amount of interlocking corporate shareholdings). And
so a large net liability position in equities in Japan’s international
balance sheet is matched by a net asset position in direct investment.
Moreover some part of the Japanese demand for foreign bonds (the
dominant form of external asset in Japan) might stem from the fact
that Japanese equity yields have been depressed and the yen raised in
value by worldwide investor demand (for Tokyo equities). Some of the
foreign bond holdings of Japanese investors should be considered as
part of the round-trip.
Fifth, China has typically enjoyed large inflows of direct investment
capital. Foreign companies have in some cases been better placed than
domestic companies to take advantage of (and discover) emerging
profit opportunities (whether from using cheap labour in export indus-
tries or for selling to the rapidly growing domestic market). China has
been in modest (and now, 2005, large) savings surplus. So in practice
the direct investment inflows have been matched by Chinese private
Table 1.6 Yen External Flow of Funds, 2005–6 (¥ 100 bn p.a.)
Inflows to Yen Outflows from Yen

Current Account Surplus 185 Official Intervention 40
Net Foreign Inflows 80 Japanese Buying of Foreign 30
to Japanese Equities Equities
Net Direct Investment from 25
Japan (outflows less inflows)
Japanese Portfolio Outflows 125
into Foreign Currencies
(bonds or money market) on
unhedged basis
Non-Japanese borrowing of 45
Yen to finance non-Yen assets
265 265
portfolio and government investment in foreign currency assets

(mainly in the form of dollar deposits with the local banking system).
To a large extent this is round-tripping, but there may also be an
element of turntable involved. The Chinese Diaspora throughout
South and South East Asia is an important category of direct investor in
mainland China. But Chinese resident foreign currency deposits are
not as a rule lent back to the Asian surplus countries. (Rather they are
lent into the euro-dollar money markets).
Sixth, during 2003–5 there has been considerable speculation on an
upward float of the Chinese yuan, which meanwhile (until July 2005)
remained fixed to the US dollar. Exchange restrictions have meant that
the main form of speculation has been local Chinese corporations
reducing their borrowing in yuan and increasing their dollar loans. In
turn the Bank of China has offset the speculative inflows by accumu-
lating foreign exchange reserves. In so far as the process described
creates an offsetting supply and demand for dollars in the Chinese cur-
rency market, this is a round-trip.
It can be seen in all these examples that round-trips, as turntables,
play an important part in the routing of capital out of the savings
surplus countries into the savings deficit countries. But in themselves
their operation cannot generate net global flows of capital unless they
influence the equilibrium level of the savings surplus or deficit in the
countries concerned. This is possible in the case of turntables but not
round-trips.
For example, if Europeans are keen to add to their holdings of US
assets at the same time as Asian investors are seeking to deploy a
raised share of their surpluses into euros, that helps to underpin the
net flow of capital towards the US (financing its huge savings deficit).
Table 1.7 Chinese Yuan External Flow of Funds, 2005–6 (US$ bn p.a.)
Inflows Outflows
Current Account Surplus 110 Chinese Reserves 170
Direct Investment Inflows 50 Portfolio Outflows 20
Foreign Currency
(Money and Bonds) (15)
Speculative Borrowing 40
Foreign Equity (5)
in Foreign Currency
by Chinese Companies
200 200
Main Currents 15
If by contrast Europeans have very small appetite for US assets, (or

put more technically, a high degree of aversion to dollar risk), and
global borrowers have little inclination (or a high degree of risk aver-
sion) to switching their liabilities into euros (from dollars), then
Asian savings surpluses seeping into euros (as Asian investors become
more familiar with euro investment) would eventually have to be
offset by an induced euro-area savings and current account deficit.
(In the short run the Asian demand for euros can find accommoda-
tion in the form of speculators moving out in the expectation of
buying back at cheaper levels later).
The counterpart to that induced swing in the euro-area savings
balance towards or into deficit (which could take place via a fall in euro
interest rates and rise in the euro) would be a shrinking of the US
savings deficit (under the influence of higher US rates). There could
also be downward pressure on the Asian savings surplus (via lower yen
interest rates) if the flow of capital from Asia to the euro-area were less
elastic (with respect to interest rate differentials) than for flows
between Japan and the US. Perhaps this divergence in interest rate elas-
ticity could be due to the euro as yet still being under-represented in
Asian portfolios, meaning considerable diversification benefits are still
obtained (by Asian investors moving into euros). Or the Asian-dollar
currency exchange rate (on average across all the currencies) might be
less volatile than the Asian-euro exchange rate, meaning that small
changes in interest rate spreads have a bigger impact on Asian capital
outflows into dollars than into euros.
Overall, the better the functioning of the euro-turntable, (better-
functioning is defined in terms of willingness of European investors to
switch into dollar assets in response to a widened rate spread in their
favour and of global borrowers to similarly switch towards euro away
from dollar liabilities) the more sustainable is likely to be a large net
flow of capital out of Asia and into the US in the face of diversification
by Asian investors away from the US dollar into euros.
How to measure?
The main primary source of measurement on global net capital flows,
turntables and round-tripping, is balance of payments data. Subsidiary
sources include statements of external assets and liabilities produced at
regular intervals by many advanced industrialized economies. In addi-
tion there is the data on savings and investment produced as part of
the national income accounts.
All of this data is produced by national statistics offices. Some con-

solidation (across countries) occurs in euro-area capital account data
but not so far current account data. (Various forms of capital export
and import are measured net of intra-area flows). The guiding principle
of balance of payments statisticians is to aggregate all transactions
between residents and non-residents, broken down into the various
categories of merchandise, services, invisibles, or capital. And the
guiding identity which would hold if measurement were comprehen-
sive and accurate is that net capital exports (imports) equal the current
account surplus (deficit) (as discussed above, see p. 3).
The capital flows measured by the statistician are between residents
(of the country in question) and non-residents. These include a huge
mass of flows between financial intermediaries (for example a US bank
lending to a European bank). In principle, net capital exports over a
given period add to a country’s net holding of foreign (external) assets
by the same amount, adjusted for valuation changes. (In any given
period – say a quarter or year – big valuation changes due to currency
or capital market price fluctuations can bring changes in net asset posi-
tions which dwarf those attributable to net flows).
Capital flow data as described should be distinguished from cur-
rency flow data. Here the aim is to measure fluctuations of interna-
tional final demand and supply for assets in a given currency. “Final”
means excluding the whole array of financial intermediaries. “Assets”
include equities, bonds and money. “International” means the buyer
is non-resident of the country issuing the currency. Net additional
supply of assets in the given currency to international buyers
(investors) can come only via the issuing country running a current
account deficit, or residents there (in the issuing country) adding to
their net position in foreign currency assets, or by non-residents (of
the issuing country) issuing net debt in the given currency. The
guiding principle is that final aggregate international supply (mea-
sured in flow terms over a given period) of and demand for assets in
the given currency must be equal.
As illustration of currency flow estimation, consider the global flow
of funds in US dollars. International final demand for dollar assets
includes not just foreign demand for US assets but also US dollar-
denominated assets throughout the world. That would include for
example US dollar bonds issued by Brazil, or dollar deposits issued by
banks in London or Singapore. Supply includes not just US net buying
of foreign goods and services (as reflected in the current account deficit
or savings deficit) but also US net buying of foreign equities and cor-
Main Currents 17
porate assets (direct investment) and also foreign countries running up

net liabilities in dollars as a counterpart to their own current account
deficits or accumulation of non-dollar assets.
Currency flow data are not estimated or published by official statisti-
cians. But they can be put together as “guesstimates” from primary
source data. They bring two important advantages compared with the
traditional balance of payments data. First, their focus is on the ulti-
mate sources of new international demand and supply of assets in a
given currency rather than on where precisely the flow of capital
crosses the frontier of the country (or area) of issue.
For example, take the accumulation by Japanese investors of inter-
national dollar bonds issued by non-US borrowers. The latter may in
turn be reducing their borrowing of dollars from US banks (replacing
bank loans with bond issuance). In the US balance of payments it is
the reduction in US bank lending to foreigners which is registered –
not the transactions in dollars between non-US residents (Japanese
buying of foreign dollar bonds). Yet the bank is only acting as a
passive intermediary with respect to final foreign demand for US
dollar assets.
Another example relates to foreign exchange intervention by non-US
central banks. Suppose the Bank of Japan buys massive quantities of
dollars (so increasing the reserves held by the Government of Japan)
and deposits these with Japanese banks both in Tokyo and London
(foreign subsidiaries and branches of Japanese banks). In the US
balance of payments what becomes registered as a result of this original
demand is an inflow into the US via the banking system. But this tells
us nothing about the ultimate final demand (for dollars).
The second advantage of currency flow data (following on from its
focus on currency demand and supply) is its potential use in the ana-
lysis of forces operating in the exchange markets. Several of the main
theories of exchange rate determination are built on demand and
supply for assets denominated in the various currencies. Issuance of
dollar liabilities by non-US borrowers add to the supply of dollar assets
in global markets as much as does US excess demand for goods and ser-
vices (the current account deficit) or US demand for foreign assets.
Evidently foreign dollar and domestic US assets are not perfect substi-
tutes for each other, but neither are the various types of US domestic
assets.
In principle there is much to be gained towards the understanding of
exchange rate dynamics by focusing on final demand and supply for
dollar assets wherever located rather than on data about capital flows
across the US coastline (in a transaction between resident and non-

resident). The latter include a large blur of intermediary transactions
and also matched external borrowing and lending by the US non-bank
sector. (For example, large net purchases by US investors of dollar
paper issued by foreigners would be registered as a capital outflow from
the US and there would be a corresponding inflow of funds somewhere
in the US balance of payments to finance this. But in reality the two
are offsetting and the US outflow of funds into foreign dollar paper
does not add to its net international supply).
Insights can also be gained from currency flow analysis into the so-
called US current account sustainability issue (see Mann, 1999). A
common cry of the dollar pessimists has been the huge size of the US
current account deficit as if this could ultimately exhaust the global
appetite for US dollar assets. As we shall see in a later chapter
(5) that is a phantom danger, when account is taken for example of the
fact that in various periods there have been huge supplies of dollar
assets from non-US borrowers, whereas in the period of mega US
current account deficits these foreign supplies have all but dried up.
Net capital flow – present and past

A table of the world current account balances provides the main
insight into net global capital flows. The table shows the current
account balance for each country or selected group of countries. In
principle these add up to zero. In practice, there is a large and vari-
able global gap – with the total of all current account balances adding
up to a large negative number. The economic significance of this is
discussed fully in the next chapter. For now it suffices to note that
the global gap matches to a considerable extent investment income
accumulating in offshore tax havens. This income is not treated as a
credit in any of the IMF reporting countries. Yet the interest and div-
idend payments by the respective debtors are in general registered in
national balance of payments.
If there were 100% accurate measurement, and national savings sur-
pluses or deficits as revealed in the national income data were exactly
equal to the current account balances which in turn were exactly equal
to net capital flows, then we could describe the world current account
as a statement of the net flow of savings from (savings) surplus coun-
tries to deficit countries. In practice there are errors, and so the table of
world current account balances provides only an approximation to the
underlying savings flows. (In Chapter 2 it is shown how the various
Main Currents 19
types of error including the aggregate global gap can yield indirect esti-
mates of grey and black capital flows.
In Tables 1.1 and 1.2 (pp. 4–5) we show the world balance of pay-
ments in 2005 and at five-yearly intervals back to 1975. The dominant
feature of present net global capital flows as revealed is the huge
current towards the US. US net inflows of capital (approximately equal
to the current account deficit) are estimated at around $800bn. That
corresponds to a huge savings deficit in the US economy – a reflection
mainly of a large household sector savings deficit (stemming from a
low level of personal savings compared to Europe or Japan and
booming residential construction). There was a considerable structural
budget deficit in the US, but budget woes plagued also several of the
surplus countries, including most prominently Japan. The main ulti-
mate sources of net capital outflows are the advanced economies in
East/South East Asia (Japan, South Korea, Taiwan, Hong Kong, and
Singapore), with an estimated surplus of $230bn, Middle East oil
exporters, $220bn, Western Europe excluding the UK (euro-area,
Switzerland, Norway, and Sweden), $120bn, and Asian developing
countries (China, India, and others) $130bn. The UK is the largest net
importer of capital outside the US, at around $60bn p.a. Australasia
and the transition economies in Central and Eastern Europe (excluding
Russia) are each – considered as a group – not far behind. The underly-
ing story (behind the deficit) includes some combination of low house-
hold savings, strong investment, or large budget deficits. The aggregate
global gap amounts to around $150bn (equivalent to 1.3% of US GDP).
A more detailed geographical breakdown on Europe would show the
surplus in Western Europe excluding the UK and Mediterranean areas
(Spain, Portugal, Greece and Italy) at around $200bn, broadly the same
as for the advanced economies in East Asia. But there is a flow of
capital within the euro area – from Germany and the Benelux coun-
tries towards the South. Currents of capital flow within a currency area
are one subject of Chapter 7. Here the subject is the capital flows
between currency areas or countries with their own sovereign money.
Amongst the savings surplus countries there are two groups of small
countries with extraordinarily high surpluses relative to their economic
size – one in East Asia and one in Western Europe. The Asian group
includes Taiwan, Hong Kong and Singapore, for which savings
surpluses range from 10 to 20% of GDP. There is a similar range for the
European group including Switzerland, Sweden and Norway. In
absolute terms the aggregate surplus of each group is around
$70–110bn (Asian group towards the lower end of the range in 2005
influenced by the surge in oil imports). There are some common

themes and some individual factors behind these huge savings
surpluses.
A common theme is population ageing and state-sponsored pension
provision at a high level involving high present mandatory contribu-
tions. Political risk and the associated efforts of the resident population
to build up foreign asset portfolios (rather than plough savings into
domestic fixed assets) are an important element in the case of Taiwan,
Hong Kong, and even Singapore. In the case of Norway there is the
explicit political decision to invest huge state oil revenues in a welfare
fund for pension provision in the future and taking into account the
long-term decline of oil production.
Amongst the developing countries, there are no persistent savings
and current account surpluses as of the mid-2000s except in the impor-
tant case of China (where a large savings surplus is emerging most
probably on a long-run basis). Amongst the Middle East oil exporters
the tiny states with huge oil resources – Kuwait and the UAE – are
always in surplus, but not always by a large amount. The Asian devel-
oping countries (principally Indonesia, Malaysia, Thailand, and
Philippines, and India) are now (2005–6) in slight surplus and were in
large surplus (around $50bn maximum) in the aftermath of the 1997
Asian debt crisis. But further back, especially during the mid-1990s
boom, they were in large deficit.
Some commentators and policymakers have suggested that the
natural situation of the developing countries should be to be in large
savings and current account deficit – as the counterpart to large inward
flows of capital to take advantage of investment opportunities in
rapidly growing economies. But domestic investment opportunity is
only one part of the story. Savings rates are very high, reflecting a com-
bination of population ageing and lack of confidence in pension provi-
sion. And a high level of political risk in most cases goes along with a
considerable appetite for foreign assets (partly by way of unregistered
capital flight).
To complete the snapshot of present global net capital flows we
need consider the situation of Eastern Europe, Australasia and Latin
America. The so-called transition economies (in Eastern Europe) are in
surplus by around $20bn, but that is a combination of a large surplus
for Russia (around $80bn – reflecting a jump in oil revenues associated
with the 2003–5 oil price shock) and large deficits (relative to eco-
nomic size) for the other East European economies most of which are
already in the EU or embarked on an entry program. The latter’s
Main Currents 21
deficits match a shortfall of domestic saving below investment –

natural for economies in which savings rates are not especially high
(in contrast to in East Asia) but where there is considerable investment
opportunity as part of the process of long-run convergence with the
more advanced economies in Western Europe and where budget
deficits are large (relative to economic size).
The Australasian current account deficits are accounted for mainly
by Australia and are in part symptomatic of a consumer and real estate
boom in the first half of the 2000s (already the real estate market had
started to cool in 2004–5). Also in the long-run, Australia has been a
large capital importer, related to the depth of investment opportunity
in the commodity extraction industries (and the insufficiency of
domestic saving for exploiting these). Finally, the developing countries
in the Western Hemisphere (including Mexico) are in aggregate
running an almost zero savings and current account deficit (in 2005).
That should be considered an abnormal situation in the aftermath of
debt crisis (Argentine default, Brazil crisis).
These observed net capital flows (current account balances) as
described may well be out of line with the global equilibrium solution
where at least all the big economies were operating at around their pro-
ductive potential and planned savings and investment spending were
equal to actually realized amounts (as discussed in an earlier section).
Equivalently, a contemporary snapshot of net capital flows could be of
a transitional stage on a way to the equilibrium solution. In particular
Germany had been in virtual recession during most of 2004 and per-
sonal savings had risen there as households responded to grown risks
of unemployment and heralded cut-backs in social protection. Two
stories, however, could be told about the path going forward.
Perhaps forces would emerge to push up domestic spending in
Germany (for example, new investment opportunity or a fall in the
savings rate). And then the euro-area savings and current account sur-
pluses would fall, and the euro-area might actually become a capital
importer in the long-run. Alternatively, the source of German eco-
nomic distress in the early 2000s might be that inside the observed
large savings surplus is an even larger one seeking to emerge. (This
would be the case if many Germans would ideally like to save at a
greater pace but are constrained by income levels which reflect eco-
nomic output below productive potential). Then as the German price
level fell and the euro turned back down, the German savings and
current account surpluses could rise from the present 5–6% of GDP to
say 10% of GDP. Germany would return to economic health via the
emergence of mega capital exports and savings surplus matched by

buoyant exports.
Similarly in some degree it is an open question whether present net
savings surpluses (and capital exports) in East Asia (including Japan
and China) are below or above final equilibrium levels. If below, and
the same in Europe, then the implication could be that the US savings
and current account deficits would have to rise to even higher levels in
the long-run as part of the global solution. That hypothesis runs
strongly against a chorus of current economic commentaries from
almost all sources, which is doubtless influenced by how such an
outcome would be out of line with previous examples from modern
history (see Obstfeld and Taylor, 2002). Deficits running at anywhere
near 5% of GDP for any country have always proved to be “unsustain-
able” (see Chapter 5 for more detail). And the present deficit is out of
line with previous US experience, even exceeding as a percentage of
GDP the levels recorded in the late nineteenth century when the US
was a rapidly developing economy. It remains to be seen what weight
should be given to a fairly short period of historical evidence, most of
which has been under very different institutional setting.
In Tables 1.1 and 1.2, we can easily see how far out of line with
“normal experience” is the present structure of net capital flows – even
though there has been some considerable variability over time. Back in
1975 and 1980 (both years partly covered by recession) the US was in
small surplus. Western Europe, Japan, and the Asian countries were
in small or modest deficit. Latin America was in huge deficit (by over
1% of US GDP in 1980). The Middle East countries were in huge surplus
(by around 1% of US GDP in 1980, and 1.5% in 1975 – both years soon
after an oil shock). The aggregate global gap was not far off today’s level
relative to US GDP (around 1%). In broad terms the East Asian savings
surplus had not emerged yet on any substantial scale (albeit that the
Japanese surplus had begun to show through in the late 1970s, but was
then temporarily suspended by oil price shock and US recession) and
nor had the US savings deficit.
The mid-1980s snapshot reveals a Japanese savings surplus and US
savings deficit already of large amount (around 2.5% of GDP for the
US). And Europe was in modest surplus. Massive UK savings deficits
had not yet appeared. The Asian Tigers (Hong Kong, Singapore, Taiwan
and South Korea) were in small deficit as were the other Asian coun-
tries (including China) further behind in development. The Western
Hemisphere deficits had collapsed in the wake of US and some
European banks lost in the earlier lending boom to that region. And
Main Currents 23
the Middle Eastern oil surpluses had all but disappeared. And so the big
differences with 2005 were, in sum, the situation of non-Japan Asia
(still in deficit) and of the Middle East (not in huge surplus – as indeed
the mid-1980s were a period of cheap oil).
In the snapshot for 1990, the US savings and current account deficit
had fallen back, mainly under the influence of recession. The Japanese
savings surplus, which had temporarily declined during the bubble
years of the late 1980s, was already re-building. In Western Europe
excluding the UK the savings surplus had fallen back as the German
economy was on the threshold of its unification boom, whilst the UK
was in huge deficit, in line with its then real estate bubble and
consumer spending boom. Latin America was still quiescent as a net
borrower.
On into 1995 (a year of mild growth cycle downturn for the
US economy associated in part with the Mexican “shock”) the main
new developments were a modest growth in Continental Western
Europe’s savings surplus as the German unification boom was fol-
lowed by bust and France had been driven into near depression con-
ditions by the “Seven Years War of the Hard Franc” (Aeschmann and
Riché, 1999). Savings deficits in the Asian developing countries had
grown substantially in line with the economic boom and bubbly real
estate markets in that region. And Latin America had enjoyed a
renaissance amongst international investors (albeit that was begin-
ning to change with the Mexico shock, in which default was only
avoided with massive US financial aid). The Middle East countries
were still in around zero balance.
In the snapshot for the first year of the 21st century (2000), the big
change is the emergence of a mega US current account deficit (at over
4% of GDP). This reflected in considerable part the information tech-
nology led investment spending boom (or even bubble) together with
a further fall in US household savings. The euro area had swung into
small deficit in line with its own mini-boom. The big new elements
in the global flow of funds were the transformation of the advanced
and developing small economies in East and South East Asia into
large aggregate surplus and a jump in the aggregate global gap. The
obvious factor behind the former development (Asian surpluses) was
the recessionary influence of the 1997 Asian debt crisis and the end
of the investment spending bubbles throughout the region. A related
factor was the attempt of global portfolio investors to reduce their
net asset holdings in the Asian developing countries (and other
emerging market economies).
How to identify currency turn-tables and round-trips

As we have seen, world current account balances are the key to measur-
ing the net flow of funds across the globe, from savings surplus to
deficit countries. But they have little to tell us about where and how
currency turntables are operating or about the extent and nature of
round-tripping. A first handle on this comes from the detailed tables
on capital flows which are published as a component of each country’s
(or currency area’s) balance of payments. A second handle comes from
various types of survey data.
Consider for example the capital account of the euro-area balance of
payments. The euro-area in the early and mid-2000s has been the cur-
rency turntable par excellence – attracting large amounts of funds from
outside, particularly Asia, and re-exporting these. The euro-area itself has
been in only small savings surplus or deficit. An indication only of the
size of the euro-area turntable can be found in Table 1.3 (see p. 10). The
clue is under the debt section of portfolio investment. In 2003 and 2004
over €200bn of foreign inflows were recorded into bonds issued by euro-
area residents, with a similar amount of outflows (investment in bonds
issued by non-residents of the euro-area) taking place.
These bare numbers, however, reveal only hazy information about
the underlying currency flows. A large share of the bonds issued by
euro-area borrowers and bought by foreign investors might have been
denominated in currencies other than the euro. And foreign investors
in turn might have bought many euro-denominated bonds issued by
non-residents of the euro-area. These latter purchases would not be reg-
istered directly in the euro-area balance of payments (but would exert
influences – for example via the issuer having swapped the euro pro-
ceeds into another currency – which would show up elsewhere, for
example under the heading of credits and loans). The foreign bonds
purchased by euro-area residents might largely be in euro denomina-
tions (non-resident borrowers issuing in euros), and it might be the
corresponding borrowers who are in fact taking the currency risk of
exporting funds from the euro-area.
It is plausible that many borrowers outside the euro-area and mainly
in the traditional savings deficit areas of the global economy (where
interest rates tend to be higher than elsewhere) have taken advantage
of the new deep capital markets in euros to issue debt there, and some
without hedging the implicit currency risk. (If they hedge, then they
are not in fact playing any part in the export of funds from the euro-
area). It is possible that before the euro was launched, some interna-
Main Currents 25
tional borrowers had below the optimum share (in terms of risk
diversification) of their liabilities in European currency denominations
due to the lack of developed bond markets in them. Most likely the
Asian savings surplus countries have played only a negligible part in
this liability shift.
In broad terms, the telling of the story of the euro-area turntable in
the global flow of funds has to remain largely anecdotal. Evidence of
the latter type includes media interviews with leading fund managers
and large corporate treasurers about their long-run strategies. Some
evidence might come from data on bond issuance in the interna-
tional capital markets broken down by currency and residence of bor-
rower. And there is also sometimes information (on turntable flows)
derivable from balance sheets of external assets and liabilities. The
same type of patchwork story can be put together for the case of the
UK turntable.
The data (see Tables 1.4 and 1.5, p. 10 and p. 12 ) is consistent with
the story of the UK being a substantial source of capital flow into the US
in the form of direct investment. Total direct investment outflows (to all
destinations) ran at around £33bn p.a. in 2002–4. At end-2003 the UK
had net external assets in the form of direct investment amounting to
over $250bn. There is no geographical breakdown available of capital
flows into or out of the UK. This means that direct evidence of the
turntable hypothesis – that the UK plays an important role in chan-
nelling capital flows to the US via importing capital from the savings
surplus countries and itself buying US businesses – is unavailable.
Some limited data on geographical breakdown comes from survey
data on the outstanding external assets and liabilities of the UK, but
this is not broken down by type (portfolio, or direct investment, for
example). More data is available from the regular 5-year surveys by the
US Commerce Department on US external assets and liabilities (by
country). But there are huge problems in deciphering these – not least
due to the distinction between the legal place of ownership (for
example a Netherlands Antilles holding company) and the actual resi-
dence of the final owner. Asian flows into Sterling might come via
banks in Switzerland, the euro-area, or the US, and geographic analysis
of UK bank liabilities by country would provide little information as to
ultimate source.
Huge net portfolio inflows into UK bonds or inflows via the UK
banking sector (run-up of foreign deposits in Sterling) are also consis-
tent but not conclusive with respect to the main story (capital inflows
from Asia coming into the UK and being recycled partly in the form of
direct investment outflows to the US). It might well be that much of

the eventual sourcing of the UK’s net external liabilities at end-2003 of
£75bn on portfolio account and £256bn under “other investments”
might lie in the savings surplus countries, but who can prove it?
The same paucity of evidence on geographic breakdown handicaps
seriously any effort to statistically verify or even estimate the amount
of round tripping. For example, some evidence on round-tripping can
be seen in Japanese statistics. According to Ministry of Finance data the
stock of external assets in the form of direct investment amounted to
¥39tn and liabilities to ¥10tn at end-September 2004, making a net
asset position in this category (direct investment) of ¥29tn. Offsetting
that is a net liability position in equities of ¥38tn (with foreign hold-
ings of Japanese equities estimated at ¥71tn and Japanese holdings of
foreign equities put at ¥33tn).
A reasonable presumption taking account of anecdotal evidence is
that the geographical spread of direct investment outflows from Japan
– with substantial concentrations in North America and Europe – is
similar to that of portfolio inflows into Japanese equities (largely from
European and US fund managers). But there is also likely some non-
overlap, with respect to important flows of Japanese direct investment
into the Asian developing countries and small advanced economies,
with no corresponding significant equity inflows from these. Hence
there could be a small amount of currency turntable activity involved
in the Japanese global flow of funds on direct and equity portfolio
account. (In this, European savings surpluses are transformed by the
intermediation of the Japanese corporate sector into inflows to the
emerging market economies).
How to map currency flows

The capital accounts in the balance of payments, together with the
analysis of currency turntables and round-tripping, are stepping stones
towards constructing currency flow of fund tables for the main areas of
the world economy. As already discussed these combine current
account and capital flows and focus on the ultimate sources (origina-
tors) of currency flows rather than on the precise point at which funds
enter or exit a particular political jurisdiction or currency area. In prac-
tical terms that means banking flows are largely excluded, in that
banks for the most part are passive agents carrying out currency flow
instructions rather than creating substantial net open positions (in
foreign exchange) for themselves.
Main Currents 27
The currency flow of fund tables are either historic (relating to a

period which is past and for which all statistical information is already
available) or in the nature of a forecast. The order of construction here
is to start with the savings surplus countries (Japan, small advanced
Asian economies, non-EU savings surplus countries in Western Europe,
Middle East oil exporters), moving on to the tax havens and offshore
centres, then to China, the euro-area turntable, the Sterling flow of
funds, and finally the dollar flow of funds.
We start with the Japanese yen flow of funds (Table 1.6, p. 13), con-
structed in late 2005 for the 2-year period 2005–6 (and so combining
evidence for 2005 with a forecast for 2006). A main source of inflows to
yen is the huge Japanese current account surplus (meaning that
Japanese exporters’ sales of foreign currency for yen far outweigh
Japanese importers’ demand for foreign currency). This surplus is fore-
cast at ¥18tn p.a. for 2005–6. On top ¥8tn p.a. of foreign funds are pro-
jected to move into Japanese equities (involving the purchase of yen
against foreign currencies). Notoriously volatile equity flows are of
course hard to forecast. The underlying assumption here is that the
improved profitability of Japanese companies and the fact of their
25
20
15
10
0
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04
Figure 1.1 Foreign holdings in Japanese equity markets (as % of total market
value)
prospective 1-year forward earnings yields being no longer far below

US levels for the first time in over two decades mean there could be a
further period of catch-up demand (in flow terms) from abroad. That
forecast, however, is not made with confidence.
Turning to outflows from yen, a key assumption is that the govern-
ment of Japan will remain an important buyer of foreign currency
assets, albeit only on an intermittent basis and on a much reduced
scale from 2003 and early 2004 (mainly US dollar bonds and money
market instruments). On top, there is a small amount of Japanese
buying of foreign equities, and a continuing net flow of direct invest-
ment out of Japan (with investment abroad by Japanese companies
outweighing foreign direct investment in Japan). These items – as
indeed the previously mentioned categories of inflows to yen (equities
and current account surplus) – all correspond one-to-one to items
found in the traditional balance of payment data.
The novelty is to make a direct guesstimate of the remaining large
outflows – first, changes in the total of Japanese net unhedged holdings
of foreign currency bonds or money market instruments and second,
additions by non-Japanese borrowers to their yen liabilities (for the
purpose of financing non-yen assets). The first outflow would also include
Japanese residents (corporations or investment institutions) reducing
their foreign currency liabilities by re-financing in yen. The second
outflow has sometimes loomed large in Japanese currency flows, being
labelled the “yen carry trade”. This describes the borrowing of yen at near
zero rates to help carry inventories of higher yielding non-yen assets.
Some of these (non-yen assets) are in euro-denomination, meaning that
they play a role in developing the euro-area as a turntable in the global
flow of funds (see above). But most are in the higher coupon currencies –
mainly US dollars, but also British pounds, Canadian dollars, and
Australian dollars for example – issued (with the exception of Canada) by
countries in savings deficit (chief of which is the US).
Any estimates of the carry trade’s size have been highly tentative. Data
from the Bank for International Settlements (BIS) shed some light on
non-bank foreign (non-Japanese) borrowing of yen, whether from banks
in Japan or offshore. But much of the carry trade may have been in the
form of borrowing dollars, and then carrying out currency forward
or currency hedge transactions, which would “wash up” in Japanese
balance of payments statistics as inter-bank borrowing of yen (by foreign
banks from Japanese banks). Much else, however, washes up under that
same category – including changes in the extent to which Japanese insti-
tutional investors hedge their holdings of foreign currency bonds.
Main Currents 29
Typically the conventional data on Japanese capital flows show large

but volatile outflows into foreign bonds, matched in part by external
inflows via the banking sector and external borrowing operations of
the non-bank sectors. Several large Japanese investment institutions
play foreign bond yield curves on a massive scale – meaning that they
buy bonds and borrow short-term funds in the same foreign currency
(or equivalently hedge in the forward exchange market). These yield
curve plays do not induce currency flows but they loom very large in
Japan’s balance of payments data.
Another implicit assumption in preparing the yen flow of funds for
2005–6 is that there is no significant international build-up of funds
in the Japanese currency. Balance of payments data may show some
long-run increase in foreign holdings of Japanese bonds, but these are
likely offset by a rundown in foreign holdings of near zero-rate yen
money holdings, either with Japanese banks or banks outside Japan.
And there is some long-run shrinkage of the foreign euro-yen bond
market (issues of yen bonds by non-Japanese borrowers), meaning
that part of the inflows from abroad into the Japanese government
bond market are not new additions to final foreign demand for yen
fixed-rate assets (but instead replacement of one form of yen bond
investment by another).
A decrease of non-Japanese holdings of foreign yen euro-bonds
(matched most likely by a repayment of outstanding amounts by
foreign borrowers) would not normally give rise to an outflow in the
portfolio section of the traditional capital account (in Japan’s balance
of payments) but somewhere in the labyrinth of banking and credit
transactions. (Let us make the usual assumption that the foreign issuer
of the euro-yen paper had no exposure to yen risk, having swapped the
initial yen liability into a non-yen one. Then the combination of its
repayment and foreign investors moving the proceeds into Japanese
government bonds would result in an inflow via the Japanese portfolio
capital account matched by an outflow somewhere in the banking and
credit sector).
The flow of funds table for the yen is designed to cut through arcane
balance of payments accounting to show what is really going on in
terms of yen currency flows as triggered by ultimate investors and bor-
rowers shifting their currency mix. But there is huge imprecision in the
cutting!
Next we move on to the group of small advanced economies with
large savings surpluses in Asia and Europe (see Tables 1.8 and 1.9). In
principle the data here is largely consistent with capital flows in the
balance of payments. Only the Swiss franc amongst the various

respective currencies is used significantly as an international money
(with large amounts of foreign borrowing in that currency).
For monies which are mainly national in use there is less scope for
divergence between currency flow and capital flow tables. The main
guesstimates here concern portfolio flows. Available balance of
payments tables do not adequately distinguish underlying non-bank
from bank flows or hedged from unhedged bond transactions. The
aggregate buying (across the two groups of savings surplus countries)
of foreign currency bonds (on a unhedged basis) and equities may
well amount to around $115bn p.a.
Then there are the present (2006) high savings surplus countries in
the mid-East (enjoying a bonanza of oil revenues). Their aggregate
Table 1.8 Small Advanced Asian Economies* – External Flow of Funds,

2005–6 (US$ bn p.a.)
Inflows Outflows
Aggregated Current 45 Official Reserves 30
Account Surplus
Net Direct Investment 20 Portfolio Outflows 35
and Equity Inflows Foreign Money and Bonds (35)
Foreign Equities (10)
65 65
* South Korea, Taiwan, Hong Kong and Singapore
Table 1.9 Non-EU Savings Surplus Countries* – External Flow of Funds,

2005–6 (US$ bn p.a.)
Inflows Outflows
Aggregated Current 120 Portfolio Outflows 80
Account Surplus Foreign Equities (25)
Foreign Money and Bonds** (55)
Foreign Borrowing*** 30
Inflows into Equities 10 Net Direct Investment Abroad 20
130 130
* Norway, Sweden and Switzerland

** includes operations of Norwegian State Pension Funds
*** almost entirely foreign borrowing of Swiss Francs (in the so-called “carry-trade’’)
Main Currents 31
current account surplus in 2005–6 is estimated at around $240bn p.a.

(see Table 1.10). In addition there is a small amount of net direct invest-
ment inflows into their oil sectors. Private and public sector acquisition
of foreign portfolio assets are merged into one category given the
difficulty of distinguishing what is what in the desert kingdoms or
sheikdoms which make up this category.
We skirt over the group of countries described as tax havens and off-
shore centres, because this subject is dealt with in depth in the next
chapter (see Table 1.11). Suffice it to say that the large amounts of
investment income accumulating in these centres are treated in official
statistics of global balance of payments as if they are extra-terrestrial
locations. Their balance of payments with the rest of the world finds
no place in the IMF reporting system.
By the method revealed in the next chapter, the savings surplus in
this hidden area of the world economy is put at around $80bn. Around
$50bn of this total could be attributed to that proportion of invest-
ment income received on hidden wealth there which is rolled over into
new investments. On the basis of anecdotal evidence (about fund man-
agement practises of Swiss and Luxembourg private bankers, for
Table 1.10 Mid-East Oil Exporters (High Savers) – External Flow of Funds,
2005–6 (US$ bn p.a.)
Inflows Outflows
Aggregated Current 240 Public and Private 270
Account Surplus Portfolio Outflows
(Bonds) (225)
(Equities) (45)
Net Direct Investment Inflows 30
270 270
Table 1.11 Tax Havens and Offshore Financial Centres – External Flow of
Funds, 2005–6 (US$ bn p.a.)
Inflows Outflows
Hidden Investment 50 International Money 40

Income Saved and Bonds
Equities 10
50 50
example) we could guesstimate that around $40bn p.a. of the re-

investment goes into international monies (principally US dollars and
euros) and $10bn p.a. into the main equity markets (in Europe, US,
and Japan). (see Table 1.11).
Turning next to the Chinese external flow of funds, the illustrative
number in Table 1.7 (see p. 14) suggest that the main inflows to the
yuan come from a current account surplus (US$110bn p.a.), direct
investment inflows ($50bn) and speculative borrowing by Chinese cor-
porations (who are replacing local currency with US dollar borrowing
in the hope of profiting from an eventual revaluation or upward float
of the yuan). The projected offsetting outflows from yuan take the
form of China accumulating foreign exchange reserves (by around
$80bn p.a.) and similar size portfolio outflows by Chinese residents
mainly into foreign currency deposits (with local banks) but also into
bonds and a small amount into equities.
(Note that in the traditional balance of payments concept, Chinese
accumulation of dollar deposits with resident banks would not be
treated as a capital outflow – as these are a domestic asset. The outflow
recorded would be any resulting on-lending abroad or investment
abroad by Chinese banks. In fact, what occurred in 2004–5 is that
Chinese residents reduced their holdings of dollar deposits at Chinese
banks, concerned about the risk of exchange loss, and Chinese banks
were simultaneously facing a surge in demand for dollar loans from
corporate borrowers. The shortfall resulted in Chinese banks increasing
their net borrowing abroad. But the banks were not the primary actors
in the speculative currency flows – only passive intermediaries. Hence
they do not appear in the yuan flow of funds).
Table 1.12 Sterling Flow of Funds, 2005–6 (US$ bn p.a.)
Inflows Outflows
Net Inward Equity Inflows 10 UK Current Account Deficit 40
Portfolio Inflows 75 Direct Investment Abroad 45
(into Equities) (20)
Portfolio Outflows 20
(into £-bonds and money*) (55)
Equities (15)
Direct Investment Inflows 20 Foreign Currency (5)
105 105
* includes borrowing in foreign currency by UK residents to finance £-assets

Main Currents 33
Finally before we come to the euro and US dollar flow of funds

there is Sterling to consider (see Table 1.12). As we have seen, the UK
is an important savings deficit area within the European context and
also plays a significant role as a currency turntable. These points can
be drawn out from the illustrative Sterling flow of funds (see p. 32).
The main source of net outflows from Sterling into foreign currencies
is the huge (relative to UK economic size) current account and
savings deficit. Direct investment abroad runs at £40bn p.a. (in which
there is a large US-directed element). The main inflows to Sterling are
worldwide money and bond investment (mainly from Asia and
Continental Europe). In addition there are small inflows in the form
of direct investment and equity buying. The big guesstimate here, vir-
tually calculated as a residual, is portfolio inflows into Sterling money
and bond markets – defined to include UK resident borrowing of
foreign currency to finance pound-denominated assets. (Note that
data in the UK balance of payments for these items are a jumble of
bank and non-bank flows and do not indicate the ultimate source. An
investor in Singapore placing funds in a Sterling deposit in Paris or
buying a Sterling-denominated bond issued by a non-UK borrower
would be an ultimate source of demand for Sterling, but would be
hidden from UK statisticians recording where capital from abroad
hits the UK shore).
When we come to the euro-turntable, the amount of guesstimating
becomes even larger (than in the case of Sterling) (see Table 1.13). It is
impossible from published data to form any reliable estimates of the
new funds which global investors (outside the euro-area) are putting
into euro money and bonds. Inflows into debt instruments, as shown in
the euro-area balance of payments, include foreign currency liabilities
in addition to euro-liabilities of euro-residents, whilst excluding inflows
into euro-paper or deposits issued by non-residents of the euro-area.
The capital inflow data (in the euro-area balance of payments) do not
distinguish well bank intermediaries from original wealth-holders. And
there is no way of distinguishing inflows into bonds from final investors
taking an open currency position in euros from a whole range of
financial institutions who might simply be “playing the yield curve” in
euros without taking any currency position. Indeed the distinction
between bank and non-bank in the analysis of global capital flows is
sometimes nebulous. Is a Swiss bank acting as a fiduciary agent for an
ultimate investor picked up in the data as a bank or non-bank? IMF data
provide estimates of central bank reserve changes by currency and BIS
data throw light on non-bank deposit activity in the euro-money
Table 1.13 Euro Flow of Funds, 2005–6 (€ bn p.a.)
Inflows Outflows
Current Account Surplus 15 Net Direct Investment Abroad 60
Euro-equities 90 Foreign Equities 60
Euro-money and Bonds* 180 Foreign Currency 30
(Money and Bonds)
Foreign Borrowing of Euros 135
to Finance Non-euro Assets
285 285
* Includes borrowing in foreign currency by Euro-area residents to finance €-assets
markets outside the euro-area (but in the so-called reporting area). But
there remain large unknowable areas.
As a guesstimate we put the amount of additional funds (originally
in a currency other than euros) being put by ultimate wealth holders
(including corporations and investment institutions) on a unhedged
basis into euro-denominated bonds and money market instruments
wherever situated at around €180bn in 2005–6. (This amount includes
non-euro borrowing by euro-area residents to finance euro-assets,
whether in the form of financial instruments or real assets). Much of
this surely comes from the Asian savings surplus countries and
also from the savings surplus countries in Europe outside the EU
(Switzerland, Norway, Russia), mid-East oil exporters, and tax havens
or offshore centres. There are two other big guesstimates in the euro
flow of funds. First, there is the amount of new capital put by euro-area
resident ultimate wealth-holders into foreign currency money and
bonds. (This should be calculated as net of any switch in liability com-
position of euro-area residents away from euros and back into foreign
currencies). Second, there is the amount of net borrowing in euros by
non-residents of the euro-area, for the purpose of financing activities or
assets outside the euro-area. (The banking sector can be assumed to
wash out in this analysis as it typically does not assume large currency
positions on its own account).
Again, some small clues can come from BIS data on offshore transac-
tions (broken into bank and non-bank components). But these only go
a little way towards improving our understanding. As illustration, we
put outflows into foreign currency assets (money and bonds) at around
€30bn p.a. and foreign borrowing of euros at around €130bn p.a.. (This
Main Currents 35
Table 1.14 US Dollar Flow of Funds, 2005–6 (US$ bn p.a.)
Inflows Outflows
Asian Central Bank Reserves 220 US Current Account Deficit 800
Other Reserves 50
Foreign Buying of US Equities 70
Foreign Private Sector Buying 480 Net Direct Investment Outflows 40
of US Dollar Bonds/Money
(on unhedged basis):
Japan (100)
Other Asia (50)
(including China)
European Non-EU High (30)
Savings
Mid-East High Savers (100) US Buying of Foreign Equities 50
Euro-area (20)
Others (e.g. Russia) (20)
Grey areas of World (160) Net Foreign Borrowing –70
Economy (incl. capital of Dollars*
flight, laundering, etc.)
820 820
* less US borrowing of foreign currency to finance acquisition of US dollar assets (financial

or real)
This item includes also, for example, speculative borrowing of dollars by Chinese corporations
would include for example a UK real estate company financing its UK

property holdings partly in euros or Brazil financing a part of its
current account deficit in euros).
The grand culmination of the flow of fund analysis is the US dollar,
summarized in Table 1.14. As for all the other flow analyses in earlier
tables, the focus is on ultimate foreign (here non-US) wealth holders’
allocation of new funds to the currency in question (here the US
dollar) and on ultimate borrowers (non-US) adding to their net liabili-
ties in the given currency (here dollars). (There is a smaller additional
item – foreign currency borrowing by US residents to finance holdings
of US dollar assets – which is netted from the borrowing total – see the
footnote to the table). Hence much of what looms large in conven-
tional balance of payments data drops out (for example US banks bor-
rowing and lending abroad, US non-bank sector lending and
borrowing in dollars with foreign counterparties) and some important
omissions are brought back in (for example, foreign accumulation
of dollar paper issued by non-US residents or dollar deposits in banks

outside the US).
The largest inflow is on the part of Asian Central Banks (including
Japan, China, small advanced economies in East and South East Asia,
and other developing countries). Central banks outside Asia typically
plough back only interest earnings into reserves without making new
additions from heavy foreign exchange market intervention. (There are
some exceptions – for example Russia in the mid-2000s on the back of
huge energy revenues. Moreover, there is some lack of clarity as to
what part of Mid-East oil export surpluses feed official foreign
exchange reserves as against private sector portfolio investments).
The next biggest identifiable inflows (to US dollars) are by private
sector investors in Asia. Japan is the single largest element here, but
the other countries are also as important in aggregate. Primary
balance of payments sources do not reveal the extent of such flows
with any clarity. Raw data fail to identify directly buying of dollar
paper issued by non-US borrowers including banks. (As already men-
tioned, there will be some reflection of these primary transactions on
the US capital account, but it is virtually impossible for the analyst of
the latter to decipher where the original force lies behind the sta-
tistical movements observed) Then comes the deployment in dollar
money and bonds by mid-East investors, and by the owners of funds
held in offshore centres and tax havens (including for example,
Switzerland, Luxembourg, Caribbean islands) reinvesting saved
income. (Much more is discussed about this last-mentioned item in
the next chapter). And last – on the in side of the dollar flow of fund
ledger – comes the biggest guesstimate of all, the amount of invest-
ment funds flowing into US dollars from the grey or black areas of
the world economy (excluding re-invested income in tax havens).
This item includes capital flight, money laundering, the investment
of legitimate income such as shipping revenues accruing offshore and
some other categories. These are the subject matter of the next
chapter.
We turn next to the funds flowing out of US dollars. The biggest
item here is the mega current account deficit of the US. Then there are
two quite modest items – net direct investment abroad (there is a ten-
dency in recent years for US outward direct investment to exceed
foreign direct investment in the US) and net US funds going into
foreign equities. Although modest, these net items are quite volatile
from year to year. Then we come to what is in practice calculated as a
residual item – net foreign borrowing in US dollars to finance invest-
Main Currents 37
ment outside the US less US resident borrowing of foreign currencies

(non-dollar) to finance investment in the US.
A main example of the first type of flow (net foreign borrowing in
dollars) is speculative borrowing in dollars by Chinese companies (to
finance investment in China) hoping to gain from an eventual appre-
ciation of the yuan (see p. 32). Other examples would include gov-
ernments of developing countries financing themselves in US dollars
(as has happened intermittently on a large scale in Latin America, for
example and further back in Europe – where sovereign names such as
Italy, Belgium, and Spain, were top favourites in the euro-dollar bond
markets).
Such flows can only be guessed at even when data on new interna-
tional bond issues by country and currency are available. (For example,
the fact that a jumbo bond issue by a given borrower is denominated
in dollars does not mean an increase in dollar liabilities overall for that
particular name, given the likelihood of offsetting swap transactions to
alter currency exposure). An assumption behind the guesstimates in
the Table 1.14 is that the present only small current account deficits or
even surpluses in countries which have been typically large borrowers
of dollars (Asian developing, Latin American developing) is likely
reflected in a low overall foreign borrowing total. One further element
justifying that assumption is the extent to which non-dollar curren-
cies, particularly the zero or low interest rate yen, have gained ground
vis-à-vis the dollar in the external liabilities of those borrowers. (That
tallies with the anecdotal evidence on the amount of “carry trade”).
A main example of the the second type of flow (resident borrowing
in foreign currency) is also essentially speculative. In particular, US cor-
porations may be taking advantage of lower interest rates abroad and
betting that these will not be offset by adverse exchange rate change.
The reader might well ask at this stage whether given the huge
imprecision in the estimating of global flow of currency data the
effort is worth the candle. Unfortunately the answering of that ques-
tion will take quite a few chapters more of explanation. But jumping
ahead of our story, the answer is yes! And already, in looking at the
final table on the global flow of dollar funds, the reader might
already be even more dubious than before of simplistic accounts of
how present large US savings and current account deficits are unsus-
tainable. There is a broad – and strong range – of global inflows into
US assets, amplified as the case may be, by powerful turntables. Much
work has to be done before even a highly tentative judgement could
be made about sustainability.
2
Black Money
It is impossible to give a comprehensive picture of international money

flows without at least sketching the movement of black or grey capital
around the globe. For obvious reasons, officially compiled balance of
payments data provide no direct measures which would help in the
sketch. Fortunately, however, for the analysis of global capital flow,
even grey and black capital does not move completely without trace on
the data. The principles of double-income accounting (which apply
also to balance of payments data) and the zero sum condition (all
current account balances should add up to zero) means that hidden
capital flows leave clues somewhere in the global payments records.
A first step towards utilizing what clues are available in the data is to
set out a description of sources, destinations, and intermediaries, in the
hidden global flow of capital. One main source is wealth, itself gener-
ated in wholly legal economic activity, which seeps out of high tax or
high-risk political jurisdictions into low or zero tax safe-haven centres.
Safety and low tax are dependent on keeping the assets invisible to tax
and regulatory authorities in the country of origin (of the funds).
Offshore financial centres and tax havens, especially those with well-
enforced banking secrecy, play an obviously important role both as
intermediaries and destinations with respect to this type of capital
flow.
The inflow of legally-earned money into hidden areas of the world
financial system should be distinguished from funds whose source is in
criminal activity including narcotics dealing and trafficking. And a
related distinction can be made with respect to the use of funds once
having entered the safely hidden areas. Some funds simply accumulate
there, with growth dependent on investment returns, and may be
spent in a way that is wholly legitimate (mainly the acquiring of goods
38
Black Money 39
and services for the owner or his/her chosen beneficiary as a genuine

gift). Others are spent for the purpose of furthering criminal activity
(including terrorism).
Grey vs. black

At the level of international governmental co-operation the distinction
just made between hidden capital flows which are criminally tainted
and those which are not is critical to which official agency is involved
in policing and with what degree of government backing. Almost all
governments are involved in tracing and hopefully impeding global
capital flows which stem from and feed criminal activity. This is a
central component of what Moisés Naím (2003) has famously
described as the Five Wars of Globalization. These are the battles to
control the illegal trade in drugs, arms, intellectual property, people,
and money. According to Moisés governments have been fighting
these battles for centuries, and generally losing them. Thanks to the
changes spurred by globalization over the last decade their losing
streak has become even more pronounced.
Most financial centres and tax havens ostensibly co-operate in
search and destroy missions against criminal activity making use of
secret transit or even long-time parking facilities within their banking
system. The Financial Action Task Force (FATF) was established in
1989 at a G-7 Summit with the brief of co-ordinating and spearhead-
ing an international campaign against criminal money laundering.
(The FATF’s secretariat is housed at the OECD’s Paris headquarters but
is an independent organization). Its ultimate sanction against recalci-
trant nations (which refuse to co-operate) is a recommendation for
economic sanctions. There are at present (2006) only three identified
non-co-operating nations – Nauru, Myanmar and Nigeria (see FATF,
2006).
The effectiveness of the FATF has been questioned. In particular, the
ultimate criminal organizations behind certain capital flows might well
have been successful in disguising their true ownership even from the
banks. And there are grounds for difference of opinion as to whether
the authorities in the various financial centres or tax havens are trying
hard enough to uncover the various disguises. Back in 1999, Raymond
Baker of the Brookings Institution concluded that anti-money launder-
ing efforts around the world are a failure (see Baker, 1999). But the
effort continues and has been most recently intensified with respect to
terrorism.
By contrast, there is not universal (or even near-universal) agreement

on co-operation regarding the flow of capital in and out of grey areas in
the world financial system where the source and end-destination are non-
criminal. The responsible authority with respect to making such flows
more transparent for taxation purposes is the OECD. That organization
derives its authority in this field from a May 1996 declaration of Ministers
(whose governments belong to the OECD) calling upon the OECD to
“develop measures to counter the distorting effects of harmful tax compe-
tition on investment and financing decisions and the consequences for
national tax bases”. A preliminary report and recommendations were
approved by OECD ministers in 1998, (“Harmful Tax Competition: An
Emerging Global Issue”) with Luxembourg and Switzerland abstaining.
The OECD Committee on Fiscal Affairs was instructed by the Ministers to
also develop a dialogue with non-member countries (of the OECD) and
formulate measures.
In 2000, that Committee, in a report under the title “Improving
Access to Bank Information for Tax Purposes” proposed an “agreement
on exchange of information on tax matters”, whereby the tax authori-
ties in each country would share information about income (particu-
larly interest and dividend payments) paid to each other’s residents.
(For example, France would be obliged to provide German fiscal
authorities with information on request about income paid by French
banks to a particular German resident).
So far, the OECD efforts on tracking down for taxation purposes the
movement of capital through grey areas of the international financial
system have lacked momentum at a global level. Within the EU,
however, considerable developments have taken place. All member
countries (of the EU), with the exceptions of Austria, Luxembourg, and
Belgium, signed up in 2004 to an exchange of information (with
respect to interest income paid to EU residents) from June 2005. (The
three mentioned countries have been given a 10-year exemption, to be
reviewed subsequently in the light of whether Switzerland, in particu-
lar, has signed up to the OECD convention on information sharing). In
return for the exemption, the three EU countries as just listed have
agreed to levy a withholding tax on income received by residents of
other EU countries. Switzerland has agreed to apply the same tax as
Belgium, Austria and Luxembourg, on EU resident accounts (with the
revenues mainly recycled to the governments of the political jurisdic-
tion in which the particular non-resident lives). The tax starts at a rate
of 15% in 2005–8 (June to June), rises to 20% in 2008–11, and finally
to 35% from 2011 onwards.
Black Money 41
The Swiss government points to the fact that non-declaration of

investment income is not a criminal offence in Switzerland and so its
enforcement agencies will not co-operate with foreign governments
seeking to pursue this particular suspected misdemeanour on the part
of their residents or nationals who are clients of Swiss banks. Beyond
the issue of economic self-interest for Switzerland (based on the impor-
tance of its financial sector) lies the belief of some political liberals
(both in Switzerland and the world outside) that banking secrecy is a
basic right. It is up to governments to design taxation systems around
this (putting higher taxes on visible wealth and on consumption, and
less on income which can be diverted to secrecy-protected banking
systems). And indeed that is what happens in some degree. Viewed in
this light, banking secrecy in tax havens might be seen as a useful
external limit to governments pursuing populist taxation agendas
which could eventually lower the general level of economic well-being.
In addition it is a chance for all to share in some haven from an all-
powerful or all-prying state. Bank secrecy provides a vital chance to
gain protection (albeit not 100% certain) from the demise of that state
or its defeat in war.
So far the principle of banking secrecy in Switzerland and Luxembourg
has been upheld against considerable pressure from outside. These two
countries, however, are not alone in offering banking secrecy. Singapore,
and various Carribean offshore centres also enforce secrecy (see Suss et al,
1988). (Singapore, unlike Switzerland and most Carribean centres – which
are UK dependents – does not co-operate with the EU in the taxation of
income paid to EU residents). These centres (Singapore and Carribean),
however, are exposed to distinct political risks – actual or potential – from
the mainly EU-related risks in Switzerland or Luxembourg. (In particular,
could Singapore have to bend to Chinese military and economic might
under certain circumstances and curtail or infringe banking secrecy or
other forms of protection for specified groups of clients)? The popular
opponents of banking secrecy quote estimates of the huge amounts of
funds flowing through the grey areas in the international financial system
which largely depend on the institution of banking secrecy. But these
numbers do not distinguish criminal from non-criminal flows.
As illustration, Raymond Baker (1999) in testimony to the US Senate
Committee on Government Affairs, concluded, “The passage of
corrupt money from developing and transitional economies into the
US and Europe is estimated at a minimum of $20bn per year and
perhaps as high as $40bn per year. Mispriced international trade gen-
erates a flood of money from developing and transitional economies
into the US and Europe of at least $80bn per year. The total of these
two components of illegal flight capital is therefore at least $100bn
per year flowing into western economies. It is estimated that at least
half is immediately or eventually transferred into the US. A more
exhaustive examination of illegal flight capital, including an estimate
of the exploding wire fraud component and money that spills from
developing economies directly into offshore tax havens often without
immediate assistance by western business people and bankers,
although eventually lodged in US and European accounts, would
produce substantially higher figures, likely multiplying the total to
several hundred billion dollars annually.”
Methods of detection
Indeed, when it comes to tracking the flow of money through the
international financial statistics which are available, the distinction
between criminal and non-criminal source or destination is virtually
impossible to make. Drug king-pins can use the same methods as the
legitimate business owner to channel funds into the chosen tax haven
without these coming to the attention of regulatory (including tax)
officials. (In fact, increasingly, the king-pins use ostensibly legitimate
business enterprises, often in areas of the economy where much of the
turnover is usually for cash, to carry out these fund movements). They
may also use the same methods to extract income or capital from their
wealth secreted in tax havens for the purpose of buying goods and
services, without the extraction becoming visible to prying authorities.
In sum, though detective work into the publicly available interna-
tional financial data can yield some return to effort in terms of identi-
fying global flow of funds passing through grey areas of the world
economy they cannot in general distinguish the shade of grey –
whether nearer black (criminal) or white (legitimate). An exception to
that rule is the criminal diversion of supranational agency lending to
governments of developing countries into the private accounts of their
rulers. The technique used by researchers in this area is to estimate the
amount of liabilities to supranational agencies (for example the World
Bank) for a given country according to loan data available (from the
agencies themselves). Then external liabilities of the given country as
reported to the IMF and BIS are compared with these estimates. If the
reported liability total seems too small, it could well be that the short-
fall has a counterpart in (hidden) private capital outflow on the part of
the rulers. There could be currency flow implications if the official
Black Money 43
loans are in a different currency denomination from the assets accu-

mulated by the rulers. But there are no grounds for presuming such a
divergence as a general rule.
Another technique used by “capital flight detectives” (not directed at
embezzlement by rulers as above) is to reconcile exports as reported by
country A to country B with imports from A reported by country B.
A systematic excess of reported imports (into B from A) over exports
(from A to B as reported in A) would suggest that there is under-
invoicing (of exports from A) occurring as a means of effecting hidden
capital exports (from A). Specifically, exporters in country A might be
quoting lower amounts on their invoices used as trade documents than
what in fact they are receiving – with the difference being paid directly
by the buyer (in B) into a foreign bank account (controlled by the
exporter). Implicitly part of the story must be the buyer (in B) entering
(for official purposes) the whole of the amount paid (the invoice
amount plus the supplemental payment) and this being picked up (by
trade statisticians) in B’s import total. (If, by contrast, the buyer has to
conceal the extra payment, then there would be no revealed discrep-
ancy). Another similar practice is for (a firm in) A to be over-invoiced
for imports from B, with the supplier in B rebating an amount direct
into a foreign bank account controlled by (the firm in) A. If in B’s trade
data, the export to A is registered as the net amount received less the
rebate, but in A’s trade data, the import from B is recorded at the full
invoice amount, then there is a detectable discrepancy.
Researchers who have used these two techniques have come up with
some remarkable results. For example, one study (Boyce and Ndikumana,
2003) estimates that in the period 1970–96 capital flight from 25 low-
income countries in sub-Saharan Africa totalled more than $190bn. With
imputed interest earnings the accumulated stock of flight capital from
these countries would amount to $285bn – meaning that they were in
fact net creditor nations (see also, Collier, 2003).
The two techniques are indeed ideal for investigations into capital
flows pertaining to one country or group of countries. When it comes
to detective work on global capital flows there are techniques (in fact
two main ones) of broader relevance. These involve scrutiny of two
error items identified in global balance of payments data and sometimes
discrepancies in reconciliation between national income accounts and
balance of payments data might be suggestive. The two error items
include first, the total of so-called errors and omissions entries, summa-
rized across all countries; second, there is the total of all reported
current account balances (and its difference from zero) which should
equal zero (if all countries reported) but in practice is a large negative
amount. Let us look at these in turn.
Errors and omissions

The average annual total of errors and omissions in national balance of
payments data (summed across all countries reporting to the IMF) in
the 5-year period 2000–4 was a negative $55bn. (In three years the
total was large and negative, in two small and positive). What could
contribute to this? (Note that by averaging over several years we seek
to eliminate random sources of error in the estimation process).
At a national level, there are several main possible reasons (other than
randomness) for the balance of payments failing to balance – hence the
need for the statistician to insert a balancing item for unrecorded items.
These include unregistered capital exports (for example, in the form of
banknotes). Such (unregistered) capital outflows are a source of negative
contribution to the errors and omission total.
Then there are smuggled imports (these could include illegal sub-
stances, including narcotics; but there is also the smuggling of legal
merchandise to avoid payment of value added tax). These also are a
negative source of errors and omissions in the balance of payments.
Negative contributions (to errors and omissions) can also stem
from invoice tampering undertaken by exporters or importers in the
given country (A) to facilitate hidden capital outflows from a trade
partner (country B). We describe this form of hidden capital outflow
as “synthetic” in that no direct international transfer of funds is
made by the ultimate capital exporter. An example of tampering is
the payment of supplementary amounts to foreign suppliers of goods
and services (as described in the section above). This only becomes a
source of negative contribution to total errors and omissions (across
all reporting countries) if the payments are not registered in the
import total (of the country where the buyer is resident). There is no
general rule on this – sometimes it is included in the import total,
sometimes not. A similar source of negative errors and omissions
exists with respect to rebates of amounts paid by customers in the
trade partner country. Take the example of an exporter in country A
receiving the full invoice price for goods sold to a customer in
country B. The exporter then rebates a part amount (as a settlement
discount) into the customer’s foreign bank account (so facilitating a
hidden export of capital by the latter). If balance of payments data
collectors in country A register the full export amount on the invoice
Black Money 45
with no account being taken of the rebate, this would give rise to a
negative errors and omissions item.
In any one country’s balance of payments, hidden capital flows and
related goods flows might net out to show no trace (in the errors and
omissions item). But when the trade partner’s balance of payments
data are considered too, all trace cannot usually be erased. Specifically,
in country B above, unregistered capital exports and an overstatement
of imports (or understatement of exports) both might cancel each
other out. (In simple terms, the trade surplus is estimated at a lower
level than the underlying reality, and capital exports are similarly
under-recorded, and so the balance of payments arithmetic is not
affected). The errors and omissions item in the balance of payments
data for country A, however, or a negative sum of trade balances (in
goods and services) across all reporting countries, might well give the
game away. Traces can indeed emerge at the global level (in the form
of a negative trade balance total), even though various invoice prac-
tices, and the quirks of how these are picked up by the statisticians,
mean that errors and omissions either at the level of one particular
country or added up for all reporting countries reveal little.
Of course different traces might become so inter-laced as to make
clear decipherment impossible. Hidden capital inflows, in particular,
can leave traces opposite in sign to hidden capital outflows. An
example (of hidden capital inflow) would be foreigners disguising their
ownership of assets (in the given country) under a resident name for
fear of confiscation or freezing in the event of war or revolution. An
alternative motive for hiding can be the evading of restrictions on non-
resident ownership. For example, overseas Chinese participated in this
way in the booming real estate market in China during 2003–5. Capital
inflows so disguised (funnelling into a phoney resident account) are a
source of positive errors and omissions in the balance of payments sta-
tistics. Another example of hidden capital inflow would be exporters of
narcotic drugs from developing economies stashing the proceeds via
money laundering transactions into resident owned accounts in the US
and Europe.
In itself, goods smuggling sometimes gives rise to offsetting errors in
the two countries which are party to the particular trade. In the
country exporting narcotics, there might be a positive contribution to
errors and omissions (from the given export), whilst in the importing
country there might be a negative contribution. The word “might” is
used because in many cases narcotics exports will have a direct coun-
terpart in the form of hidden capital outflow; and the import of
narcotics may be associated directly with hidden capital inflows; and

so there is no decipherable trace anywhere in the balance of payments
statistics.
As another example of blurred traces, some hidden capital exports from
country A in the form of banknotes (giving rise to negative errors and
omissions in country A) might be credited to so-called resident accounts
in country B which are in fact non-resident owned and will so contribute
to a hidden capital inflow there (giving rise to a positive errors and omis-
sions item in country B’s balance of payments). But netting out is far
from total. Some goods and services which are smuggled into country A
may be registered as exports in B. Some capital exports in the form of
notes go directly into accounts which are registered as non-resident in the
receiving country.
In Table 2.1 an illustrative breakdown is given of net contributors to
a “normal” total errors and omissions item, summed across all coun-
tries reporting to the IMF, of a negative $55bn p.a. (corresponding to
the 5-year average referred to above). Of course in any particular year
there can be a large amount of white noise (including non-offsetting
mistakes in recording wholly legitimate and transparent international
transactions in goods, services, and capital) affecting the outcome
(which can be very different from the hypothesized average underlying
amount). The numbers given in the table are “underlying” values for
each item. Each estimate is largely a guess (except for the total error
which is deduced from an averaging procedure for IMF published
data).
Disguised capital inflows (item 1) have sporadically been a source of
large positive errors and omissions items in the US (back in the late
1970s and early 1980s, for example, subsequent to the US freeze of
Iranian assets) and most of the time in Switzerland (where some black
foreign money is reputedly registered in the name of resident attorney
accounts). Anecdotal evidence suggests that various disguising prac-
tices have been widespread in the London residential real estate market
(resident names as purchasers standing behind an ultimate foreign
owner) and in a variety of hot property markets around the globe
where non-residents cannot participate directly. Given the weight of
evidence which is available, $125bn per annum seems well within the
ballpark of annual capital inflows worldwide hidden under resident
names. In general the purchase of real estate under “white” resident
names is a main route for laundering black or grey foreign wealth.
Hidden capital outflow in the form of banknote exports or other
unregistered forms (for example, wire transfers) is shown at $100bn
Black Money 47
(item 2). This is almost pure guesswork, but together with item 4 (syn-
thetic hidden capital outflow in the form of invoice tampering not
picked up by data collectors on either side of the trade transaction) and
item 3 (smuggling of goods) less item (1) (disguised capital inflows) add
up to the correct total (a net negative $55bn). The smuggling of
imports is a net figure – with the underlying gross amounts of smug-
gling (including the hidden illegal export and import of narcotic drugs
and armaments, for example) considerably larger. There are more tax
incentives to smuggling imports than exports (for example, avoidance
of sales taxes) and so a net import amount of $40bn is shown. Capital
flight facilitated by invoice tampering (under-reporting exports with
the balance paid into a foreign account or over-reporting imports with
a rebate of amount paid put into a foreign account) non-reported on
either side of the border is shown at $40bn. That is guesswork. But for
the purpose of capital flow analysis it is the sum of items 2 (non-
reported capital outflows) and 4 (synthetic capital outflows created via
invoice tampering non-reported by both exporter and importer) that
matter, not the precise division between them.
We know little about the geographic sources of the capital flight in
the direct form of banknote and other unregistered capital exports or
in the synthetic form of secret invoice tampering (hidden from data
collectors in both countries – importing and exporting). Anecdotal evi-
dence and other research suggests that there is a large share from devel-
oping and transitional economies. But also included is the suitcase
money from European investors with destinations in Luxembourg and
Switzerland or from US investors into the Caribbean centres. And of
course there are the mafia and other crime organization whether in the
advanced or developing economies which use the full array of invoic-
ing and banknote export techniques for laundering ill-gotten gains in a
way which fuels the hidden outflow of capital. One of the most blatant
techniques was uncovered in March 2002 when the authorities located
a tunnel across the Mexican-US border through which billions of dollar
banknotes had been smuggled in one direction in exchange for
narcotic drugs passing in the opposite direction.
Some of the hidden outflow of capital from particular advanced
economies flows back in. For example US mafia organizations having
exported funds to the Cayman Islands (in a way which contributes to
the negative errors and omissions items in the US balance of pay-
ments) might then place them there in US dollar money or bond
instruments. This re-placement would give rise most likely to a recog-
nized (by US balance of payments statisticians) capital inflow to the
US. Implicitly, in Chapter 1, the total foreign flow of funds into US

dollars from grey areas of the world economy (see Table 1.14) excluded
this recycling of US owned capital (to the Caribbean and back). But
that same item does include a guesstimate of the bilateral balance of
payments between the US and the exporters of narcotics.
As illustration, the US current account deficit might be around
$20–30bn larger than the published amount due to the non-recording
of illegal narcotic drug imports. The global net export revenues of nar-
cotic suppliers (not recorded in any balance of payments data) might
be around $50bn annually. Net export revenues translated into hidden
capital accumulation by drug exporting kingpins should be distin-
guished from estimates of trade turnover which are some ten times
higher than this. Suppose $40bn of those revenues end up in various
forms of dollar investments, whether in the US or elsewhere. Then we
could say that the narcotics trade and associated capital flows (which
do not include the already mentioned capital export activities of drug
dealers in the US) might generate a net inflow of as much as $20bn
annually in the global flow of dollar funds.
That amount is much smaller than the amount of funds coming into
dollars worldwide from hidden capital flows (in direct and synthetic
form) as derived above from the errors and omissions item across all
balance of payments data (in Table 2.1 under items 2 and 4). This is
one key component of the data detective’s estimate of total foreign
grey capital flowing into dollar assets. The other key component comes
Table 2.1 Total Errors and Omissions, 2005–6 (summed across balance of
payments data for all countries reporting data to IMF) (US$ bn p.a.)
(1) Disguised Capital Inflows 125 (2) Capital Outflows such as 100
(hidden under resident banknote exports and
names) other unregistered forms
(3) Net Smuggling of Goods 40
(4) Synthetic Capital Outflows 40
in form of trade invoice
Total Net Errors and Omissions 55 tampering which is hidden
(negative)* (1) – (2) – (3) – (4) from data collectors in both
exporting and importing
countries
180 180
* based on average of past 7 years

Black Money 49
from an analysis of the total of the current account balances in the

world balance of payments and its difference from zero, described in
what follows as the aggregate current account gap.
Aggregate current account gap clues

We have already seen in the previous chapter (see Tables 1.1 and 1.2)
that the total of world current account balances typically (during the
past three decades) amounts to a negative amount equivalent to
between 1 and 2% of US GDP. The sources of this discrepancy have
been reviewed at fairly regular intervals by the IMF statisticians (see for
example, IMF World Economic Outlook, October 2000). That analysis
only goes so far as it excludes the more speculative considerations
about grey or capital flows that concern us here. But it is nonetheless a
useful starting point in the detective work. The IMF single out a
number of factors contributing to the aggregate gap – missing invest-
ment income, missing income of shipping companies, discrepancies in
merchandise trade and transfers. Other researchers, including the study
by two Federal Reserve economists, (Marquez and Workman, 2001),
follow the same approach.
Missing investment income has long been recognized as a big factor in
the aggregate global trade gap. According to IMF estimates for 2004 the
sum of investment income surpluses and deficits across all reporting
nations came to a negative sum of around $100bn compared to a total
current account gap widely projected for 2005 of around $130bn. (For
example, the OECD secretariat in June 2005 forecast a gap of $140bn for
2005 and $200bn for 2006. That compared with an average of $135bn
p.a. for the five-year period 1999–2003). Discrepancies in this account
reflect mainly misreporting of portfolio investment income. These dis-
crepancies stem from incentives to hide capital outflows, the growth of
offshore financial centres, and some recording idiosyncrasies.
The incentive to underreport capital outflows arises largely from
the scope to evade tax on the corresponding investment income.
Under-reporting of capital outflow leads to an under-reporting of
investment income. Balance of payments statisticians use cumulated
capital outflows to estimate the corresponding stock of claims on for-
eigners. These estimates are then used to compute investment
income. Thus understating capital outflows translates into understat-
ing the associated income. We have already discussed some forms of
under-reporting capital outflows – those which contribute to the
aggregate errors and omissions item, diversion of official loans by
corrupt rules of developing economies into their private wealth pool

(in a tax haven), and wealth accumulation by drug barons out of the
export proceeds of narcotics sold to the advanced economies.
It is important to realize that the total of missing investment income
is not comparable one-to-one with the current account balances of
reporting countries. The latter, as we have seen in the previous chapter,
correspond to savings deficits or surpluses. That is not the case with
missing investment income. We must first analyze how much of the
missing income is saved and how much spent, and where the spending
is recorded. We can construct a hypothetical country, say Global Tax
Havens, into which all the missing investment income flows, and into
which there is a large continuing flow of grey or black capital from the
rest of the world matching unreported aggregate income there.
Suppose all the spending by Global Tax Havens (whether out of invest-
ment income or capital as the case may be for any particular investors
with secret accounts there) were recorded as net exports of goods and
services by the IMF reporting countries (in aggregate) and could be
identified as equal to say $50bn annually. (This $50bn figure in fact is
the estimate used in our analysis below – see Table 2.3). Then the
reporting countries in aggregate would have an underlying surplus on
trade (in goods and services) of $50bn and an overall current account
deficit of $50bn (allowing for their aggregate deficit on investment
income account of an estimated $100bn as discussed above).
The hypothesized equivalence (between spending out of hidden
investment income or capital in tax havens and net exports from the
reporting countries) holds only if two conditions are satisfied. First, all
the spending would have to be picked up as exports in the statistics of
the reporting countries. Second, there must be no consistent influences
pushing the world aggregate trade balance away from zero other than
net trade with the Global Tax Havens as discussed. In fact neither con-
dition is satisfied, as we shall see below.
As regards the first condition, we could imagine a hypothetical situa-
tion in which indeed all spending out of the Global Tax Havens would
be recorded as exports in the rest of the world. Wealthy residents of
developing countries, for example, might find only abroad the type of
goods and services that they seek. (This might apply, for example, in
the special case of health services). Both they and residents of
advanced industrialized economies might be trying to avoid conspicu-
ous consumption in their own country where it could draw the atten-
tion of the tax authorities. Their spending might be picked up largely
as tourism exports in the reporting countries. Entrepreneurs with secret
Black Money 51
accounts in tax havens might inject funds into their legitimate (or ille-
gitimate) businesses by having some of their purchases of services
invoiced to companies under their control and registered in an off-
shore centre (and then not charging the respective businesses for
them). This is more difficult to do in the case of goods (in that in most
cases the entrepreneur would not want these shipped to where the off-
shore company resides). In the case of services, there is no official track
of to which geographic location they are delivered.
In practice, it must be doubted whether all spending from Global
Tax Havens is indeed registered as exports in the reporting countries,
but this could be nearer the truth in the case of trade in services than
in merchandise. Recorded world trade in services is in modest deficit
(by an estimated $20bn annually on average in recent years). This is
despite an un-recording of shipping revenues (corresponding to fleets
registered under flags of convenience) estimated at around $60bn
annually. There could be some offsetting positive bias in non-shipping
services trade due to errors in recording of transfers. IMF economists
suggest that the total of service exports, ex-shipping, might be over-
recorded by around $20bn due to advanced economies treating remit-
tances back home of foreign workers as transfers (in their balance of
payments) whilst the recipient country treats them as foreign earned
income. But that would still leave net services trade including shipping
revenues (adding back in the estimated omission of $60bn as above) in
surplus by around $20bn.
Some of that surplus might be due to spending on services by the
shipping companies themselves. Equivalently, their net revenues,
before purchase of ships, might be near say $50bn rather than $60bn
and it is that smaller total which should have been added to the crude
estimate of the world trade balance in services. Even so that would
leave the services balance, adjusted to exclude net shipping revenues
and for errors in transfers accounting, in slight surplus. And to judge
the information content of that slight surplus we have to acknowledge
the non-fulfilment of our second condition above. There is indeed an
important bias tending to push reported world trade in both goods and
services into deficit – and that relates to the systematic under-reporting
of export income by economic agents seeking to export grey or black
capital. The bias stems from the under-reporting being one-sided (by
the exporter, but not the opposite-number importer), as against the
two-sided under-reporting which is a source of negative errors and
omissions totalled from all reporting countries’ balance of payments
(as described above).
The fact that the non-shipping global services trade balance is in

slight surplus despite this bias towards negativity, suggests that there is
an important volume of service exports invoiced to offshore centres
and tax havens (and for which there is no corresponding import
reported) and of offshore-financed tourism. Indeed in recent years,
tourist trade balances reported to the IMF for all countries sum to a
positive $30–40bn, consistent with under-reporting of tourism imports.
That would characterize the situation of spending by offshore-financed
tourists not being recorded as imports in their country of residence.
(Some of this spending might be out of newly arrived capital into the
tax havens rather than as a deduction from current income).
Part of the total spending out of Global Tax Havens is inevitably cat-
egorized as domestic expenditure in the reporting countries – and this
(incorrect classification) tends to push the world trade balance into
smaller surplus (and the world current account balance into greater
deficit) than would match the underlying balance of trade (and current
account balance) of the Global Tax Havens. In particular, some resi-
dents of the advanced economies use offshore bank credit cards or
simply cash (collected from their foreign accounts) to pay for goods
and services in their own country. (This particular practice has become
more hazardous in recent years, given widespread investigations by the
US Internal Revenue Service and more recently the UK Inland Revenue
into the credit card companies). And there are many other ways of
disguising the origin of funds used to finance expenditure that would
be registered as domestic in the national income accounts. The
classification of some exports to Global Tax Havens as domestic spend-
ing tends to drag the aggregate registered trade surplus of the reporting
countries below its theoretical level (and thereby pushes some esti-
mates of hidden wealth transfers into offshore financial centres to well
in excess of underlying reality).
There is also the treatment of shipping to consider (in explaining how
the actual aggregate trade balance of the reporting countries might differ
from theory). In the illustrative calculations above regarding the services
trade balance we suggested that shipping companies saved as much as
$50bn annually offshore (gross revenues of the offshore shipping com-
panies less current expenditures). Some part of these savings could be
spent on new ship deliveries, not recorded in any national balance of
payments as imports – meaning that perhaps as little as $20–30bn annu-
ally accumulates to the offshore ship owners on a net basis. (As illustra-
tion, Greece, where many shipping concerns are registered, does not
include a shipping account in its balance of payments, treating such
Black Money 53
business activity as offshore). By the same token, global merchandise

imports are most likely under-recorded on account of shipping. IMF
economists suggest, moreover, that synchronization problems in them-
selves mean that the total of merchandise trade balances should sum to a
substantial positive number (rather than zero).
The synchronization problem is based on the observation that when
world trade is growing (the norm), the lag between export and import
registration (exports registered first) means that world trade would tend
to be in recorded surplus. Another source of positive bias is the ten-
dency for OPEC countries to report oil sales at the official price and
importing countries at the actual price (taking account of secret dis-
counts). There is also the smuggling of imports to avoid quotas (where
these goods are reported as exports in the delivering country) or
various forms of taxation. (On a net basis such smuggling has already
been “guesstimated” at $40bn in Table 2.1). Despite these considerable
positive biases, the overall recorded world merchandise trade balance
has been in only modest surplus (by around $35bn p.a. on average in
the 7-year period 1998–2004). That would be consistent with manipu-
lation of export and import prices, undertaken so as to effect hidden
capital exports. (This manipulation occurs, of course, both with respect
to merchandise and services trade).
The form of invoice tampering is identical to that already discussed
above under the heading of total errors and omissions in the world
balance of payments. But this time, there is asymmetric treatment by
the official statisticians on both sides of the transaction. As illustration,
an exporter under-invoices customers and arranges for an additional
sum to be paid into a secret bank account in a tax haven. The statisti-
cians in the exporting country record deliveries at face value of the
invoice. But in the importing country, suppose the statisticians record
the full value of the goods or services including the payment into the
secret account. The business in the importing country would label the
extra amount as a commission of some type, and there may possibly be
some type of paperwork supplied by the exporter in this regard. The
importing business might intend to claim the expense of the commis-
sion against its own profits for tax purposes. As a result of the asym-
metric treatment, a net deficit contribution is made to the global
balance of trade. The same analysis applies in the situation of an
importer over paying for goods and then being refunded part into a
secret account. If the refund is recognized by statisticians in the export-
ing country (as a rebate of some type), then again there is a negative
contribution to the world trade balance.
Invoice tampering is an important element in the overall reconcil-

iation of the global current account gap with the estimate of savings
in the Global Tax Havens. This is done in Table 2.2. The estimated
global current account gap in 2005–6 is put at $130bn. To that we
must add estimated net spending on smuggled goods (recorded by
the exporting country but not the importing) and missing ship
imports – see line 5, US$55bn – and timing differences (which lead
to understatement of the total current account deficit of the report-
ing countries) amounting to an estimated $25bn (line 7), making a
total of $210bn (line 1 + line 5 + line 7) which has to be explained
by missed sources of savings in the world economy or under-
recorded savings. A guesstimate is that saving out of investment
income accumulating in tax havens and offshore centres amounts to
around $50bn (line 2). Then there is an adjustment item – line 4 –
which relates to spending by Global Tax Havens wrongly categorized
as domestic expenditure within the reporting countries rather than
as exports (to Global Tax Havens). Finally there is the residual item –
line 6 – hidden net capital exports to offshore centres and tax
havens in the form of invoice tampering which contributes to the
global current account gap. By subtraction, this item amounts to
$115bn annually. It is important to realize that these hidden capital
exports are calculated net of any amounts spent out of them during
the current year. Such spending would add to recorded exports.
Table 2.2 Analysis of the Global Current Account Gap, 2005–6 (US$ bn p.a.)
(2) missing savings accumulating 50 (1) estimated global current 130

in tax havens out of account gap
investment income
(3) savings surplus of 25 (7) timing differences in trade 25
international shipping
companies off-shore
(4) domestic spending financed 20
by off-shore funds
(6) hidden net capital exports 115 (5) unrecorded spending on 55
in form of invoice tampering imports of ships and
(transparent in one but smuggled imports
not both trade partner
countries)
210 210
Black Money 55
This category of hidden capital inflow to the offshore centres and

tax havens together with the investment income accumulating there
must either be spent or saved. That is the basis of the reconciliation
shown in Table 2.3 below. It is important to realize that the inflows
recorded here (under line 1) are only those omitted from the savings-
investment (or implicitly net export) balance estimation in the
reporting countries. The large amount of transfer payments – of
savings recorded but transferred clandestinely either to tax havens or
between reporting countries – are excluded. Many of these have been
described in the previous section (see Table 2.1). In broad terms the
inflow of unrecorded savings from the rest of the world into the tax
havens estimated at $115bn (line 1) plus income received on unde-
clared (secret) assets held there estimated at $100bn (line 2) equals
spending from the offshore centres ($50bn) (some of this is recorded
as exports from the rest of the world to the Global Tax Havens, the
other part – put at $20bn above – as domestic expenditure) (line 3)
plus net accumulation of capital in the Global Tax Havens (estimated
at $165bn p.a. as in line 4).
Table 2.3 Tracing Trade Balance Divergences to Global Tax Havens, 2005–6
(US$ bn p.a.)
(1) inflows (to havens) via 115 (3) spending from offshore 50
invoice tampering which centres out of investment
effects global current income
account gap
(2) investment income in 100 (4) net savings in offshore 165
off-shore centres centres
215 215
Reconciling the loose ends

How do the around $115bn of new savings annually flowing in to off-
shore centres and tax havens (excluding the re-investment of savings
from income accumulating there) together with unregistered capital
exports from the reporting countries amounting to $100bn and syn-
thetic outflows of $40bn referred to in Table 2.1 (lines 2 and 4) (but
which do not detract from savings as estimated in the reporting coun-
tries) relate to the around $180bn of inflows to dollar bonds and
money market instruments from “grey areas of the world economy” as
identified in Table 1.14? If we deduct a guesstimated $20bn of net

accumulation in dollar instruments by the shipping companies, that
leaves $160bn to be explained.
We might reduce that amount ($160bn) by around $25bn (see p. 48)
to take account of a net demand for dollars guesstimated at in the nar-
cotics trade (the US is a net importer of narcotics, but exporters of nar-
cotics globally are attached to the US dollar as their main investment
vehicle). The remaining $135bn comes out of the net unreported
savings of $165bn in Global Tax Havens, the $140bn hidden transfers
of savings (already registered in global aggregate national income
totals) from the reporting countries (Table 2.1) net of any induced
foreign (non-US) borrowing of dollars to finance these (in the context
of external balance), and the corrupt diversion of loans from official
agencies to governments in the developing countries (see pp. 42–3).
Are there any other clues to hidden capital flows, especially those gen-
erating global demand for US dollar assets, in any of this? At the begin-
ning of this chapter we referred to the residual income error – the
difference between the savings surplus or deficit identified in the
national income accounts and the current account in the balance of pay-
ments. As a matter of national income accounting, this difference is
identical to the divergence between the measure of national income
based on the expenditure or production estimates and that based on
aggregate income estimates. (In principle, if measurement were accurate
there would be no error). There are many possible sources of divergence,
none of which appear to be systematically related to the generation of
hidden capital flows. The income measure appears to more subject to
white noise over short periods of time.
One possible source of systematic divergence (between income and
expenditure measures) is failure of national income statisticians to
identify fully final expenditures and for some of these to be counted as
intermediary outputs. On the income side of the ledger, however, these
are not counted as deductions from corporate profits. And so estimates
of national income would be greater than of national expenditure – a
positive income residual. An important example of this phenomenon
was during the years of the US bubble economy in the late 1990s,
when the US current account deficit was systematically greater than
the recorded savings deficit by around 1% of GDP. And that compared
to expenditure-based measures of the economy being around 1% below
income based measures.
One particular source of difficulty (in identifying correctly final
expenditure) has been that enterprises in the new economy could not
Black Money 57
readily identify that part of their sales which were to final customers
(consumers) as against other enterprises. As illustrations both computer
software and hardware makers had no precise knowledge as to what
share of their output was satisfying retail or business demand and the
latter was overestimated. (Equivalently, too many new economy sales
would be picked up as intermediary business expenditure rather than
as private consumer expenditure and so excluded from estimates of
GDP).
In principle investment spending might be underestimated in grey or
black areas of the economy (and treated instead as intermediary
output). Mafia organizations presumably do not present corporate
accounts in which business investment is presented at full value. And
some of their consumer spending might be camouflaged. But the under-
recording of spending which results would often be closely matched in
an under-recording of income. Similarly, all the forms of export and
import invoice tampering discussed would have an equal impact on
income and spending measures of the economy without affecting the
national income residual (and thereby creating a divergence between
the savings and current account gap). In any case, the divergence of the
savings deficit below the current account deficit (or equivalently of the
expenditure-based measure of GDP below the income measure) dwin-
dled during the early 2000s and indeed went substantially into reverse
(with the savings deficit exceeding substantially the reported current
account deficit in 2003, for example).
That reverse residual (income based measure of GDP below expendi-
ture based measure) narrowed sharply during 2004 and early 2005,
virtually disappearing, but there was no evident explanation this time.
A simultaneous emergence of a large positive errors and omissions in
the US balance of payments could be consistent with a leap in
unrecorded exports, but there was no obvious reason to associate that
with any grey or black economic activity. The reverse residual widened
in the middle two quarters of 2005, suggesting that white noise was an
important part of any overall explanation.
In practice, thereby, it is possible to restrict the statistical pursuit of
hidden capital flows to the balance of payments data rather than
delving into a study of national income residuals. The subject of
hidden net capital flows, identified by the techniques illustrated in this
chapter, can be distinguished from the much bigger topic of estimating
the size of the grey economy, whether nationally or globally. Hidden
net flow analysis, as in this chapter, depends on an interpretation of
statistical differences, not levels. Even so, a fuller picture of secret
capital flows would clearly require an array of anecdotal evidence,

drawn in particular from private bankers in the offshore centres and
tax havens. But for obvious reasons of client confidentiality this is not
in general available.
Information from banknote markets and flows

The detective statistician seeking to trace the flow of grey and black
capital internationally may well try one further route to those dis-
cussed so far. This involves a direct exploration of international whole-
sale banknote markets and of available evidence on net banknote
flows. The links are obvious. We have already seen how a considerable
element of hidden capital outflows take the form of residents (of the
country in question) exporting banknotes (on a clandestine basis) and
having the proceeds directly credited to accounts outside their own
political jurisdiction.
Traditionally Switzerland has been the principal centre of the whole-
sale international banknote market – something of a niche market, in
effect. Capital flight in the form of banknotes has entered the country
in large quantities. There are two options for the foreign owners of
these – either they credit them directly to an account denominated in
the same currency and then move on from there (into their chosen
investment), or they sell the banknotes in the market in exchange for
Swiss francs.
As illustration, a Belgian dentist arriving in Geneva with a suitcase of
100,000 euros in say 500 euro denomination has the choice of either
crediting these directly to a euro current account (with his Swiss bank)
or selling them for francs. Normally there would be an administration
charge for crediting them to a euro current account – but still if his or
her ultimate intention is to buy a euro or US dollar investment, for
example, that would be a cheaper course of action than converting first
into Swiss francs. The Swiss bank would find itself with a euro liability
(the newly created euro deposit owned however transitorily by the
Belgian dentist) matched by assets in the form of euro banknotes.
Whether the Swiss bank sends these (the euro banknotes) to its cor-
respondent in the euro-area for crediting or offloads them in the Swiss
wholesale banknote market depends entirely on where the present
wholesale banknote market quote lies relative to the inter-bank trans-
fer rate (for bank deposits in the respective currencies). The bank must
take account of transportation costs (mainly related to security) with
respect to note shipments. Much will depend on whether the actual
Black Money 59
demand for euro notes in Switzerland (mainly on account of Swiss

residents visiting Switzerland, but also, for example, on the part of
euro-area residents converting some undeclared revenues into euros for
spending purposes back home) is greater or less than the present
supply. Moreover Switzerland as an entrepot centre in the banknote
trade may experience large demand from wholesalers in other centres
(outside the euro-area) for euro-banknotes, if indeed the rate at which
these are offered is less than the cost of shipment directly from the
euro-area (to the third party country).
Can officials at the ECB, by monitoring the total of physical ship-
ments of euro notes to and from Swiss banks as reported by euro-area
banks obtain any idea of the extent of grey or black capital outflows?
The answer is most likely negative. First of all the reports on ban-
knote flows are obtained at a national level in the member states
rather than at the euro (ECB) level. Second, the implications of net
flows in either direction are unclear. A large flow of euro notes from
Swiss banks back to euro-area banks might indeed imply that some
capital flight is occurring, but it could also be the case that there is
not a substantial demand on the part of Swiss residents in the
eurobanknote exchange market. Rather they may have a large float in
euro banknotes which in the main are obtained against accounts
held directly with euro-area banks. Or it could be that euro-area resi-
dents tend to buy their Swiss francs for tourist spending purposes in
Switzerland (where banknote transaction charges are relatively small),
whilst Swiss residents largely use bank cards or credit cards in their
foreign spending.
Even so, in some cases, data (available usually only to the central
banks concerned) on non-euro banknote flows in and out of Switzer-
land might have informational content with respect to hidden capital
flows. For example, the UK central bank might suspect that persistent
large net flow of pound banknotes from Switzerland to UK banks was
indicative of some capital flight from the UK – even though other
explanations were plausible (for example, banks in Germany or Central
Europe might find it cheaper or more convenient to obtain pound
banknotes for selling to their own tourists – visiting the UK – in the
Swiss wholesale market than directly from UK banks). By contrast a
large persistent net flow of pound banknotes to Switzerland, not cor-
responding to an imbalanced trade in tourism (more Swiss visitors to
the UK than UK visitors to Switzerland), might be indicative of hidden
investment income in Switzerland being converted into pounds for
spending in the UK. But all of this is very tentative.
In the case of non-convertible currencies, the analysis of banknote

flows is somewhat different. Non-convertible currencies are subject to a
range of exchange restrictions, and these usually include limits on the
import or export of banknotes (denominated in the given currency). In
particular, foreign banks would not be able to ship banknotes back to
the country of issue and credit them there on a 1:1 basis into bank
deposits (in the given currency). For example, Chinese citizens who
smuggle yuan banknotes to Singapore or Hong Kong sell them there
for the local currency. But in principle the yuan banknote exchange
rate could fall well below the official rate (the yuan buying less dollars
in the banknote market than the official) as the dealer in the wholesale
market is not able to credit any excess inventory to a yuan deposit
account. Much of the time there may be no such discount (of the ban-
knote below the official rate) as tourist demand for yuan banknotes
might easily absorb supplies at the official rate. (The extent of tourist
absorption can be restricted by the given country – in this case China –
putting restrictions on the amount of banknotes which tourists can
bring in). In addition, in recent years, there has been some speculative
demand for yuan banknotes outside China on the part of investors
seeking to profit from an expected appreciation and unable to invest
directly in yuan deposits. In principle the discount of banknotes on an
inconvertible currency below the official rate can be an indicator of
capital flight pressure from the country of issue. But lack of a discount
does not mean that capital flight is absent.
Some part of wholesale banknote market activity, of course, is related
to accumulation of US dollar banknotes and to a lesser extent of euro
banknotes within the global grey or black economy. In many parts of
the world, especially now that nominal interest rates are everywhere so
low compared to recent historical experience, these banknotes are
hoarded as an important form of saving. They also have important
transaction uses (with the dollar being used widely as unit of account
outside the US). Many residents of developing economies would hold
US dollar or euro banknotes in a vault (or under a mattress) as an ulti-
mate safe-haven. They may not be dealing in the size required to have
access to offshore banking centres. Dealers (or in some case smugglers)
would in many cases buy the dollar or euro banknotes in the interna-
tional wholesale market centres (for example Zurich) and ship them
into the respective developing economies, charging in many cases con-
siderable mark-ups in their onward distribution to local investors. In
many cases the dealers would receive local banknotes in exchange.
Somehow they must succeed at the end of the line in exchanging these
Black Money 61
into convertible currencies that can be used as payment in their whole-

sale banknote market transactions. The methods used might include
recourse to the procedures already mentioned earlier in this chapter –
for example, siphoning the local banknotes into local cash enterprises
which in turn can use various invoice tampering techniques to export
them to the international market-place.
According to US balance of payments data, the annual flow of US
banknotes to foreign investors (a credit item in the capital account) has
ranged between $15 and 25bn p.a. in the past 10 years (1995–2004). A
study by the Federal Reserve in 2002 (see version as BIS paper, 2004)
put the estimated amount of US dollar banknotes held abroad at
between US$310bn and US$435bn (out of a total circulation of
$620bn). The models used for estimation purposes are based on
confidential data about currency shipments to and from the Federal
Reserve Banks, data collected by the US Customs Service, data on cash
processing at the Federal Reserve Banks and less formal information
collected during international study trips (see also report of US
Treasury Secretary, 2003). The Federal Reserve study took a mean esti-
mate of foreign holdings at $414bn, of which $120bn (29%) was in
Russia and other former Soviet Union members, $95bn in Asia (23%),
$57bn in Middle East and North Africa (14%), $12bn in sub-Saharan
Africa (3%), $46bn in Europe (11%) (including central and Eastern
Europe), and $83bn in Latin America (20%). The Federal Reserve study
notes five basic motivations for international holding and using of
cash dollars.
First, in times and places where the political or economic situation is
uncertain, dollars are held for security against inflation and general
calamity. Second, expatriate workers throughout the world often carry
their earnings to their home countries in dollars and between visits
home some of these workers hold dollars in cash rather than in the
bank. Third, travellers to other parts of the world carry dollars because
they are easier to exchange than local currencies. Fourth, cross-border
trade in many areas is conducted largely in dollars. Fifth, the informal
or “off the books” sectors in many economies are highly dollarized.
According to the Federal Reserve’s study no more than 30 institu-
tions worldwide participate actively in the wholesale buying and
selling (including transport and delivery) of physical US banknotes (see
also testimony to Congress of Baxter, 2004). In 1996 the Federal
Reserve Bank of New York (FRBNY) established an extended custodial
inventory (ECI) program – prompted by the Treasury’s introduction of
new design banknotes and in recognition that an assured supply of US
currency abroad helps to maintain stability in international financial

markets throughout the world. An ECI facility is an overseas cash
depot maintained by a private sector bank that holds currency for the
FRBNY on a custodial basis in a segregated area of its vaults. The
FRBNY manages the ECI program and bears the costs associated with
providing management oversight and monitoring the program. It co-
ordinates the shipment and receipt of currency between the Federal
Reserve facilities and the ECIs. All banknotes while in inventory at an
ECI, and during transit between a Federal Reserve facility and an ECI,
are carried on the books of the FRBNY. The dealers account with the
FRBNY is debited when he delivers notes to his customers and credited
when he buys notes and adds them to inventory.
Each wholesale dealer that enters into an ECI arrangement maintains
an account at a Federal Reserve Bank. The dealers that operate the ECIs
must enter into a contract with FRBNY, with a number of requirements
to be met. These include correct sorting (of old and new notes), atten-
tion as specified to counterfeiting (with various reporting obligations).
The principal hubs for the distribution of US banknotes are Frankfurt,
London, Zurich, Hong Kong, and Singapore. Wholesale banknote
dealers purchase approximately 90% of the US banknotes that are
exported to international markets from the New York Federal Reserve.
According to the contracts (between the dealers and the FRBNY),
each operator (dealer) is specifically prohibited from engaging in trans-
actions affecting ECI inventory with countries against which the US
has imposed sanctions. ECI operators are also obligated to provide the
New York Fed with monthly reports showing all countries that
engaged in US dollar transactions with the operator during the preced-
ing month and the volume of those transactions. The information pro-
vided by the ECIs to the New York Fed has given the US government a
valuable tool for estimating stocks and flows of US currency abroad.
In practice, there is the risk of false reporting and illegal (against the
terms of the contract between the dealer and the FRBNY) shipment of
notes. One important case of such transgression came to light in 2003,
following the discovery (April 2003) of $650m of dollar banknotes in
Baghdad by US armed forces (see Baxter, 2004b). The trail, involving in
part the tracking of serial numbers, led eventually to the UBS ECI facil-
ity in Zurich, and eventually that bank disclosed that it had not cor-
rectly reported (to the FRBNY) shipments of notes, and that there had
been important despatched of these (by UBS) to Iran in particular and
also Cuba, Libya and the former Yugoslavia (all sanctioned countries).
The conclusion of this affair included the cancelling of the contract
Black Money 63
between the FRBNY and UBS, the Swiss Federal Banking Commission
(EBK)’s suspending UBS’s license to conduct banknote trading business,
and the payment of a $100m civil money penalty by UBS. In effect
UBS had deceived the FRBNY systematically over an 8-year period. The
penalty should be compared to the total net profit made by UBS in
banknote currency trading during the 5-year period 1999–2003. Until
the suspension, UBS had been transacting $140bn annually in the
wholesale banknote market (in more than 100 currencies). Its
banknote processing facility at Zurich airport had processed each day
four million individual bills – with a headcount of 65 full-time and
180 part-time staff. In 2004, the New York Federal introduced new pro-
cedures and amended outstanding contracts (with ECI dealers) so as to
hopefully prevent the same type of avoidance occurring in the future.
The euro, as a supranational currency, is not subject to the same
type of distribution regime (in the global banknote markets). Indeed,
as a principal international asset in banknote form it can be seen as a
successor of the Deutsche mark (see Seitz, 1995). This had a payments
and store of value role throughout Eastern Europe estimated at as
much as DM80bn ($50bn) in the 1990s (Bundesbank, 1995). With the
demise of Deutschemark banknotes (2002), euro-banknotes took over
that role. And in line with the largest denomination Deutsche mark
note being 1000, the largest euro banknote was fixed at 500. But of
course in most of the member countries of EMU there had not been
such a large banknote. The rapid growth in demand for euro currency
in the years following its launch (in banknote form) (2001) went way
and beyond what could be explained by the reversal of the run-down
in cash holdings before the changeover (from old notes in the individ-
ual currencies) took place. The IMF in its 2005 report on the euro-area
endorsed the view that demand for euro cash was being buoyed by its
use in the grey or black economy, both in the euro-area itself and
globally. The same IMF report cites estimates that in 2004 around 15%
of the total value of euro banknotes circulated abroad (outside the
euro-area), well short of the 65% equivalent estimate for US dollar
banknotes (circulating outside the US). But the ECB and IMF
comment on a continuing large net shipment of euro banknotes to
outside the euro-area which could be consistent with a growing role
for these in the global grey economy.
The launch of a 500 euro banknote did spread some concern right
from the start that this might emerge as a magnet for international
crime (given that the largest US dollar banknote is only 100). As an
apparent counterpoise to this threat, the ECB has disclosed plans to
incorporate Radio Frequency ID (RFID) tags into the largest denomina-

tion euro banknotes. Hence law enforcement officials would be able to
employ monitoring equipment (at airports for example) to learn the
serial numbers of euro-banknotes surreptitiously at short-distances (see
Juels and Pappa, 2003).
There are many technical and political issues raised by such a pro-
posal. Could criminal elements use the same monitoring equipment to
locate cash hauls? And could the monitoring equipment pick up a
whole series of serial numbers in a stack of notes? Liberals are con-
cerned with the ability of state officials or private detectives to monitor
how individuals spend and whether their spending power comes out of
illicit cash hoards. It is fairly easy to imagine techniques for evading
the new Big Brother controls, but these all involve varying degrees of
inconvenience. And there is the obvious constraint that if one country
moves to tagging its banknotes it may well lose out in international
banknote markets to other countries which do not.
3
Driving Forces
What drives the global flow of capital? Earlier in this volume (Chapter 1),
a geography of the main currents was presented. These start off in (cur-
rency) areas of the globe in savings surplus and end up in areas of savings
deficit. But what are the forces which drive the currents? And from what
source do these forces derive power?
The driver of the currents is the prospect of an improved rate of
return to capital, measured to take account of risk. Or put more techni-
cally, the force behind the current is the attraction of a better overall
portfolio mix (from the viewpoint of the investors and borrowers)
between risk and expected return (or cost).
What power fuels that force of attraction? In analyzing the force of
attraction (to global capital flows) and the source of power (behind the
force) it is necessary to take account in particular of exchange risk,
exchange rate expectations, and political or credit risks, alongside
several other factors. Further, it is essential to distinguish the flow of
capital under hypothetical situations of stable long-run equilibrium
from those of disequilibrium or only transitory equilibrium.
The most simple and direct force of attraction is interest rate spreads.
As a tendency, but not as a general rule, capital tends to flow out of
countries where (real) interest rates are low into those where interest
rates are high. A further tendency, with important exceptions, is for
interest rates in savings surplus countries to be low and for those in
savings deficit countries to be high. Similarly, expected returns to
equity investment in the low interest rate country tend to be also low –
a fact in itself encouraging an outflow of this type of capital (equity).
Hence (real) interest rate spreads play a large but not exclusive role in
the driving of capital flows out of the savings surplus countries into the
savings deficit countries. The ultimate power sources are the factors
65
behind the emergence of savings surpluses and deficits. Examples

include demographic trends, investment opportunity, asset bubbles
(followed by bursting), and expectations of strong trends in real
exchange rates.
As investors resident in the savings surplus countries (with generally,
but not always, low interest rates) add to their wealth over time there
will be a flow of funds into the savings deficit countries, on the reason-
able assumption that they allocate a share of their portfolios to higher
rate of return monies (and to national equity markets where expected
earnings returns are relatively high). And as borrowers around the
globe add to their liabilities denominated in the low interest rate cur-
rencies for the purpose of financing assets accumulated in the high
interest rate currencies the flow gathers further strength.
In order to understand more fully how interest rate spreads can
potentially drive the flow of capital it is helpful to consider in some
depth the concept of rate neutrality, both within a domestic and global
context. Neutral rates are conceptual based on a hypothetical situation
in which full economic and market equilibrium holds. They cannot be
identified in a simple survey of the market landscape.
A question of neutrality
The origin of the concept of interest rate neutrality goes back to Knut
Wicksell (1851–1926). He defined the natural interest rate as that at
which the hypothetical closed economy would be in overall equilib-
rium – meaning resources (labour and capital) fully utilized and no
inflationary or deflationary pressure. When the interest rate is at its
natural level, the marginal rate of return to new investment in the
given economy is equal to the marginal rate of time preference (the
premium which households put on the utility of present consumption
compared to future consumption) which is equal to the given interest
rate. The definition of natural rate can be elaborated to take account of
such real world facts as uncertainty, heterogeneity (assets belonging to
different risk classes – for example equities and bonds), steady-state
inflation expectations and significant exchange risk between sovereign
(or regional monetary union) currencies. These additional facets
emerge in what follows (both in this and subsequent chapters).
In monetary economies there is no automatic mechanism such that
market rates are continuously near or at their natural level. And the
natural rate itself cannot be perceived directly. But there are equilib-
rium forces which cause market rates to tend towards the natural rate
Driving Forces 67
over long periods of time in a well-ordered monetary system. The

dynamics stem from the central bank’s efforts to preserve price level
stability (or in the Wicksellian context, to maintain the national cur-
rency on the gold standard). If the market rate is persistently below the
unknown natural rate, then an inflationary process would get under
way (or the inflation rate, up to now stable, would start rising). And so
the central bank would take steps to push market rates higher (into
line with the natural rate). Conversely if the market rate is persistently
above the (unknown) natural rate, then a deflationary process would
develop. And so by trial and error the central bank would edge market
rates close to the natural rate.
The problem is that trial and error might be very large and noisy
(meaning serious inflationary or deflationary disequilibrium). The lags
are long and variable. Moreover the natural rate of interest is itself
likely to be fluctuating through time. And so the central bank is
seeking to estimate by trial and error a moving target. An additional
issue is that the natural rate of interest is a real variable, and so its esti-
mation based on observed nominal market rates amongst other factors
is dependent on an assessment of inflation (or deflation) expectations.
(Specifically, the nominal rate of interest which corresponds to the
natural rate differs from it by expectations regarding the movement of
the price level over time). To Wicksell, there was no such thing as
steady state inflation or deflation – only price level stability (consistent
with periodic upswings and downswings in prices which cancelled out
over the long run). In today’s world, however, stability is generally
defined in terms of low but stable inflation.
In particular, under the late period of the Greenspan Federal Reserve,
in which the search for the “neutral” rate became the guiding them of
monetary policy, the unofficial aim was to hold the average inflation
rate over time at somewhere between 1 and 2% p.a. (some FOMC
members preferred a lower rate). The concept of neutral rate used by
Federal Reserve officials differs from the natural rate in that it is
defined in nominal terms (rather than real) and in the context of stable
low inflation rather than long-term price level stability. Through the
buzz of comments from Federal Reserve officials came the message that
they viewed neutral rates as being within a 3–5% range and expected
trial and error over the medium-term to reveal the true level. Some
officials justified the gradualist adjustment of money rates (rather than
large bold moves) in terms of the painstaking search for neutrality –
allowing time for careful analysis of the economic impact of earlier rate
moves.
When Federal Reserve spokespersons talked about the neutral inter-

est rate they referred implicitly to short-term money market rates.
Some other economic commentators, and the older literature on the
natural rate of interest, focus on an implicitly longer maturity interest
rate. In practice there is always some degree of blur surrounding the
choice of maturity. Consumers and business decision-makers take their
cue not from an overnight money rate but from an average level of
interest rates which they expect to pertain over the period from now
until their horizon date. The central bank does not and cannot fix the
interest rate over such long time-periods – but its monetary stance and
short-maturity rate setting practices can be an important influence on
the market rate levels for longer periods (particularly the short and
intermediate maturities).
The situation of long-maturity market rates diverging from neutral
and driving the economy towards higher inflation can occur through
misjudgement in the market-place as well as through monetary error.
But the process would only go so far without monetary ratification (the
central bank sharing in the misjudgement of neutral). Suppose as illus-
tration long-term rates had been set in the market-place at too low a
level, meaning for example a capital spending and a consumer boom
got under way, creating inflationary pressure. The responsibility of the
central bank would be to promptly tighten monetary conditions, most
likely by pushing up money market rates. The reality (perceived with
the benefit of hindsight) is that for much of the time market rates are
out of line with neutrality. This misalignment has both a domestic and
international dimension.
In the real world, it is essential to extend the concept of neutrality
beyond the closed economy to a global economy with several distinct
currencies. In this context, interest neutrality is defined by two sets of
conditions. The first refers to the domestic dimension, already dis-
cussed above. The second refers to the global dimension. The interna-
tional spread between neutral rates, with exchange rates at a level
consistent with long-run equilibrium (see below), must be sufficient to
drive capital flows equal in size to the matching savings surpluses and
deficits. The determination of the neutral level from a domestic stand-
point (meaning that the economy operates at full productive potential
with stable low inflation) and from a global standpoint is part of a
joint process involving also the discovery of the equilibrium path for
exchange rates through time.
In any given economy there is a trade-off (from the viewpoint of
domestic equilibrium) between the neutral level of the interest rate
Driving Forces 69
(defined in real terms) and the real exchange rate. A fall in the real
exchange value of the national currency, meaning that profits increase
in the traded goods and service sector of the economy, provides a stim-
ulus to aggregate demand. A rise in the (real) interest rate would have
an offsetting influence on domestic demand. And so there is a contin-
uum of real exchange rates and interest rate levels (a higher interna-
tional value of the national or area currency going together with a
lower interest rate) at which the economy would be in overall balance
from a domestic viewpoint.
But also an external equilibrium condition has to be met. There is a
continuum of interest rates and exchange rates, for which net capital
outflows (or inflows) equal the current account surplus (or deficit), in
turn equal to the savings surplus. At a higher interest rate (relative to
those abroad), the given economy would require a higher international
value for its currency, as a higher interest rate means a lower momen-
tum of capital outflows. Hence for external balance the current account
surplus must fall. (A higher international value of the national or area
currency means – everything else the same – a smaller current account
surplus). Hence in the continuum of real exchange rates and interest
rate levels consistent with external balance a higher exchange rate goes
along with a higher interest rate.
There is one unique pair of real interest rate and exchange rate at
which the particular economy is in both external and internal equilib-
rium, determined for a given level of foreign interest rates. In a global
general equilibrium solution, in which all interest rates are at a neutral
level from both domestic and external viewpoints, it would be true
that all economies were in balance (meaning output equal to produc-
tive potential, inflation low and stable), that capital flows were equal to
the underlying savings surpluses or deficits, and that these summed to
zero (across the globe) (see Bosworth, 1993). There would be one set of
equilibrium exchange rates (both spot and forward) between currencies
corresponding to that solution. The forward rates for maturities
stretching out far into the future would be close to the perceived equi-
librium path of the exchange rate. (The path is a probabilistic concept,
based on an average of future possible economic scenarios – see
Chapter 8, p. 221). The relationship between forward rates and the
spot rate would be in line with neutral interest rate spreads as deter-
mined by interest rate parity conditions.
Most of the time, actual exchange rates and interest rates around the
globe are different from the hypothetical and invisible set of equilibrium
exchange rates and neutral interest rates at which internal and external
balance would hold everywhere. At a given level of foreign rates, out of

line with the conceptual set of neutral rates for the global economy, it is
still possible for one or more economies to be in full internal and exter-
nal equilibrium. The central banks in those economies may be well
satisfied that the Holy Grail of neutral interest rate level has indeed been
found. But that satisfaction could be undermined by a shift in foreign
interest rate levels and exchange rates. The warning signs of a looming
shock could be a seizing up of global capital flows (as described in the
next chapter) – symptomized perhaps by spiralling exchange rates
between certain currencies and large internal imbalances (for example a
high degree of slack) in various major economies.
In sum, the search for the neutral level of interest rate in any large
country or currency area should be undertaken in principle as part of a
wider search for the general equilibrium solution to the global
economy. In practice, several commentators and most officials would
satisfy themselves with a partial discovery of neutrality – for a given
level of foreign rates. Foreign exchange or foreign interest rate shocks
are treated as exogenous events rather than something waiting to
happen from an initial disequilibrium situation. Nonetheless, the
concept of a general equilibrium solution, which could well incorpo-
rate large and continuing capital flows between countries (or currency
areas) corresponding most likely to a spread between interest rates in
each currency, proves useful in market analysis, as we shall see.
That general equilibrium solution depends on the nature of the
international monetary regime. A change in the global monetary
system can lead to a shift in neutral interest rates and equilibrium
exchange rates. In particular, a reduction in exchange risk (as would
occur in the shift from a freely floating system to say an international
dollar standard) means that much larger global capital flows occur in
response to a given spread between real interest rates (in different cur-
rencies). As illustration, the neutral level of US interest rates would be
lower in the case of the Asian countries with huge savings surpluses
having their currencies anchored firmly to the US dollar than in that of
their currencies floating freely and with considerable independence. As
a corollary the neutral level of Asian interest rates would be lower in
the floating case (than in the dollar anchor case).
Currency preferences
Strong currency preferences on the part of investors in the big savings
surplus countries could in principle cause (neutral) interest rates to be
Driving Forces 71
lower in some important savings deficit countries than in some modest

savings surplus countries.
To illustrate this point, let us suppose that if the euro-area and US were
each closed economies, their neutral level of interest rate would be the
same – meaning most likely that savings propensities and investment
opportunity were broadly similar in each. Then let us superimpose on
this the emergence of a huge savings surplus in East Asia, with investors
there having a strong preference for US dollars over euros. (A manifesta-
tion of that preference would be Asian investors allocating a much
higher share of their savings to dollars than to euros if dollar and euro
interest rates were at the same level).
The Asian currency preference (for US dollars) would cause US interest
rates to fall below euro rates. (Both sets of rates – euro and US dollar –
would most likely decline in absolute terms as part of the process of
generating savings and current account deficits to offset the Asian sur-
pluses). The US would eventually be in much larger savings and current
account deficit than the euro-area, but with a lower level of interest
rates on dollars than on euros. The extent of the divergence (between
US and euro-area savings deficits and between interest rates) would be
held in check by a tendency of Asian investors to reduce their target
proportion for dollars in response to their growing interest inferiority
(below euros). Other influences holding the divergence in check would
include US investors stepping up their investment in euros (in response
to its growing interest rate advantage over US dollars) and other global
investors or borrowers responding similarly (investors switching from
dollars to euros and borrowers from euros to dollars).
Suppose the starting position (before the emergence of the Asian
savings surpluses) had been a modest US savings deficit and an equally
modest euro-area savings surplus, reflected in US interest rates being
somewhat above euro-area rates. In principle, a strong dollar preference
amongst Asian investors could turn that situation around into the US
having a huge savings deficit, the euro-area a small savings surplus or
modest savings deficit, and with US interest rates below euro rates.
That result would depend on there being considerable inelasticity in
global portfolios (both amongst borrowers and investors) with respect
to changes in the interest rate spread between euros and US dollars. (If
the elasticity were high, then the strong Asian preference for dollars
would be offset by other investors switching from dollars to euros and
borrowers in the opposite direction).
Indeed when in 2003 the US was in around 4.8% of GDP deficit and
US interest rates across short and medium-term maturities were below
euro-rates, it was possible to construct such a theoretical justification,

especially if account were taken of the around 2% of GDP steady state
capital inflows to the US dollar from grey and black areas of the world
economy (as outlined in Chapter 2). But there was a competing expla-
nation. According to this a falling savings propensity in the US (includ-
ing the government sector) was playing a role in widening the US
current account and savings deficits and in fact actual market rates on
dollars had fallen well below the conceptual neutral level for the US
economy. Indicative of that situation was the overall weakness of the
US dollar. If low US rates reflected a strong Asian preference for dollars
only, then the dollar should have been generally strong.
Subsequent events were more in line with the competing explana-
tion. By second-half 2004 the US savings and current account deficits
exceeded 6% of GDP and interest rates at short and medium maturities
had risen substantially – to well above euro rates. In 2005 the US
(savings and current account) deficits were at near 6.5% of GDP, and
the euro-US dollar rate spread widened further (in favour of the US)
(see Figure 3.1). Hence it was evident that not all the US savings and
current account deficits were an induced response to a strong dollar
3.5
3.0 10-yr swap spread US – Euro
2.5 2-yr swap spread US – Euro
2.0
1.5
1.0
0.5
0.0
–0.5
–1.0
–1.5
99 00 01 02 03 04 05
Figure 3.1 US$ vs. Euro, 2-yr and 10-yr swap rate spreads
Driving Forces 73
preference in the savings surplus countries. Indeed, some of the savings

surplus in Asia and elsewhere might even be seen as explained by the
higher-than-otherwise global level of interest rates which was a conse-
quence of the low US savings propensities and buoyant residential con-
struction – related to the red-hot residential real estate markets. (It is
not mutually exclusive to hypothesize that high foreign savings
induced low world interest rates which in turn stimulated US spend-
ing, and that the readiness of the US household sector to be stimulated
helped to keep a floor under world rates and so sustained a high
savings surplus outside the US).
Capital flight and unpopular currencies

The opposite case to a savings deficit country having relatively low
interest rates, reflecting strong global currency preference in its favour,
is a savings surplus country having relatively high interest rates
because of the unpopularity of its currency. Popularity (or unpopular-
ity) should be interpreted broadly to include a range of financial, eco-
nomic and political considerations.
An example of the phenomenon (of currency unpopularity) is the
currency of a country in which capital flight is rampant and where
global investors perceive a high degree of monetary and political risk.
Domestic investors have a strong demand for foreign assets (hidden
outside their own political jurisdiction) so as to escape from high taxa-
tion and the risk of confiscation or exchange controls. The risk or actu-
ality of high inflation in the domestic money might also be a factor in
domestic investors targeting a high proportion of foreign assets (in
their portfolios).
The strong momentum of domestic capital outflow means that the
given country might have to run a current account (and savings)
surplus to match (see p. 8), requiring a cheap real exchange rate
together with high real interest rates. (The dampening effect of high
real rates on domestic demand is offset by the stimulatory effect of the
low real exchange rate).
There is a possible alternative offset to the stream of domestic capital
outflow – an influx of foreign capital. That could occur where there is
asymmetry between risks as perceived by domestic and foreign
investors in the given country. For example, foreign investors might be
confident that any redistributive taxation or exchange restrictions will
be applied to domestic investors only. And in that only a small share of
their worldwide portfolio is allocated to assets in the given country
they might be much more tolerant of inflation risks there than would
be domestic investors.
In this last case, political and inflation risks do not become a source
of large real rate spreads in favour of the country in question nor does
it emerge with a large savings and current account surplus. Instead the
risks drive a large amount of round-tripping. Large foreign inflows into
the country (attracted by somewhat elevated real rates) are matched by
strong waves of domestic capital flight. Even so it is likely that the
given country would be in some degree of savings and current account
surplus, unless there are the additional factors of robust investment
opportunity and perhaps a low personal propensity to save.
Examples of the phenomenon of an economy in large savings
surplus (on a long-run basis) with relatively high interest rates –
explained by a momentum of capital flight without fully matching
inflows – have included both developed and developing economies.
There were stages in the quarter century ended 1995 when several
European countries, including Italy and Belgium, had large savings sur-
pluses and high interest rates together. Analysis of these periods,
however, is complicated by the fact that the respective currencies were
not always freely floating. In an adjustable peg system large but usually
transitory interest rate spreads can reflect principally expectations of a
coming adjustment of the currency parity. Amongst developing or
transition countries, Brazil and Russia provide illustrations of large
savings surpluses co-existing with interest rate levels that are high by
international comparison, reflecting a strong momentum of capital
flight.
There is a further example of where an economy with a relatively
high neutral interest rate level (by global comparison) could also be a
long-run net exporter of capital. That is where the government is pur-
suing a policy of aggressively accumulating foreign exchange reserves
over a long period of time (decades), funding this by issuing debt
denominated in its own currency. Technically this type of foreign
exchange reserve build-up is described as “sterilized intervention” –
meaning that there is no overspill into monetary creation. In practice,
most episodes of sterilized intervention have ended in failure and were
not announced as a multi-year, let alone multi-decade, policy. The suc-
cesses have been the governments of small countries where the propen-
sity to save is high not low and so where the neutral rate of interest is
low. Two contemporary examples (of the exception) are Norway and
Singapore, where public agencies accumulate massive amounts of
foreign assets on an announced long-run basis. In the absence of these
Driving Forces 75
accumulations, the real exchange rate of the national currency

(meaning its international value) would be higher and the neutral
interest rate would be lower than its already depressed level.
Various commentators (for example, Dooley et al, 2004a) have sug-
gested that some governments of East Asian developing economies
(Singapore is an advanced economy) might be pursuing long-run poli-
cies of foreign exchange accumulation so as to depress their real
exchange rates. The purpose would be to give a fillip to economic
growth via the export sector, in accordance with the hypothesis that
exports play a special role in fostering overall development. That view
is in itself questionable. Productivity growth might be fastest in the
non-traded goods and services sectors. And if the method used to
depress the real exchange rate pushes up the neutral rate of interest
that would surely be a drag on the overall rate of domestic investment
spending, intuitively a counter-growth strategy. That criticism applies
to the method characterized by massive accumulation of foreign
exchange reserves financed non-monetarily. The demand for foreign
assets on the part of the government would in itself drive the neutral
interest rate up and the real exchange rate down. The higher neutral
rate would go along with a raised domestic savings surplus that would
be the counterpart to the public capital outflow into foreign assets.
And the lowering of the real exchange rate would stimulate aggregate
demand (via its influence on net external demand) as an offset to the
drag from the higher rates (on domestic demand).
There are limits in any case to the effectiveness of non-monetary
(sterilized) long-run accumulation of foreign assets by the government
as a means of depressing the real exchange rate. In particular, the climb
in domestic interest rates which results could induce a massive inflow
of foreign funds. The inflow would temper the climb (in rates) long
before there would be much impact on the domestic savings surplus.
In effect a huge round-trip could get under-way – foreign capital
inflows matched largely by public sector accumulation of foreign
assets, with little effect on the real exchange rate or on the neutral
level of interest rates. In practice, this round-trip might be limited in
extent under a currency regime where there were restrictions on capital
inflows or where asset markets in the given currency were very poorly
developed. Even so, there could be speculation that the policy would
not be sustained in the long run, triggering huge short-term inflows of
capital. These would undermine the policy.
Dooley et al (2004b) implicitly suggest that West European nations
successfully followed a policy of depressing their real exchange rate via
massive purchases (sterilized) of foreign exchange (US dollars) during

the era of the Bretton Woods System (say, 1958–71). And indeed some
West European countries at that time had remarkably underdeveloped
financial markets and comprehensive restrictions on capital flows
(both of which might would have inhibited capital inflows and so the
round-trip phenomenon described). (The restrictions in the main
applied only to the export of capital by domestic residents but none-
theless they detracted from the potential investment appeal of the
given currencies). But the historical experience of Germany (during
the late 1950s and 1960s) certainly does not fit the case-book. Foreign
exchange accumulation by the Bundesbank occurred in spurts corre-
sponding to periods of speculation on revaluation of the Deutsche
mark, not in accordance with a policy determined by the government
in Bonn for depressing its real value.
The massive accumulation of dollar reserves by East Asian countries
during 2003–4 was the backdrop to Dooley and Garber describing
them as belonging to a re-vamped version of Bretton Woods (see
Figures 3.2 and 3.3). There are several problems with the analogy.
900
800
700
600
500
400
300
200
Japan China
100
0
02 03 04 05
Figure 3.2 China – foreign exchange reserves, 2002–5 (US$ bn)
Driving Forces 77
300
250
200
150
100
Hong Kong
50 Taiwan
S. Korea
0
02 03 04 05
Figure 3.3 Hong Kong, Taiwan and S. Korea – foreign exchange reserves,
2002–5 (US$ bn)
First, it is not obvious that any country under Bretton Woods

Number One followed a strategy of real exchange rate depression via a
long-run program of massive foreign exchange accumulation.
Second, in the mid-2000s none of the Asian countries intervening on
a large scale (in foreign exchange markets) announced that this was
part of a strategy of long-run sterilized foreign exchange accumulation.
Rather, public pronouncements suggested that the accumulation was
related to short-run foreign exchange policy tactics (countering “specu-
lative” moves). In the case of China, official foreign exchange pur-
chases on a massive scale in 2004–5 could be seen as a substitute for
private capital outflows, seriously inhibited by exchange restrictions, in
matching an emerging huge underlying savings and current account
surplus (at an estimated 7% of GDP in 2005).
Third, the intervention in several instances was not sterilized, or at
least not fully. In so far as a country intervenes to stabilize its dollar
exchange rate, leaving the intervention unsterilized, it is in fact not
following a policy of long-run depression of its real exchange rate. The
follow-on monetary expansion (as the intervention spills over into

money supply) would push up the domestic price level relative to that
abroad (and so contribute to real appreciation of the currency if
remaining at a fixed nominal exchange rate).
In principle, a government which saw a low real exchange rate as vital
to economic development would do better to encourage a high rate of
domestic saving (including fiscal surpluses) and remove all barriers to
capital exports rather than relying on a massive long-run program of
official foreign asset accumulation (financed via the debt markets rather
than via monetary creation). It is open to debate as to how far any gov-
ernment has followed such a strategy explicitly, rather than perhaps by
accident. For example, during Germany’s golden period of growth in the
late 1950s and early 60s, a high savings rate (of which strict fiscal disci-
pline was one element) and exchange market liberalization (controls on
capital outflows were abolished by the end of the 1950s) meant that the
Deutsche mark could remain at a cheap overall real level (albeit that
there was one small revaluation in 1961) despite a strong momentum in
domestic capital spending. Most recently the high savings rate in China
could be seen as one potential element in an overall strategy aimed at
maintaining a low real exchange rate for the yuan. But there is no evi-
dence that the Chinese authorities ever saw this as the grounds for pro-
moting domestic saving and they have been unwilling to remove
restrictions on capital outflows – a step which would have been essential
to full implementation of any such strategy.
Sometimes domestic capital flight can perform the role of keeping
the real exchange rate down despite vigorous domestic investment
(and despite a corresponding tendency for the overall savings surplus
to fall, before considering the knock-on effects to saving from upward
pressure on interest rates stemming from capital flight), in much the
same way as sterilized foreign exchange market intervention over a
long period. The limit to that role comes from the possibility of a large-
scale round-trip getting under way. As we have seen, in the country
from where capital flight is taking place foreigners might believe they
are less subject to various risks (or more able to dilute them) than
domestic investors. In that case capital flight goes together with heavy
capital inflows and even an overall savings and current account deficit.
A historic example of the phenomenon of capital flight braking a
tendency for real exchange rate appreciation in a country experiencing
an investment spending boom was Germany during its brief economic
miracle of the interwar period (1924–7) (see Brown, 1986). Interest
rates remained substantially higher in Germany than in the US,
Driving Forces 79
despite the German currency’s stabilization (in 1924 under the so-
called Dawes Plan), reflecting both domestic political and financial
risks and also foreign concerns about an eventual inability (of
Germany) to service external debt. In effect continuing domestic
capital flight and risk aversion of foreigners meant that the savings-
investment balance swung into only modest deficit and there was only
slight real appreciation of the mark (price level in Germany rising rela-
tive to in the US) even though there was tremendous pent-up demand
for capital towards reconstruction (following the damage and deple-
tions of war and its hyperinflationary aftermath). The counterfactual
historian would argue that the German miracle would have been
greater and long lasting if there had been no drag of capital flight,
even though this benefited the export sector by depressing the real
exchange rate below where it otherwise would have been. At lower
interest rates there would have been more rapid reconstruction. A full
analysis of the German interwar miracle years would also have to take
account of the influence on the equilibrium solution (real exchange
rate and interest rates) of reparation payments.
More modern history – with illustrations drawn from the developing
countries, especially in Latin America – also provides examples of the
dampening influence of capital flight on the real exchange rate level
and so acting as a substitute for long-run sterilized foreign exchange
intervention aimed at the same result. But the economic benefits of
that situation are as dubious as in the earlier examples above.
Speculation on real exchange rate trends

So far, in analyzing the force of interest rate spreads between currencies
driving global capital flows, we have not considered the possible
influence of strong expectations regarding exchange rate change over
long periods of time. Where such expectations exist, interest rate
spreads (between currencies) are better viewed simply as part of a
general equilibrium solution rather than as a driving force with its
source of power in divergences between savings or investment propen-
sities. As we shall see, divergences which can be identified in such cir-
cumstances might well be created in considerable part by feed-back
effects from the exchange rate expectations.
A first illustrative example is based on the so-called Balassa effect. As
normally expressed, this refers to an underdeveloped economy which
is rapidly growing and catching up with the advanced economies. The
hypothesis is that productivity growth in the traded goods and services
sector outpaces that in the non-traded (goods and services) sector by

considerably more in the catch-up economy than in the advanced
economies. Correspondingly prices in the traded goods and services
sector fall relative to those in the non-traded sector, with this relative
price decline being much faster in the catch-up economy (than in the
advanced economies). On the basis of the Law of One Price holding
(traded goods prices are the same everywhere when converted at
current exchange rates), that translates into a real appreciation of the
national currency (its nominal exchange rate depreciates by less than
the positive inflation differential between itself and other countries or
appreciates by more than the negative inflation differential, as the case
may be) of the catch-up economy.
An unfamiliar variation of the Balassa effect, but one that is potentially
important in the major currency markets, is the case of an advanced
economy where up until now its non-traded goods and services sector has
been notoriously unproductive (with its level of productivity much lower
relative to that in the traded goods/services sector than is the rule for
most other OECD economies). Japan and to a lesser extent Switzerland
are examples of such countries. Suppose in the long-run there were to be
a catch-up of productivity levels in the non-traded goods and services
sector of these laggards amongst the advanced economies. The catalyst
could be social and economic reforms and a new opening up of hitherto
protected economic activities to foreign competition. (For example in
Switzerland, several commentators see the new bilateral treaties entered
into with the EU in 2005 as being just such a trigger). Then the relative
price of traded to non-traded goods (and services) in the laggard
economies would tend to rise towards the benchmark (relative price) in
the other advanced economies – meaning a trend real depreciation of the
national currency (Swiss franc or Japanese yen in our example). We could
call this the reverse Balassa effect.
Suppose all markets are in equilibrium and then a reverse Balassa effect
emerges as a dominant expectation as regards the next decade, taking for
illustrative purposes the Swiss franc. At the pre-recognition (of the
reverse Balassa effect) level of the Swiss franc and of Swiss interest rates
there would now be external imbalance. The Swiss franc would fall to a
lower level. For internal balance the interest rate (in Switzerland) would
rise (in line with the stimulus to aggregate demand via the external
sector from the lower value of the franc). In the new equilibrium, Swiss
interest rates would be higher and the franc would be lower than previ-
ously, plus there would be a built-in expectation of further real deprecia-
tion of the franc (on the assumption that previously there had been no
Driving Forces 81
expectations of real appreciation or depreciation). But some of the

initially expected real depreciation would have happened up front.
In effect, during the early stages of the reverse Balassa effect
Switzerland would be pushed (by higher interest rates) into larger
savings and current account surplus (with correspondingly larger
capital exports). Swiss interest rates now would be higher in absolute
terms and relative to the rest of the world. In general where the
national currency is expected to be in long-run real decline, the given
country could be both a capital exporter and have interest rates which
are high by global comparison – the reverse of the more usual situation
of savings surplus countries having relatively low interest rates. The
savings surplus is an induced response (via interest rate rise) to the
shift of expectations (towards weakness) regarding the real exchange
rate. In the Swiss case, rates may well remain low by international
comparison, but by a smaller margin than prior to the recognition of a
reverse Balassa effect. This is because the savings surplus is already so
large (see Figure 3.4). The introduction of the reverse Balassa effect
would mean it (the surplus) becomes even larger.
14.0
current account balance as % of GDP

12.0
net investment income as % of GDP
10.0
8.0
6.0
4.0
2.0
0.0
80 82 84 86 88 90 92 94 96 98 00 02 04
Figure 3.4 Switzerland – current account and net investment income,

1980–2004 (as % of GDP)
The same type of analysis applies to the Balassa effect in its mainstream
sense (rapidly developing country with a currency which is appreciating
in real terms as a reflection of productivity growth in its traded goods
sector much faster relative to in its non-traded goods sector than is the
case amongst the advanced economies on average). Here the emergence
of expectations regarding long-run real appreciation go together with an
immediate rise of the currency, a fall in the neutral level of interest rates,
and larger net capital imports (corresponding to a diminished savings
surplus induced by the lower interest rates). And so in the case of strong
expectations regarding the real appreciation of a currency, the capital
importing country could have relatively low (by global comparison)
interest rates (again the reverse of the more usual situation).
The Balassa effect is not the only grounds for strong long-run expec-
tations regarding real appreciation (or real depreciation in the case of a
reverse Balassa effect). (And in any event, “strong” must be qualified by
the realization that no-one can be sure that the process of economic
convergence will continue). For a country running a huge savings
surplus and so exporting capital there might well be expectations
regarding long-run real appreciation. These would stem from percep-
tions of a rising surplus on investment income account (in the current
account). Under some scenarios (to be discussed more fully in Chapter
5), the rising investment income surplus might mean that the trade
surplus in goods and services would have to fall (as a share of GDP)
over the long-run, and this might have to be induced by a real appreci-
ation of the domestic currency. This is all very tentative. To give the
reader a glimpse of a special scenario to be viewed later (Chapter 5), if
the rate of return on foreign assets is below the growth rate of the
capital exporting country, and its savings surplus is edging higher in
the short and medium-term, then a long-run steady state could be
reached in which external assets as a share of GDP remains constant,
and where the real exchange rate is no higher than at the start.
But let us suppose that the central scenario is for some gradual real
exchange rate appreciation of the given currency as a consequence of
rising investment income. Then the neutral level of interest rate would
be somewhat lower and the real exchange rate path somewhat higher
than in the case of where no such appreciation were expected. The
present savings balance would shift in a negative direction (smaller
surplus or larger deficit). As we shall see in the next chapter it may be
that due to the constraint of the zero rate boundary (in a conventional
monetary system nominal interest rates cannot fall below zero) real
interest rates cannot fall to the possibly negative level which would
Driving Forces 83
correspond to the equilibrium solution under conditions of strong

expectations regarding real appreciation (especially where a high
savings surplus is already depressing the real neutral rate).
In the practical example of Switzerland, already referred to, any expec-
tations regarding long-run real appreciation of the franc due to a rising
investment income surplus (Switzerland’s savings and current account
surplus runs at 10–15% of GDP) might well be cancelled out by the real
depreciation tendency that would result from the reverse Balassa effect.
The same cancelling out of expectations (regarding real appreciation and
depreciation) might also hold in the case of the Japanese yen. On the
one hand, there is a clearly rising trend through time of investment
income relative to Japanese GDP (see Figure 3.5). On the other hand over
the long-run there will surely be some convergence of productivity in
the Japanese non-traded goods and services sector with the much higher
level in other advanced economies – a process which as we have seen
generates expectations of real depreciation over the long-run. (Japanese
productivity in the traded goods sector is already at, or in some sectors
above, the best level in other advanced economies).
5.0
4.0
3.0
2.0
1.0
0.0
current account balance as % of GDP

–1.0
net investment income as % of GDP
–2.0
80 82 84 86 88 90 92 94 96 98 00 02 04
Figure 3.5 Japan – current account and net investment income, 1980–2004 (as
% of GDP)
Equity flows and the rapidly growing neighbour next door

How can we reconcile the attempt to describe global capital flows as
driven by interest rate spreads adjusted for exchange rate expectations
and exchange risk with the fact that two main items in traditional
capital account data (a part of the overall balance of payments) – direct
investment and equity portfolio (flows) – are not evidently responsive
to interest rates?
A first point is that a flourishing of direct investment opportunity (in
a given country A) for foreigners is in fact likely to go along with a
neutral interest rate higher (in A) than on average elsewhere. The
neutral rate rise would go along with the frontier of investment oppor-
tunity expanding by more than domestic savings. If foreign companies
investing in the given country take advantage of the new investment
opportunity by raising capital in the domestic credit market (of
country A), then in aggregate they put upward pressure on interest
rates there. If instead they bring in capital from abroad, domestic rates
would still rise (in line with the higher neutral rate), but there would
be less foreign inflow into the domestic money and debt markets and
less foreign corporate borrowing there.
In effect direct investment inflows financed outside A would tend to
reduce the extent of (uncovered) interest rate arbitrage opportunity for
outsiders (not involved in direct investment) in the form of borrowing
in foreign monies to lend in the domestic money (of country A). The
overall equilibrium interest rate spread would not be different in the
two cases. So, in general, direct investment inflows, in so far as they are
financed abroad, substitute for inflows of capital that otherwise would
have come through debt and money market channels. Just because the
flow of capital out of a savings surplus country into the savings deficit
countries takes mainly the form of direct investment does not mean
that the normal (neutral) rate spread would fail to emerge in favour of
the capital importing country.
A similar point can be made with respect to equity flows. In so far as
equity inflows from abroad are induced by a flourishing of investment
opportunity in the given country (A), these are a substitute for money
and debt inflows, but they may well not change the final neutral rate
spread (in favour of the given country), unless home bias in equity
investment is less than for bond and money investment.
As illustration, suppose perceived investment opportunity picks up
in country A, meaning that expected domestic earnings growth of cor-
porations quoted in its equity market improves. If this rise in expected
Driving Forces 85
equity earnings growth goes along with a rise in interest rates (in
country A), then foreign inflows of capital would most likely go into
both equity and bond (or money) markets there. The foreign demand
for equity would likely go along with some new issue of equity by
domestic corporations (as well as debt) to finance their stepped up
investment spending. In effect capital inflows in both equity and debt
would contribute towards the financing of the investment boom,
accommodating a rise in that country’s savings deficit. Only in the
special case of foreign investors in equity having no home bias, might
it be possible to imagine huge foreign equity inflows going along with
a fall in the leverage ratio of the corporate sector (in A) (as corporations
there issued equity to retire debt) and a narrower neutral interest rate
spread in A’s favour than if the inflow had been constrained to take
place entirely in the debt or money markets.
One main form of direct investment opportunity is that created by
the combination of cheap labour costs and the shrunken costs of
global management. The information technology revolution in partic-
ular has made it more profitable for corporations in the advanced
economies to tap cheap labour resources abroad, in that management
control over vast distances is now lower cost and more efficient. And
foreign plants or service centres can now more cheaply be integrated
into global supply operations of the given firm. The flow of capital out
of the advanced economies to take advantage of the new direct invest-
ment opportunities would tend to push up the level of neutral interest
rates there (advanced economies) as part of the process of inducing an
increased savings surplus.
As regards the level of economic welfare in the advanced economies
(from the viewpoint of labour) there would be two opposing
influences. On the plus side would be an improved terms of trade, as
the developing countries generated an increased demand for high-
technology imports, whilst there own exports tended to fall in price.
On the minus side, the capital-output ratio in the advanced economies
might fall, or fail to rise as much as otherwise, meaning some potential
downward pressure on real wage levels there (compared to where they
otherwise would be). (For a discussion of this point, see for example
Slaughter and Swagel, 1997). It is possible, though, that none of this
(capital flows from advanced to developing countries) would take place
if the process of rapid economic growth driven by new investment
opportunity in the developing countries generated a rapid rise in
savings propensities there. Then global savings might outstrip the new
investment opportunities.
The above analysis of the influence on global interest rates and

rate spreads of the emergence of direct investment opportunity in
the developing countries requires some elaboration in applications
to the case of the “neighbour next door”. Much depends on the par-
ticular circumstances. As illustration we might consider Japan as the
big advanced economy next to China, or Germany next to the
emerging market economies in Central and Eastern Europe (includ-
ing Russia). In both cases enterprises in the advanced economy
(Japan or Germany as the case may be), because of their geographic
position and historic (including linguistic) links, have an advantage
compared to outside (corporate) investors in exploiting the new
opportunities.
If the new opportunities are mainly in the form of producing low
technology goods for export to global markets (not just the capital
exporting country) then there may be a new turntable role for the
neighboring advanced economies. In the illustrations, the capital
outflow from Germany or Japan would put some upward pressure on
interest rates in those two (capital-exporting) countries, which would
in turn pull in financial capital flows from the rest of the world. There
could be some modest real depreciation of their currencies (the euro
and yen respectively) compensating for the drag on domestic demand
from higher interest rates. But any interest rate or exchange rate effects
could be muted by the turntable flows assuming mainly equity rather
than debt form. Specifically non-German investors, for example, might
view equities of German companies which are in a position to gain
from the new direct investment opportunities in Central and Eastern
Europe as “hot”, and these companies might in turn use a substantial
amount of equity finance towards their Eastern expansion, raising their
equity-debt ratios in the process.
If by contrast, the new investment opportunities in the big develop-
ing country (or group of countries) next door go along with a compres-
sion of investment opportunity in the particular advanced economy
(Germany or Japan) then the outcome might be a real depreciation of
its currency (the euro or yen), more substantial in size than in the previ-
ous example, and a lowering of its neutral interest rate level. An
example of compression would be German companies finding that they
could more profitably locate operations next door (in the cheap labour
market country) than domestically for the purpose of meeting both
domestic and global demand for their product (or service). And foreign
(non-German) companies would not be able to come in and make profit
on the domestic operations now given up by the German companies (as
Driving Forces 87
they would face competition from the German transplant operations

across the border and they might not possess the same management
resources or know-how inside the German economy). Moreover, the
demand for imports into the developing country might not be focused
on the country (Germany) which is supplying most of the direct invest-
ment capital.
Disequilibrium scenarios
We have observed (see p. 69) how for much of the time market interest
rates are out of line with neutrality (from both a domestic and global
perspective) and exchange rates (spot and forward) out of line with the
fundamental equilibrium path. And, as we saw in Chapter 1, savings
surpluses and deficits as estimated by the statisticians might be well
out of line with the levels that would prevail in a state of general equi-
librium. Hence the analyst of global interest rate relationships and
exchange rates should become familiar with the analysis of disequilib-
ria. We return to this theme later in this volume (Chapter 8), but
provide two introductory examples at this stage.
First, take the example of the huge US current account deficit that
burst through all previous records in 2004 and beyond. There was
much talk amongst economic commentators and policy-makers about
the non-sustainability of the US current account deficit and the poss-
ible over-stretching of the normal market mechanisms of adjustment.
Some commentators were bold enough to maintain that the dollar
could only fall, and by a big amount, over the long run and by more
than was presently discounted in the market-place. (The topic of
sustainability is discussed in greater detail in Chapter 5).
Contrarian economists argued, however, that the giant US deficit
was in large part a reflection of autonomously large savings surpluses
abroad. Surely there existed a set of neutral interest rates (higher in the
US than in the savings surplus countries) and equilibrium exchange
rates at which private capital flows between the savings surplus coun-
tries and the US would be in balance and all the major economies in
internal equilibrium? The big question was where lay the source of
present disequilibrium, reflected in the sliding dollar. Had there been a
prior mistake in assessing the equilibrium long-run path for the dollar,
now evident with the unveiling of new information? Or were US rates
below neutral, or euro rates and yen rates above neutral? And depend-
ing on the answer to these questions was the dollar likely to eventually
rise or fall from present apparently cheap levels?
If the source of disequilibrium had its source in euro-area monetary

policy, with interest rates there (the euro-area) well above neutral
levels, then it would be possible to imagine a path to eventual equilib-
rium in which euro market rates would fall, US market and neutral
rates rise, and the US dollar appreciate. The rise of the dollar would be
the counterpart to a stronger momentum of capital inflow into the US
– in line with the widened rate spread in its favour – and a narrower US
current account deficit in the short-run at least. The implications for
the ultimate size of the US current account deficit and euro-area
current account surplus would be ambiguous. These tentative conclu-
sions stem from the following considerations.
Once the European Central Bank eventually edged money market
rates down to a level consistent with neutrality, an expansion of the
euro-area economy would mean stronger demand for US exports. If the
US economy were previously in internal equilibrium (no inflationary
pressure and resources fully utilized), interest rates there would now
rise and so would the dollar. It is possible that as economic activity
picked up in the euro-area (stimulated by the stronger dollar and lower
interest rates), the savings surplus there would eventually rise in
absolute terms, as households there took advantage of increased
income levels to boost their savings rates and corporations acted simi-
larly. During the long period of economic shock and compressed
incomes, Europeans may have been delaying their savings for retire-
ment, more concerned to maintain their current living standards. In
that case the neutral level of euro interest rates and the euro (versus
the dollar) would be even lower than if there had been no such
secondary effect (from a rise in euro-area savings propensities). The
currents of capital flows into the US and out of the euro-area would be
correspondingly stronger.
A second example of disequilibrium is where there has been a rapid
growth in exports (perhaps reflecting a productivity surge or the
gaining of competitive advantage from non-price sources, for example
the development of new products) meaning that the trade surplus
might be running ahead of the underlying savings surplus. A symptom
(of the disequilibrium situation) would be an overheating of the
domestic economy coinciding with a rising current account surplus.
The implication would be that the equilibrium real exchange rate had
risen. In the short-run, as the central bank sought to cool the
economy, market rates might be raised above the neutral rate. Hence
the savings surplus would rise temporarily above its underlying level.
The exchange rate would rise and overshoot its new higher equilibrium
Driving Forces 89
level. Private capital exports would gain momentum, driven by the

speculative expectation of a subsequent depreciation of the national
currency back down to its (raised) equilibrium level once the economy
had cooled down to a normal temperature. The expected depreciation
would outweigh somewhat any interest rate advantage on the national
currency.
It might seem to the casual observer that the example of the over-
heating economy just given was another exception to the normal situ-
ation of capital exporting countries having relatively low interest rates.
But the economy is not in a stable state. Rather the strong momentum
of net capital exports despite relatively high interest rates would be
indicative of the economy being out of equilibrium, but on the road
back to stability. During the road back, there would be strong expecta-
tions of a subsequent move down of the national currency. And so the
relatively high interest rates in the capital exporting country described
here are a special example drawn from a disequilibrium situation of the
general principle discussed in the previous section. Strong exchange
rate expectations can break the one-to-one link between savings
surpluses and relatively low interest rates by global comparison.
How can we differentiate a rising trade surplus that is due to an
autonomous gain in export efficiency from one that reflects an endoge-
nously rising savings surplus? If the source were a rise in savings
propensity, then the currency would be tending to fall, along with real
interest rates (derived from market interest rates adjusted for inflation
expectations). If the source is growing export efficiency, then economic
overheating and a rising exchange rate would be more likely. The
actual size of the recorded savings surplus is little guide as to source. As
a matter of economic arithmetic (as we have seen already in Chapter 1)
the savings surplus equals the current account surplus. The question is
whether recorded savings are in line with equilibrium tendencies or
“forced”. Unanticipated inflation might be one mechanism producing
forced saving (via the windfall erosion of monetary assets’ real value
and households’ attempts to recoup this loss). Another mechanism
could be the non-availability of goods and services (meaning long
queues and waiting periods).
An imperfect example of the disequilibrium situation described is that
of China in 2004, when a rising current account surplus was accom-
panied by evidence of overheating. The example is imperfect because
the Chinese currency was at a fixed exchange rate, not floating, and
private capital outflows from China were heavily restricted. The argu-
ment put forward by many economic commentators was that the
Chinese currency (the yuan) should be re-valued or allowed to float

higher and monetary policy be tightened simultaneously. The essence
of their case was that the equilibrium level of the yuan’s real exchange
rate – consistent with both internal and external equilibrium of the
Chinese economy – had risen. The rise in interest rates (towards their
neutral range) would induce a higher underlying savings surplus and
currency appreciation would bear down on the export surplus. As the
two came into line (underlying savings surplus and export surplus)
inflationary pressures would subside.
A question of debate was whether in long-run stable state, China
would be in net savings surplus or deficit, and if surplus, how large?
Commentators who focussed on the likelihood of some fall-back in the
investment spending ratio from present speculative highs tended to
point to the possibility of a large savings surplus emerging. Then, from
a long-run perspective, the equilibrium level of the yuan’s exchange
rate in real terms might not be very different from its present (before
any appreciation) level and might even be lower (see for example
Bosworth, 2004). If the yuan were to shift to a floating rate regime,
then it might rise initially, and then subsequently fall. If instead it (the
yuan) were simply re-valued within an unchanged fixed rate regime,
then there might need to be a subsequent devaluation, once the equi-
librium level of the yuan fell. Evidence available in 2005 seemed to
back the commentators who focussed on the increase in China’s
underlying savings surplus, as inflation fell back and yet the current
account surplus soared to a new peak (over 6% of GDP).
One issue in the Chinese currency debate was the relevance of huge
foreign direct investment in the economy – with recorded inflows
running at as much as 5% of GDP in 2004. Much of this was in the
form of foreign companies perceiving opportunities in China that
local companies could not have exploited and the finance was most
usually in the form of cash from the relevant foreign head office. In
effect, the participation of foreign companies in China meant that the
frontier of domestic investment opportunity was pushed out beyond
where it would have been if only local companies had been players. If
China were a market economy fully integrated into the global
economy, that expansion of investment opportunity would have
mean a lower savings surplus, a higher neutral interest rate, and a
higher real exchange equilibrium level, than otherwise.
The fact that the direct investment was taking place via an injection
of foreign cash rather than via borrowing in the domestic credit
markets would not be a relevant consideration (to determining the
Driving Forces 91
equilibrium level of interest rates and exchange rates), as already dis-

cussed above in general principle (see p. 84). If the foreign companies
switched to borrowing in the domestic credit market (rather than
bringing in foreign cash) then there would be less capital outflows
from China in other forms (borrowing by subsidiaries of foreign com-
panies from domestic banks in yuan is categorized as a capital
outflow). In particular there would be stronger uncovered arbitrage
inflows of capital in the form mainly of Chinese companies borrowing
in foreign currency rather than yuan and less strong household sector
outflows into foreign money deposits (mainly in the Chinese banking
system). In terms of the capital flow data, an unchanged level of direct
investment inflows (the total is unaffected by how financed) would go
along with an increased total of foreign corporate borrowing from
Chinese banks and a decreased total of net lending abroad by the
Chinese household and corporate sectors combined.
If in fact there were a large savings surplus in China, with invest-
ment spending there running at a lower level than savings, and that
situation were to co-exist with large direct investment inflows (as
foreign companies preferred to bring in cash rather than deal in the
inefficient domestic credit market), then there would be such an excess
supply of savings in the domestic credit market that huge resident
capital outflows would be induced. The Chinese household and corpo-
rate sectors in aggregate, together with the Chinese government
(including Bank of China) would be huge net lenders abroad. That is
all on the assumption that exchange controls do not stand in the way
of the capital outflow.
Consider the situation instead where China is not fully integrated
into the world economy and where specifically exchange restrictions
prevent or inhibit the arbitrage type of capital flows just described.
Then the real exchange rate could indeed settle at a higher level as a
consequence of direct investment inflows being financed abroad rather
than locally (from Chinese banks). In the scenario of new direct invest-
ment opportunity emerging and this being financed in China – by the
relevant foreign subsidiaries borrowing from Chinese banks in yuan –
real interest rates would rise (in line with the fall in the saving surplus).
But there would be at most only a weak inflow of foreign funds to the
domestic credit markets to take advantage of higher rates there – as the
flow would be impeded by concerns about the non-convertibility of
the yuan and the possibility that today’s inflows might not be
redeemable. A particular concern might be the possible bankruptcy of
Chinese banks and the lack of any possibility of investing in yuan
outside the Chinese banking system. And the response of Chinese

private capital outflow (in so far as this could take place legally or ille-
gally) would be quite weak (in response to real interest rate change).
Chinese real interest rates would settle at a higher level, the real
exchange rate of the yuan at a lower level, capital inflows at a lower
level, and the current account surplus at a higher level, than in the free
market solution of a globally integrated Chinese economy discussed
above (where the channel of direct investment inflow – whether by
cash injection or borrowing from local banks – made no difference).
One form of direct investment inflow – foreign speculation in the
domestic real estate market – requires special consideration. This is not a
case of foreigners creating investment opportunity that brings about a rise
in the level of business or household sector capital spending relative to
savings. Rather it is a case of foreigners wishing to diversify their port-
folios into a new asset class (Chinese real estate). If China were fully inte-
grated into the world economy, increased foreign demand for Chinese
real estate would be largely matched by raised Chinese demand for
foreign assets. (Chinese investors would respond to the lower returns now
available on domestic assets by increasing their rate of diversification into
foreign assets). If there were any influence on the real exchange rate or
real interest rate level it would come from spill-over effects – such as
higher real estate prices stimulating increased construction spending or
higher consumer spending.
If by contrast Chinese capital outflows are restricted, then there is
potentially a much larger real exchange rate effect, but possibly less of
a real interest rate effect. For in this case, the capital inflows into the
real estate market must be matched to a greater extent by a fall in the
current account surplus. This comes about via yuan appreciation (in
real terms). And if the increased spending prompted by higher real
estate prices is not sufficient to bring about the matching fall in the
savings surplus, then real interest rates might even have to fall. In a full
analysis we would have to consider also the negative influence of yuan
appreciation on foreigners’ perception of direct investment opportun-
ities in China. A slowdown in direct investment inflows might play an
important part in accommodating the inflows into the real estate
sector, meaning less adjustment would be required in the savings
surplus (and the real exchange rate).
Some estimates suggested that in 2004 as much as 50% of the inflow
of foreign direct investment into China was in the form of real estate
speculation. The non-convertibility of the yuan resulted in their being
no safety valve of private capital outflows to relieve the yuan shortage
Driving Forces 93
in the foreign exchange markets. Hence directly the non-convertibility

of the yuan contributed to the underling imbalance in the foreign
exchange markets induced by large inflows into Chinese real estate
markets. The Chinese government in accumulating foreign exchange
reserves was in principle acting as a proxy for how a liberated private
household sector would have functioned.
4
Short Circuits
Ever since the great debates about German Reparations in the 1920s,
there has been an intermittent current of concern in the international
economic literature about whether under certain circumstances general
equilibrium in the global economy might be unattainable. Specifically,
could there be no combination of interest rates and exchange rates
(spot, forward, and expected) at which each and every major economy
would be in internal balance and where there would be a stream of net
capital flows between them (over time) in line with their respective
savings surpluses and deficits (with total net capital flows adding up to
zero) both in the present and in the future?
In the situation of the early 1920s when the Entente Powers imposed
reparation obligations on Germany, following its defeat in World War
One, Keynes made his famous claim that it was economically impossible
for the stipulated bill to be paid (see Keynes, 1919). “Only if it were pos-
sible to enforce a regime in which for the future no German drank beer
or coffee, or smoked any tobacco, might a substantial saving (necessary
to the payment of reparations) be effected”. Other economists, including
the Swedish economist Ohlin (see Ohlin, 1930) and the French econo-
mist Rueff (see Mueller, 2000), took a quite different view from Keynes,
claiming that he had overlooked all important income effects in his
analysis of the problem (the boost to income and so spending in the
countries which received the reparations and the converse in the paying
country).
Subsequently, in the mid-1970s, some economists claimed that the
new burden of payments imposed on the oil importing countries by
the OPEC cartel would mean permanent recession and physical con-
trols. Later still, in the mid-2000s, when the US economy slid into
huge current account deficit, there was a chorus of commentators
94
Short Circuits 95
claiming that the size of capital flows out of the savings surplus
countries into the US would be simply in some sense too large for
the normal market mechanisms to support. Economists employed
in the main supranational organizations (IMF, OECD, BIS) trum-
peted the view both in research papers and public pronouncements
that the US reliance on foreign capital inflows was now in the
danger zone where governments of all other countries in a similar
economic situation had been forced to slam on the emergency
brakes to prevent a slide into financial chaos (see for example,
Obstfeld and Rogoff, 2000; Edwards, 2004 and Freund, 2000). The
rest of the world could not be counted upon or indeed expected to
transfer capital to the US on the present scale.
The transfer problem defined

The historically continuing debate about possible breakdown in the
international economic order or national bankruptcy under the weight
of an external payments burden can be summarized under the title of
the “Transfer Problem”. Fritz Machlup, a renowned scholar of this
issue, defined the problem as follows (Machlup, 1964):
If a country undertakes to make very large payments abroad – for

military expenditures, subsidies, war indemnities, foreign aid, loans,
or investments – the question arises whether it will thereby exhaust
its reserves of gold and foreign currencies (or have its own currency
depreciate without a definite limit) or whether its trade balance will
adjust to the flow of capital and unilateral payments and thus
produce the international means of payment with which the foreign
commitments can be met. This in a nutshell is the transfer problem.
Machlup cites a range of historical examples, from Britain’s pay-

ments to its Allies during the Napoleonic Wars (1800–15), France’s pay-
ments of reparations to the newly founded German Empire after the
Franco-Prussian War (1871–5), German reparations after World War
One (1921–32), US aid transfers to Europe under the Marshall Plan and
towards re-armament in Western Europe following World War Two
(1949–55). Given the time of his writing on the subject (1950s and
60s), Machlup could not make any contribution to the issue of sustain-
ability of large private capital flows from the rest of the world into the
US in the mid 1980s or again in the late 1990s and first decade of the
2000s.
One distinction not made by Machlup is between the transfer

problem in the form of first, paying taxes (or other burdens) imposed
from without (by victorious allies, oil-cartels) and second, bridging
large divergences between savings rates or investment opportunities
internationally (an important factor behind the present huge capital
inflows to the US). In principle, though, these two variants of the
transfer problem pose different issues. With imposed burdens the ques-
tion is whether this might be simply too high – beyond the capacity of
the country, in some to-be-defined-sense, to pay. When it comes to
international private capital movements in pursuit of investment
returns, the question is whether market mechanisms crucial to sustain-
ing the flow can somehow seize up and stop working if the flow
becomes too large or if the monetary environment itself becomes
highly unstable.
A common thread through the discussion of both variants (of the
transfer problem) is the potential elasticities of substitution in produc-
tion and consumption between so-called traded and non-traded goods
and services. Net transfers out – whether in the form of private capital
outflows or reparations to victors – have to be matched by a surplus in
the production of traded goods and services over consumption of
these. If the elasticities (of substitution) are low, and the share of
traded goods and services in total production also low, then the capa-
city of a given economy to pay reparations might seem to be only a
small fraction of its total economic size (see Aliber, 2004 and Krugman,
1999).
Reparations re-visited
It is important to realize, however, that reparations burden is a liability
item which should be considered in stock (present value) as well as flow
terms. Providing international capital markets are functioning well and
various political or monetary dangers do not loom large, the burden
can be spread over a long period of time. Five years of heavy repara-
tions burdens can in effect be re-spread over 50 years or more, meaning
that the amount to be transferred in any year is only a fraction of the
annual sum under the reparations agreement (normally policed by the
actual or potential presence of a foreign occupying military force). That
is what in effect happened with respect to reparations obligations after
the Franco-Prussian War. The French government issued debt to effect
the payment. There was still full confidence in French monetary stabil-
ity, and France indeed remained long-term on the gold standard.
Short Circuits 97
France had gone through a civil war following the defeat (the suppres-
sion of the Paris Commune by the Republican forces), but that was
quickly over albeit at huge human cost.
The higher interest rates in France stemming from the government’s
demand for funds (towards paying reparations) attracted large amounts
of foreign capital (also from German investors). The cumulative surplus
in France’s goods and services trade to match the reparations paid
could be effected over a much longer period of time. In fact, in the pre-
World War One decades, France moved into huge savings and current
account surplus, with cumulative net capital outflows far exceeding the
amount of reparations imposed by Germany. (This was the era when
French investors accumulated vast holdings of Tsarist Russian bonds).
There was a prospect of the problem of German reparations in the
1920s eventually being solved in similar fashion to the earlier French
episode. The stabilization of the German currency under the Dawes
Plan (1924), the eventual final stipulation of the reparations burden,
and its spreading out over a period of decades (the Young Plan, 1929)
meant that in principle the size of the transfer in any year would surely
be small. And the Bank of International Settlements had been set up in
Basel (1930) for the express purpose of taking the political sting out of
paying reparations. In future debt servicing (related to the Young loans
and Dawes loans) of issues made to finance transfers was to be effected
through a supranational bank in a neutral country.
The ultimate problem of German reparations was not that Germans
had to stop drinking beer (or in more technical terms that trade elastic-
ities were too low) but that as credit and political risks increased in
Germany from 1929 onwards (the Nazis became the second largest
party in the Bundestag in 1930) and the US appetite for foreign assets
shrank following the Wall Street Crash, the market mechanisms essen-
tial to large net global capital flows were no longer sufficiently robust
to spread out the reparations burden through time. Indeed, in 1930–1,
Germany suddenly had to redeem a mass of foreign credits which were
not being renewed, leading eventually to a payments crisis and effec-
tively default (not just with respect to reparations, which were can-
celled in 1932 by agreement, but also with respect to foreign private
creditors).
Some historians have pointed their finger at the inappropriate
exchange rate regime in explaining the German payments debacle (see
Brown, 1986). If the Reichsmark (the name of the German currency in
the inter-war period and until its replacement by the Deutsche mark in
1948) had been freely floating or adjustable, then a timely depreciation
of the currency in 1928–9 might have jump-started a renewed inflow

of capital and also stimulated the transfer of resources into the traded
goods and services sector of the economy. Foreigners would have been
attracted to German assets by the mark’s cheapness and the prospect of
a subsequent re-bound. Other historians have claimed that so recent
was the experience of the hyperinflation (1920–3), that a floating of
the Reichsmark or its devaluation in 1929 would have been the catalyst
to an even more intense flight of capital from Germany (on the
perhaps irrational fear that the German government would again resort
to the printing press to finance its deficits). In any case, we can see
from this example that the transfer problem cannot be discussed in
isolation from the monetary and capital markets context or from the
currency regime in force.
In principle, if the reparations problem is considered within the
context of a gold standard system in the survival of which there is total
confidence and where credit or political risks are low, then the poten-
tial to spread the burden out through time is very large. The amount of
real exchange rate adjustment (fall in the national price level relative
to that abroad) required, such as to generate a trade surplus equal to
say the perpetual annuity equivalent of the present value of the repara-
tions obligation over a term of several years, might be modest only. By
contrast, where the reparations problem – or equivalent – is within the
context of a freely floating currency regime, the amount of possible
spreading out through time could be less. Exchange risk might mean
that foreign lenders would require a greater rate of return. Some of this,
however, could come from the currency (of the country paying repara-
tions) undershooting its eventual equilibrium level, meaning that
investors could look forward to some appreciation. Early on in the
process (of paying reparations) the amount of cumulative real depreci-
ation and trade surplus (to date) under the floating exchange rate case
would be greater than under the gold standard case. The amount of
economic waste, however, under the floating case might be less, if the
process of achieving even a small real depreciation (deflation of the
domestic price level) under the gold standard system means a long
period of economic slack.
Post-oil shock transfer problems

In the contemporary world, the currency regime is a floating exchange
rate system, at least as regards the major currencies issued by the
advanced industrialized economies (US dollar, euro, Japanese yen,
Short Circuits 99
British pound, Canadian dollar, Swiss franc). The example quoted

sometimes as nearest to the reparations issue are the periodic attempts
of the OPEC cartel to levy tax on the rest of the world. There are,
however, important differences. OPEC’s power to tax is not based on
military force but on ability to organize a multilateral reduction in
members’ output and to limit exploration and development of oil (or
gas) resources (in cartel countries). The oil consuming countries can
take measures to avoid the tax – in particular by creating stimuli (in
addition to the OPEC price action) to reduce domestic oil consumption
and increase domestic production of oil and oil substitutes (for
example, natural gas).
The cartel’s power is based on an inherent instability. Any one
member can gain from cheating on the others (by producing in excess
of the quotas agreed), or by secretly increasing investment in future
production capacity. But if all cheat the cartel collapses. By contrast,
victorious allies can send in armies of occupation to seize national
assets or resources in pursuance of their claims. Even so, the history of
German reparations – in particular the Ruhr occupation of 1923 –
shows that victor power has its own limits. The OPEC countries are
themselves very small (in economic size) relative to the combined
economies from which they are seeking to raise tax – the opposite situ-
ation to the coalition of Allies seeking to extract reparations from
Germany (in the 1920s).
OPEC denominates its tax demands in the currency of the largest
payee (the US) and invests its surpluses in a basket of currencies from
the major paying countries (amongst the advanced economies), includ-
ing most prominently the US dollar. Hence, early on following an oil
price jump, when the OPEC nations are largely saving their new wind-
fall, they effectively lend tax payments back to those oil importing
countries which issue international investment currencies, meaning
they (the latter) face no immediate external imbalance. The historical
tendency is for the OPEC countries to eventually spend most of their
tax revenues on goods and services from the oil-importing countries,
meaning that the income effect stressed by Ohlin and ignored by
Keynes in the debates of the 1920s is very important in this case.
The practical limit to the oil importing countries’ capacity to pay oil tax
is not the elasticity of substitution between traded and non-traded goods
(or less technically, their ability in aggregate to shift production into
exports to OPEC and consumption away from goods and services
demanded by OPEC). Instead, the short-run limit is set by the possibility
of world economic slump (caused by energy shock undermining business
and consumer confidence and spending power), in which OPEC’s total

tax-take would decline despite a sky-high price. And the long-run limit is
set by the scope for substitutions in production and consumption in the
oil-importing countries away from OPEC’s oil.
The closest analogy between the OPEC cartel levying tax and
Keynes’s account of the Entente Powers imposing reparations on
Germany is with respect to those oil-importing countries whose own
sovereign money plays no international role (and is thereby not sought
by OPEC investors) and whose economies produce hardly any goods
and services sought by OPEC. Such economies, in the face of oil price
shock, might well experience a substantial rise in their interest rate
level and a fall in the real effective exchange rate of their currencies.
The depreciation stimulates production of traded goods and services
(in which these economies are specialized) and curbs domestic con-
sumption of traded goods and services in general – meaning that the
given economy will increase its net trade surplus with other oil import-
ing countries which are in turn better placed to gain from OPEC’s
increased demand for goods and services (or from OPEC’s demand for
particular asset-types). (By contrast, for example, exchange rate adjust-
ment plays no major role in the adjustment of say the euro-area and
the US to oil shock, unless there is a serious asymmetry in their depen-
dence on energy imports or in their ability to supply OPEC markets
with goods and services, or in the popularity of their respective curren-
cies with OPEC investors).
It is possible that in the short-run following an oil shock the most
disadvantaged economies as described could not effect the raised
amount of tax payments to OPEC at a level of oil consumption any-
where near its pre-shock level. Even at a very devalued level for their
currencies and a higher level of domestic interest rates, capital inflows
would not be forthcoming in sufficient extent (to effect the payments).
Thus there could be short-run economic dislocation in which external
balance would require interest rates rising well above their long-run
neutral level and the exchange value of the national currency falling
far below its long-run equilibrium level. The economy would pass
through a period of slump.
Zero rate boundary as obstacle in solving transfer problem

In general, though, the differences between the analysis of OPEC cartel
shock and reparations are so significant that it is best to consider them as
highly distinct examples of the transfer problem and how that is solved
Short Circuits 101
in particular instances. As such both examples (of the transfer problem)

can be used to demonstrate a potential flaw in the process of market
adjustment. This flaw can also be found sometimes in the case of adjust-
ment to large changes in savings surpluses or deficits that are endoge-
nous rather than induced by an exogenous event (reparations demands
or oil shock, for example). The flaw stems from the impossibility of the
real rate of interest falling to significant sub-zero levels in a conventional
monetary system where inflation is very low or even negative (deflation).
Take the case of reparations. In the country paying the reparations,
national savings have to increase as the counterpart to the generating
of the export surplus (out of which payment is made). This (the rise in
savings) may occur via an increase in interest rates or through a swing
of the national budget into greater surplus (or smaller deficit) before
taking account of the reparations amount. There must be a counterpart
fall in savings surpluses (or increase in savings deficits) elsewhere in the
world, particularly in the countries that are receiving the reparations
payments. In a market economy that fall in savings would come about
through some combination of a decline in interest rates and an
increase in the budget deficit (before taking account of reparation
receipts in the case of recipient countries).
Of course it is possible that in the new equilibrium (after imposition
of reparations) the savings surplus in the paying country might have
risen by less than the amount of reparations and the savings deficit in
the receiving countries might have increased by less than the repara-
tions received, with global capital flows bridging the gap. The receiving
countries would be net lenders and the paying country a net borrower.
This would correspond to the case of where the net cash outflows gener-
ated by reparation obligations are spread (via international borrowing)
over a longer period than the legal term.
It may be, however, that the zero rate barrier (the fact that nominal
interest rates cannot fall below zero in a conventional monetary
system) means that an equilibrium situation cannot be reached.
Market interest rates in the recipient countries might not be able to fall
far enough to be equivalent to the very low neutral level (often nega-
tive) in real terms (in some recipient countries) at which all countries
(payer, receiving and all others) would be in full internal and external
equilibrium. The result would be a long-run disequilibrium situation in
which interest rates in the paying country had to remain well above
neutral levels, meaning depressed economic conditions there. In turn,
that weak economic situation in the paying country might add to
political risks there, intensifying its economic disequilibrium.
In the example of oil shock, where the OPEC cartel suddenly

restricts output to push up prices, there is likely to be a sudden (prob-
ably only short-run) rise in the global propensity to save. In the oil
importing countries households may reduce their savings with the
intention of cutting back their non-oil consumption by considerably
less than the full extent of the increased payments of oil tax (to the
OPEC cartel). But in the OPEC countries themselves the initial spend-
ing out of the oil tax receipts might be very low – and so their desired
savings level rises by more than the counterpart fall (of desired
savings) in the oil importing countries (measured in total aggregate
terms). In that situation the average neutral level of interest rates in
the world economy would fall – in some areas (for example countries
whose currencies are the main investment vehicle of the OPEC coun-
tries) perhaps to below zero in real terms. And so the global economy
in the aftermath of an oil shock might not be able to reach a new full
equilibrium (if indeed in important areas the zero rate boundary
combined with no inflation or deflation prevents the emergence of
negative or even zero real rates).
5.0
OPEC current account balance as % of US GDP

4.0
3.0
2.0
1.0
0.0
–1.0
–2.0
74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04
Figure 4.1 OPEC countries – current account balance, 1974–2004 (as % of US

GDP)
Short Circuits 103
In the longer run, as OPEC nations start to spend a higher propor-

tion of their revenues, and the average level of neutral rates (in real
terms) in the global economy rises, a full equilibrium might again
become feasible. In fact in the 1st and greatest oil shock of 1973–5 real
interest rates on several major currencies fell to highly negative levels
as this was possible in the context of the then double-digit inflation
rates. (See Figure 4.1 for the history of the OPEC surplus during this
and subsequent periods).
Impairment of global adjustment to raised savings surplus

The more general example of the zero rate barrier acting as an impedi-
ment to international economic equilibrium is the situation of an
endogenous fall in the savings deficit (or rise in savings surplus) in an
important area in the world economy unmatched by a simultaneous
opposite shift in savings balances elsewhere. (Note that endogenous
means that the pressure – in this case on savings – comes from within
the economic system, not from outside as in the case of OPEC cartel
action or reparations demands). This means that the average equilib-
rium level of interest rates in the world economy declines and the
neutral rate might move into sub-zero territory in at least one impor-
tant centre. Some examples from recent economic history can usefully
demonstrate the problem.
First, there is the illustration from Japan’s Lost Decade, in the after-
math of the Crash of the Great Bubble Economy in 1990. It was not
immediately nor even with a small delay realized by policy-makers or
markets that there had been a big increase in the underlying private
sector savings surplus in the Japanese economy. (The rise in surplus was
due to first, greater caution in consumption by households as their
wealth shrank and optimism on future income growth diminished and
to second, a perception of diminished investment opportunity in the
business sector). Hence market rates remained far above (what we now
know to have been) the new sunken level of the neutral interest rate at
which the Japanese economy could have reached internal and external
equilibrium (see Figure 4.2). The reputation of bond markets as vigi-
lantes against inflation did not carry over to being vigilantes against
deflation. And central bankers knew no better.
The result was that a deflationary process got under way and when
much later (1998) a substantial body of opinion both in the market-
place and amongst policy-makers viewed the new equilibrium level of
real rates as probably far below zero, there was no possibility (by then)
9.0
JGB 10-yr yield
8.0
Japanese overnight call rate
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
90 91 92 93 94 95
Figure 4.2 Japan – JGB 10-yr yield vs. overnight rate, 1990–5
under conventional monetary policy of market rates (expressed in

nominal terms) falling to a low enough level (sub-zero) to bring that
outcome about. By the time of Japan’s second post-bubble recession of
1997–8, nominal money market rates had fallen close to zero, but in
real terms, taking account of deflationary expectations, these were at
significantly positive levels.
With the stream of capital outflows from Japan thereby weaker
through most of the 1990s than what would have been the case if real
interest rates had been at their significantly negative neutral level, the
current account surplus was also less than the surplus (both current
account and savings) which the Japanese economy would have run if
in full internal and external equilibrium. The yen was well above the
level which would have been consistent with that full equilibrium, and
its elevated value was a key factor in depressing the current account
surplus. In effect the Japanese economy reached a stationary disequi-
librium or a Keynesian-type under-employment equilibrium in which
the actual savings rate was below equilibrium level in part because
aggregate national income was far short of full productivity potential
and so Japanese households reduced their current saving in the
attempt to maintain real living standards.
Short Circuits 105
Suppose markets and policy makers had more promptly recognized

the fall in the neutral level of interest rates in the Japanese economy
following the Crash of the Bubble Economy. With inflation still at a
positive level a prompt fall of market rates to very low levels would
have been equivalent to a real rate of zero or even sub-zero. There
would have been a pair of interest rates and exchange rates (both well
below those observed in practice during the period say 1991–4) at
which the size of capital outflows, equal to the savings and current
account surplus, would have been much above observed levels in line
with substantially higher (than actual) economic output. Lower inter-
est rates and the lower exchange rate would have stimulated aggre-
gate demand, whilst the raised level of the export surplus (reflecting
the cheaper yen) would have matched strong capital outflows (driven
by ultra-low interest rates in absolute terms and relative to those
abroad).
It is possible, even so, that the underlying savings surplus in the
Japanese economy had risen so far, that in the immediate aftermath of
the Crash (1991) the equilibrium level of yen market rates in nominal
terms had already fallen below zero, within the context of the currency
regime in place (a floating yen). In principle there might have been a
low level of the yen at which zero nominal interest rates could have
been consistent with internal equilibrium (aggregate demand, includ-
ing net exports, equal to the then productive potential of the Japanese
economy). But external equilibrium might have been impossible even
at a zero or very low positive nominal level. The large savings surplus
might not all have flowed out into foreign assets (with the yen so
cheap) as Japanese investors feared an eventual bounce-back of the yen
were the economy to regain the path of prosperity.
Investors might also have factored in some long-run tendency for
the yen to appreciate on account of a rising investment income
surplus. (It is possible, though, as we shall discuss more fully in the
next chapter, for a rising income surplus to be consistent with long-run
stability or the exchange rate rather than currency appreciation). More-
over a barrage of protectionist pressure from Washington and the con-
tinually broadcast simplistic (and wrong) analysis from the then Bank
of Japan Governor, Yasushi Mieno (see Brown, 2002), that a big current
account surplus meant inevitably a higher yen, might also have curbed
the potential momentum of capital outflow. In sum, the zero rate
barrier might already have been effective in the early 1990s, even if
monetary and market opinion had been more astute. That would have
meant full global economic equilibrium was not possible under the
currency (floating) and monetary (no possibility of negative nominal

interest rates) regime in place.
Short-circuit in global capital flows, 2000–4

A second case-study from the laboratory of history regarding the impli-
cations for global and country equilibrium of an endogenous jump in
savings surplus (or fall in savings deficit) comes from the bursting of
the worldwide technology bubble and of the US economic bubble in
2000. Private sector (household and business sectors combined) savings
propensities rose and investment propensities fell throughout the
globe, but most of all in the US economy. In the absence of any fiscal
policy change, the neutral level of US rates would surely have fallen
relative to that abroad, and the dollar’s equilibrium international value
would have decreased.
Aggregate demand in the US economy would have been stimulated
by the fall in interest rates and by the dollar’s depreciation. Capital
inflows to the US would have moderated in line with the shrunken
rate spread in the dollar’s favour. Reduced capital inflows would have
been consistent, indeed, with the fallen current account deficit and
savings deficit. There could have been internal balance in the major
foreign economies brought about by a decline of interest rates, albeit
less than in the US, offset only in part (in terms of effect on aggregate
demand) by the drag from the external sector (reflecting the weaker
dollar).
The savings surpluses outside the US would have fallen in line with
lower interest rates (in that the increase in savings propensities was less
than in the US and thereby more than offset – in terms of actually real-
ized savings levels – by the decline in rates). Matching the lower
savings surpluses (outside the US) would have been a reduced momen-
tum of capital outflow to the US (consistent with the shrunken rate
disadvantage of the savings surplus currencies).
Given, however, that Japanese money rates were virtually at zero
before the US bubble economy and the world technology bubble burst,
and the Japanese price level was falling, all the adjustments just
described could not take place. Moreover, the European Central Bank,
established only in late 1998, was not inclined to cut money rates in
line with neutral rates, given that inflation was still above target and its
reputation could suffer lasting damage from an early failure in achiev-
ing this. The narrowing of the average rate spread (across the major
international monies) in favour of the US would be greater than in the
Short Circuits 107
equilibrium solution described above in that yen rates could not fall in
real terms or nominal terms (and euro rates were being held high).
It is possible that in 2001 the US neutral rate even in nominal terms
could have turned negative with the Japanese neutral rate even more
negative. Given market rates in both cases stuck at zero (unable to fall
to the respective sub-zero levels), the spread between them would have
been well below the spread between the hypothetical neutral rates. In
consequence the yen would be above and the dollar below the level
consistent with global economic equilibrium. The cheap dollar (com-
pared to full equilibrium level) would most likely have meant that the
US economy could be nearer internal equilibrium than the Japanese
economy (saddled with an above equilibrium value of its currency).
In practice, the analysis must be qualified by the observations that
first, the yen itself had been in a bubble market during 2000 (see
Figure 4.3), gaining from huge foreign inflows into the overheated
Tokyo equity market and speculation on a bizarre tightening of
Japanese monetary policy which did indeed get off to a brief start
before being quickly reversed. Second, the big easing of US fiscal
1.4
EURO/USD
1.3
100 Yen/USD
1.2
1.1
1.0
0.9
0.8
0.7
99 00 01 02 03 04 05
Figure 4.3 Exchange rates, US$ vs. yen and euro, 1999–2005
8.0
10-yr conventional yield

7.0
10-yr inflation linked yield
6.0
5.0
4.0
3.0
2.0
1.0
98 99 00 01 02 03 04 05
Figure 4.4 US Treasury Bonds – conventional vs. inflation linked yield
policy which took place in 2001 under the new Bush Administration
may well have helped to keep the neutral level of US rates just above
zero (in nominal terms).
In any case, a main difference between the hypothetical post-bubble
scenarios described above and what actually happened was the long lag
in US money and bond yields coming down to near the new sunken
level of neutral rates. As in the earlier Japanese example, the monetary
authorities and the bond markets were slow to appreciate how far
neutral rates had fallen. In Summer 2001 (July and August), almost
three quarters of a year after the recession started, federal funds rate
still averaged 3.70%. It took the terror attacks on the US (September
11) to catapult the Federal Reserve into a bold easing of policy, with
federal funds rate falling to 1.75% by end-2001. Only in Spring 2003
did the Fed funds rate reach its cyclical lowpoint of 1% – just at the
time when we now know that the US economy had entered a growth
cycle upturn (a period of above-trend growth).
Private capital markets were not more perspicacious about realizing
promptly after the bursting of the bubble economy that the neutral
rate of interest for the US economy had fallen far. The yield on 10-year
indexed bonds was still at 3% in early 2002, falling to around 1.5% for
Short Circuits 109
3.0 8.0
US core* private consumption

deflator (YoY)
2.5 10-yr US dollar swap rate (RHS) 7.0
2.0 6.0
1.5 5.0
1.0 4.0
0.5 3.0
99 00 01 02 03 04 05
Figure 4.5 US inflation vs. swap rates, 1999–2005

* core measure PCE: all items less food and energy
the first time only in early 2003. Ten-year swap rates were still at
around 5.5% in early 2002, falling to 4.5% and even lower a year later.
(see Figures 4.4 and 4.5). Consistent with these long lags, it was not
until 2002 (onwards) that the dollar depreciation occurred which was a
key component of our hypothetical post-bubble scenario above. There
is obvious similarity with the perverse rise of the yen in the immediate
aftermath of the crash of the Japanese economy in 1990, also related to
delayed realization (by both markets and the monetary authority) of
the extent to which neutral interest rates had fallen.
The process of dollar depreciation got a fillip from the so-called
Bernanke monetary shock of Spring 2003. (Immediately after the top-
pling of Saddam Hussein, when financial markets were already opti-
mistic about a US economic re-bound, Federal Reserve Governor
Bernanke became the lead architect and spokesperson of a new
expansionary direction in monetary policy). Some critics would say
that belatedly the FOMC became aware of the extent to which the
neutral level of US rates had indeed fallen and realized that past over-
estimation (of the neutral rate) had resulted in the inflation rate
falling to a dangerously low level below 1% p.a. (dangerous because

that left little or no safety margin for the aggressive use of monetary
policy – involving substantially negative real rates – in the next
economic downturn).
In any case, the US Federal Reserve in Spring 2003 resolved to
breathe a somewhat higher rate of inflation into the US economy by
cutting rates to below neutral (wherever that might be). According to
the judgement of FOMC members a 1% Federal Funds rate was most
likely below neutral and putting some upward pressure on the inflation
rate. Subsequent events seemed to validate that judgement, even
though some contemporary critics argued that the FOMC was now
engaged in overkill and a period of higher-than-desirable inflation
would be the result.
With US rates finally (2003) down below (most probably) their
sunken post-bubble neutral rate, but foreign rates still above neutral,
global private capital flows out of the savings surplus countries and
into the US largely seized up. The neutral rate of interest in real terms
in Japan, for example, was surely below that in the US. In a hypothet-
ical equilibrium scenario, if nominal rates could move to negative
levels, then Japanese money rates might have been at –2%, US rates
at 1%, and say euro rates at 0 or below. At those spreads capital
would have continued to flow out of the savings surplus countries to
the US, albeit at a lesser momentum that in the bubble economy
years. Instead, Japanese rates were stuck at zero, whilst the ECB
fretted about inflation still above its 2% target and protested that in
the new world of European Monetary Union there were no grounds
for monetary policy in Europe to bend before the might of the
Federal Reserve. In fact, euro-central bankers were outspoken in their
view that the FOMC was making a big inflationary mistake which
they had no intention of following.
In Japan, long-used to the policy issues concerned with the zero-rate
boundary to monetary action, there was a response to the decline of
US rates towards neutral and below (in Spring 2003). The decrease in
momentum of private capital outflows (from Japan) as US rates fell
towards Japanese rates meant that the yen came under strong upward
pressure. A disequlibrium outcome threatened, in which the yen would
have to rise high enough to bring the current account surplus down to
the low level of private net capital exports out of Japan (held down by
the decline in US rates and the above neutral rates on yen). The climb
in the yen would intensify domestic deflation as interest rates could
not fall so as to stimulate domestic demand.
Short Circuits 111
The spectre loomed of Japan descending into a more severe under-

employment equilibrium in which private savings would indeed fall
into line with the shrunken current account surplus – due to depres-
sion of national income far below productive potential. To banish that
spectre, Japanese policy makers resolved on a program of massive
foreign exchange intervention for which the theoretical justification
was the near paralysis of private capital outflows under contemporary
conditions of ultra-low US rates and where yen rates could not fall to
negative levels. Japanese policy-makers of course did not present
nor wholly perceive their policy in this way. Rather Tokyo’s currency
diplomats defended intervention as designed to smooth out excessive
volatility and resist perverse movements in currency values.
An alternative way of presenting Japanese foreign exchange policy at
that time (2003) would have been to set a target for foreign exchange
reserve accumulation over the next few years, with clearly defined cir-
cumstances in which the pace of build-up would be reduced or
increased. These circumstances would include the rate of deflation in
Japan. Hence if deflation came to an end, and the neutral rate of inter-
est (in nominal terms) on yen again became zero or positive (rather
than sub-zero), then the zero rate boundary would disappear as an
obstacle to the Japanese economy attaining internal and external equi-
librium. A big rise in US interest rates would be another circumstance
(in which the target for reserve accumulation would be reduced), in
that the corresponding neutral rate of interest in Japan might then rise
above zero. (The momentum of capital outflow from Japan would rise
and so there might be a depreciated value of the yen together with a
positive yen interest rate at which the Japanese economy could reach
internal and external equilibrium).
The principle behind the intervention (foreign exchange reserve
accumulation), from the Japanese viewpoint, was that when market
mechanisms are not functioning (due to zero rate boundary) a
second best situation (compared to the first best of the market mech-
anism working) is to proxy the capital outflows which would have
taken place. Of course there are no hard estimates as to the extent of
capital outflows which would have taken place in such circum-
stances – and margin of discretion, susceptible to international nego-
tiation (in particular between Tokyo and Washington) – becomes
possible.
In fact, given the excellent relations between the Koizumi govern-
ment and the Bush Administration, there were no significant interna-
tional constraints on Japanese intervention policy. And that was
despite the adoption of the slogan at the Dubai G-7 summit (Autumn
2003) calling for Asian currencies to become more flexible and by
implication for intervention operations to be wound-down. But Japan
had long been a special case, with the problems of deflation as a con-
straint on Japanese monetary policy options well understood in
Washington. (see Lindsey, 1999). Suppose, however, in the situation of
very low US rates and the Japanese neutral rate in nominal terms still
below the zero rate boundary, Tokyo had indeed decided to heed the
Dubai slogans and freely float the yen (meaning no foreign exchange
market intervention at all). Was there any way of preventing short-
circuits in the global flow of capital of which one symptom would be
an upward spiral of the yen?
Can monetary base policy prevent short-circuits?

Some monetary economists might (and did!) hypothesize that an
aggressive expansion of Japan’s monetary base (or more broadly
high-powered money), even with interest rates stuck at the zero
boundary, could provide relief (from short-circuit). If the rapid
expansion of high-powered money (monetary base plus currency in
circulation) indeed helped to convince the Japanese public and
market opinion generally that deflation would soon end and indeed
be succeeded by some inflation, then the real (medium-term) interest
rate level which corresponds to zero nominal rates would fall,
perhaps even into a sub-zero range. The result would be a stimulus
to the outflow of private capital and the Japanese economy would
avoid being pushed as far into a Keynesian-type underemployment
equilibrium with an overvalued currency.
The key theoretical issue is whether high-powered monetary expan-
sion with rates already stuck at zero is indeed effective in pushing up
aggregate demand. Otherwise the hypothesized effect on expectations
would simply be a case of the Emperor’s New Clothes. The main poten-
tial channel is via asset prices. Suppose as illustration the Bank of Japan
were to target an expansion of monetary base (defined as deposits at
the Bank of Japan plus currency in circulation) over the following year
equivalent to 10% of GDP, and used this to buy some combination of
equities and foreign currency assets. (In terms of the amounts out-
standing in 2005 this would mean a more than doubling of deposits at
the Bank of Japan). Then net present holders of these assets (equities
and foreign currency) would have to be induced out of them into yen
monetary base (or yen deposits with Japanese commercial banks which
Short Circuits 113
are matched by bank deposits with the BoJ). (Of course, there can be
many turntables along the way, so it is not the person who sells
the foreign assets who has to hold yen money, but someone else down
the chain of portfolio adjustment). The induced shifts would require
that foreign currency and (Tokyo) equity rise in yen value – and both
developments would help stimulate the economy.
There is a second potential channel (between monetary base
expansion and aggregate demand in the economy). Banks able to
borrow zero rate funds in the interbank markets or wholesale money
markets might seek to impose a higher rate of charges on retail cus-
tomers (with respect to cash withdrawal, transfer, and account main-
tenance services). Effectively the retail rate of interest would become
more negative. In response, retail customers would reduce the
amount of bank deposits they hold in favour of more cash under the
mattress or elsewhere. This switch in their portfolio composition
might induce a higher rate of spending on goods and services.
Japanese experience, however, suggests that banks are very reluctant
to increase charges significantly. Perhaps they reckon that the large
marketing costs of regaining customers lost during the period of zero
rates would outweigh any present savings. And the elasticity of
demand for cash on the part of the public might be very large with
respect to an increase in charges. Then any significant rise (in
charges) across the banking industry could trigger a run on the
banks and bring into question their credit-rating or even survival. A
systemic crisis could erupt.
The third potential channel from monetary base expansion is its
influence on wider money supply aggregates. Even if we accept the
pessimistic hypothesis that the multiplier could be one or less (and
indeed the levying of charges by banks and induced cash with-
drawals would mean less than one) a huge expansion of monetary
base could lead to a significant increase in money supply for a given
year. As illustration, if in 2003–4, the Bank of Japan had pushed
deposits with itself up to ¥60tn rather than stopping at ¥30–35tn,
then maybe for a year at least wider money supply growth (M2+CDs)
would have been 4% rather than 2%. If the demand for real money
balances in Japan were a stable function of a few well-defined real
variables, then the money supply acceleration could indeed have
had an influence on the price level. But Bank of Japan experts and
most outside economists (for an exception, see Hetzel, 2003) were
convinced that no such stable demand exists in the contemporary
Japanese situation.
A negative interest rate regime

In Japan the experience with a policy of aggressive monetary base
expansion at zero rates has been judged unfavorably by many critics.
There is much scope in particular, to argue that the implementation of
policy could have been bolder and that then swifter results would have
followed. Boldness would have included huge and persistent (rather
than intermittent) use of foreign currency purchases towards stimulat-
ing monetary growth. Without that element, boldness just in terms of
rapid monetary base expansion achieved via traditional domestic asset
purchases (including long-term bonds and bills) most probably would
not have been sufficient under the given circumstances (characterized
by the neutral rate of interest below zero in real and nominal terms).
Policy implementation under conditions which excluded foreign
exchange purchases by the Bank of Japan (a free float of the yen) might
well have to include the use of non-conventional tools. One possible
step to accompany a free float of the yen would have been a negative
interest rate regime as described originally in The Yo-Yo Yen (Brown,
2002).
Under this proposal the Government of Japan would announce that
so many years from now, say five years, yen banknotes will be con-
verted into new notes, with a conversion rate of say 1000 old = 900
new. In the interval, the 1:1 convertibility of yen banknotes into yen
bank deposits would be suspended, and a sliding schedule of conver-
sion rates be set instead. As illustration, the conversion rate would be
1000 yen notes = 1000 yen deposit at the start and moving gradually
down, week-by-week or month-by-month, to around 1000 notes =
980 deposits at the end of the first year, 960 deposits at end of second
year, and so on until 900 deposits at the end (of the 5-year period).
There would have to be some fixed small charge on conversions
around month end (or more simply all the time) to prevent arbitrage
by the public in the form of putting notes into their deposits just
before the next downward adjustment in their value took place and
then taking them out at the start of the new month.
The gradual slide in the value of yen banknotes would eliminate the
usual constraint to money market rates falling below zero – in the form
of the public avoiding them by withdrawing cash, and this in turn pre-
cipitating a banking crisis. So long as the negative interest rates are
higher (less negative) than the rate of depreciation in the banknotes,
no arbitrage is possible (in the form of converting deposits into cash).
The central bank would be able to steer money rates anywhere above
Short Circuits 115
that lower negative limit (the rate of depreciation of banknotes).

Deposits held by the banks with the central bank would earn interest
at a negative rate, equal to the depreciation rate of banknotes. With
money rates now able to fall to negative levels (meaning that long-
term bond yields could also fall closer to zero), the economy (in this
case Japanese) could reach external and internal equilibrium even
under circumstances of very low US nominal rates.
Despite its apparent attractions, the regime of negative interest rates
remained a political non-starter in Japan through its years of recession-
ary deflation. There has been an array of objections.
First, with the banks unpopular, how could politicians persuade the
public that negative rates were not some backdoor method of bailing
out the banks – allowing them to accelerate at no cost to themselves
(in terms of the conventional profit and loss account) their write-off of
bad loans made in the past. And indeed negative rates would have
helped towards reducing this legacy more quickly.
Second, small savers with most of their assets in the form of bank or
postal savings deposits would be penalized to a greater extent than
wealthier investors with large holdings of equities and foreign currency
assets (which would jump in yen value as soon as the change of regime
to negative rates became a publicly aired possibility). There could be
some offset here, though, from a recovery in residential real estate prices.
Third, there would be the complex issue of adjustment to the new
regime (of negative interest rates and floating exchange rate between
cash and deposits) by the retail sector, where cash transactions are
especially important. (Banknote exchange would also present special
problems in the grey and black areas of the Japanese economy – albeit
that the substitution of dollar banknotes could ease these). In particu-
lar there could be considerable costs in re-tuning frequently cash
vending machines and automatic teller machines (ATMs) (deposit bal-
ances would be debited by less than the amount of yen cash with-
drawn). In order to cover themselves against these costs, retailers could
mark up prices (in terms of banknotes) by more than the underlying
conversion rates would suggest, and this would be unpopular. In some
areas of the retail economy there would be dual pricing – one price for
cash and one for cash for other means of payment.
Fourth, there are the non-trivial security costs at the end (after five
years in our example) of the operation of exchanging large stocks of
banknotes. As comparison, these were estimated at as much as 1% of
GDP in the case of converting the European sovereign banknotes into
euros.
When short-circuits force abandonment of currency free float

If indeed we were to conclude that a negative interest rate regime is
not politically feasible, and that aggressive monetary base expansion
at zero rates has only limited scope to influence aggregate demand or
capital flows, then a free float of the yen in the situation described (of
sub-zero neutral rates) would be a costly policy option. Is there a
better alternative option than discretionary and potentially large-scale
foreign exchange intervention? In particular, would there be advan-
tage in formally fixing the yen-dollar rate? The same range of ques-
tions apply to any situation of potential short-circuit in the global
flow of funds due to the constraint of zero rate bound to monetary
policy under conditions of deflation.
Another type of short circuit in the global flow of capital could be
imagined as follows. Suppose the underlying US savings deficit were to
narrow from its high level of the 2004–6 period, putting downward
pressure on the neutral level of US rates. Suppose further there were no
simultaneous autonomous fall in underlying savings surpluses else-
where in the global economy. Then the average neutral rate in the
global economy would fall. The neutral rate in some foreign (non-US)
savings surplus countries (in addition to Japan) could dip below zero.
Market rates above neutral (in those particular savings surplus coun-
tries) would mean their currencies (of those same countries) were
above equilibrium value and the respective economies would fall into
varying degrees of slack (recession or depression).
The attraction of the fixed exchange rate solution to the problem
just illustrated (of market rates stuck above sub-zero neutral rates) is
that it allows the savings surplus country (of small or medium-size) to
move to a higher (zero or above) neutral rate than under the floating
rate regime and so to attain potential full external and internal equilib-
rium – subject to its change of regime not being important enough in
the global economy to also pull the US neutral rate below zero! For in
the fixed exchange rate regime, the neutral level of rates (in nominal
terms) in the given country is the same as in the large country (or
group of countries) whose currency (in our example, the US dollar) is
used as peg.
An advantage of regime change as a solution to the problem of sub-
zero neutral rates (in nominal terms) is that the given country leaves
itself less open to the charge of currency manipulation. In principle, a
savings surplus country which switches to a fixed-exchange rate regime
in response to a potential short-circuit in the global flow of funds
Short Circuits 117
(brought about by fall of its neutral rate level in the context of a

floating exchange rate regime to sub-zero) solves the problem by bring-
ing about a larger real depreciation of its currency than what have been
possible under the discarded floating exchange rate regime. (One factor
limiting real depreciation under a floating rate regime are speculative
assessments of a possible eventual re-bound of the currency, leading to
some current support for its exchange rate). That larger real deprecia-
tion (possible under fixed-rate system) can come about all at once via
pegging the currency at a well-devalued rate or it can come more grad-
ually through a process of the price level falling (as the corollary to a
prolonged recession) at a fixed nominal exchange rate.
As illustration, suppose with the yen at around 110 to the dollar,
under a still floating exchange rate regime, US interest rates start to fall
(reflecting an increased savings surplus in the US), and Japan is thrown
into economic disequilibrium (as interest rates cannot fall below zero
so as to sustain capital exports and help stimulate domestic demand as
an offset to slacker external demand). The yen rises in line with the
diminished US-Japan rate spread. The climb of the yen would be part
of the process of reducing Japan’s current account surplus (consistent
with the shrunken momentum of private capital export). If the yen
were to indeed level out at a higher value – say 90 to the dollar – it
could be imagined that the fall in the Japanese price level (exacerbated
by the slacker economy) would in the end bring about a substantial
real depreciation of the currency and this would unblock the road back
to overall equilibrium. There would be no reason, however, to expect
such a levelling out (of the nominal exchange rate) under the floating
currency regime. Rather the yen’s nominal exchange value would tend
to rise in line with the differential movement of the Japanese and US
price level (in this illustration, Japanese prices falling and US prices
hardly rising). It is the real exchange rate and real interest rate level,
not nominal, which are determined in the process of achieving exter-
nal balance and internal steady state equilibrium. The relation of
nominal to real rates is determined by differential inflation.
If, instead, the Japanese authorities were in the above situation (of a
fall in the US savings deficit) to announce a new regime in which the
absolute floor for the dollar would be 100 and the ceiling 110, then in
time deflation would bring about a real exchange rate depreciation (of
the yen). This would act as a stimulus to external demand in the
Japanese economy. In longer-run equilibrium, the US would be in
somewhat larger savings and current account deficit than at the start
(just after US savings propensities rose), but with a much lower level of
interest rates. Japanese nominal interest rates would be at the same

level now as in the US (given no significant exchange risk between the
two currencies, dollar and yen) and the yen would have fallen to a
lower real value (than at the time of its fixing). The process of deflation
in Japan to get to this solution could be avoided if in response to the
US slowdown the Japanese authorities had immediately devalued the
yen to say 110–120 – advancing the argument that as monetary policy
was ineffective with rates already at zero, the move was an essential
part of adjustment.
Alternatively consider the currency regime choice for a country,
again Japan, which is already in deflationary disequilibrium (without
having to consider the new potential disturbance of a rise in US
savings) and where nominal interest rates could not fall to the equiva-
lent of the negative neutral real level due to the zero rate boundary. An
exit from the disequilibrium is possible through fixing the exchange
rate to a larger currency of an economy not in deflation (say, the US),
and not in danger of falling into deflation as a result of the change in
currency regime under question. A quick exit would be organized by
fixing the new parity at a steeply devalued level – implying a large real
depreciation. With interest rates in Japan and the US now at the same
positive level (given that exchange risk is largely eliminated), a lower
real (international) value of the yen would be part of the overall equi-
librium solution for the Japanese economy (both internal and external)
than when interest rates in Japan could in principle fall to much lower
levels than in the US (albeit subject to the limitations of the zero rate
boundary).
If the yen had been at say 100, then as illustration the new pegged
level might be 125. A much slower exit would be possible if the yen
were pegged at 100. Indeed the rise in yen interest rates (in line with
the absence of exchange risk) into equality with US rates would inten-
sify the deflation in the short-run (if indeed US rates are significantly
above zero). Longer-term relief and eventual exit would come from the
process of real depreciation – effected by the internal price level falling
yet the nominal exchange rate remaining fixed.
The question of exit from deflationary disequilibrium – actual or
potential – for the US, the largest economy in the world – is essen-
tially different from the smaller country cases described so far (most
of all Japan). Suppose that under the floating exchange rate regime,
the neutral level (with respect to internal and external equilibrium of
the US economy) of US interest rates (in nominal terms) falls below
zero (presumably in a case where inflation is already very low or non-
Short Circuits 119
existent in the US). Perhaps a process of asset price deflation is the

catalyst here. Most likely the neutral level of rates in several large
foreign economies would also be below zero in that situation, given
the importance of the US as a source of demand in the global
economy.
Under these circumstances, which historically match in several
respects the situation of the global economic slump of the 1930s (see
Kindleberger, 1986), exchange rate pegging cannot not solve the
problem of disequilibrium. As a first point, it is not feasible for the US
to peg its currency except as part of a multilateral arrangement. It is
implausible that Japan and Europe would agree to the dollar being
devalued as a prelude to a new fixed exchange rate system especially
in the context of looming or actual US economic depression. And
even if they did, it would intensify the threat of deflationary disequi-
librium in their own economies. A series of competitive devaluations
could follow, mimicking the currency wars of the Great Depression
Era. Rather, the exit from the global disequilibrium described would
be radical monetary policy pursued by all major economies, including
the US, still within a floating exchange rate context. Most probably in
the first instance radical policy would mean aggressive monetary base
expansion. In the second instance there would be the introduction of
negative interest rate regimes.
5
Sustainability
Perhaps the biggest topic in international economic policy discussions

over recent years (2003–6) has been the so-called sustainability (or
non-sustainability) of mega US current account deficits. The issue of
sustainability had also loomed large back in the mid-1980s, a previous
occasion of huge US current account deficits. It had largely faded from
view in the late 1980s and early 1990s when the deficit had fallen sub-
stantially (under the influence of a long period of US economic slack
and of a boom in Europe led by German unification). Even when the
deficit bulged in the late 1990s it was largely ignored, being regarded as
a natural counterpart of the capital spending boom associated with the
then US miracle economy. The subject came back into focus as the US
economy recovered from the 2001 recession and the deficit, powered
by a large household sector savings deficit (see Chapter 3, p. 72) and a
huge Federal budget deficit, reached new record levels (see Figure 5.1).
What is meant by non-sustainability? At its simplest the concern is
that as the trade deficit (in goods and services) continues to run at
high levels, and the interest (or dividend) burden on the correspond-
ing external debt (and other external liabilities including equity)
grows, the US could find it ever harder to attract net capital inflows on
the scale required to finance its total current account deficit. (This
latter aggregate is defined as equal to the deficit on trade in goods and
services plus net transfers abroad plus the deficit on factor income
account. This last item consists in the US case mainly of investment
income). Why might the financing get ever harder? As the US external
debt grew relative to GDP, so the story goes, foreign creditors would
become growingly alarmed about whether the US economy could
service this in the long-run and demand an increased premium
against risk. And in any case foreign investors would become resistant
120
Sustainability 121
2.0
1.0
–1.0
–2.0
–3.0
–4.0
current account as % of GDP

–5.0
investment balance as % of GDP
–6.0
–7.0
80 82 84 86 88 90 92 94 96 98 00 02 04
Figure 5.1 US current account and investment balances, 1980–2004
to accumulating dollar assets as these came to represent a higher and

higher share of their overall portfolios. Even before such resistance
“kicked in”, the rising current account deficit (as a share of GDP) on
account of increasing interest and dividend payments to foreigners
would surely tend to outstrip the underlying gap between equilibrium
levels of savings and investment in the US, meaning that forces build
up which would narrow the trade deficit. (These forces could take
several forms including exchange rate and interest rate changes, bud-
getary shifts and asset price adjustments).
A key issue in the discussion of current account deficit sustainability
is the strength of these corrective forces. Is there a risk of market failure
– meaning perhaps that these forces are in some sense too weak or fail
to emerge altogether? Market failure in turn would provide justification
for direct government or G-7 action to tackle the imbalances. A main
source of possible failure – the zero rate bound to nominal interest
rates blocking a fall of interest rates to a neutral sub-zero level in the
savings surplus countries – has been highlighted in the previous
chapter. Putting that possibility to one side, corrective forces should
indeed emerge as foreign investors’ appetite (for US dollars) wilted,

credit risks (with respect to US assets) increased, and the savings deficit
lagged behind the current account deficit. Upward pressures would
develop on US interest rates and downward pressures on the US dollar.
Why – apart from the case of market failure above – could the invisible
hand of the markets not be relied upon to hold the US and foreign
economies to a long-run equilibrium path?
An implicit theme of the pessimists (on sustainability) is that
markets are ignoring some factors relevant to determining an equilib-
rium path for the US dollar through time. In particular, we have
already seen that some pessimists are troubled by the market’s noncha-
lance regarding rules of thumb (p. 95). No country in history has ever
run trouble-free current account deficits of more than 5% of GDP (see
Slok and Kennedy, 2004 or Obstfeld and Rogoff, 2004). The experience
if running for any length of time has always ended up in crisis. So why
should we expect that the US would be an exception? (The US current
account deficit crossed the 5% threshold already in early 2004). Other
pessimists base their case on a consideration of so-called trade elastici-
ties and provide horrendous accounts of how much relative price
change or budget deficit reduction would be required to bring about a
substantial narrowing of the US current account deficit from present
levels. (See for example Brook et al, 2004). (The similarity of this strand
of pessimism to that of Keynes in the reparations debate has already
been highlighted in the previous chapter). Simultaneously they suggest
implicitly that markets are presently underestimating the difficulty of
future downward adjustment to the path of deficits. When inevitably
the estimates become more realistic at some point in the future there
will be an acute crisis of the US dollar, which would impose heavy
costs on the world economy.
Before reviewing these arguments in detail and analysing some
further possible causes of market failure (in coping with huge US
current account deficits) it is useful to derive the formula for how US
external debt would grow through time on account of rising servicing
costs (on the basis of the trade deficit running at a constant share of
GDP).
Growth arithmetic of mega current account deficits

Suppose at the start, year 0, the US has no external debt (net) and runs
a trade deficit (including transfers) equivalent, as a proportion of GDP,
to d. Suppose real GDP grows at an annual rate of g. And the trade
Sustainability 123
deficit remains at d, as a proportion of GDP. The real interest rate is

assumed to be stable at r. Then the size of the external debt as a pro-
portion of GDP at the end of year T can be expressed as:
⎛ ⎛ 2
⎛ 1 + r ⎞ T −1 ⎞ ⎡ ⎛ 1 + r ⎞ T ⎛ 1 + r ⎞⎤
1+ r ⎞ ⎛ 1+ r ⎞
d ⎜1 + ⎜ +
⎟ ⎜ ⎟ + LLLLL + ⎜ ⎟ ⎟ = ⎢1 − ⎜ 1− ⎜ ⎟⎥ d
⎜ ⎝1+ g ⎠ ⎝1+ g ⎠ ⎝1+ g ⎠ ⎟ ⎢ ⎝ 1 + g ⎟⎠ ⎝ 1 + g ⎠⎥⎦
⎝ ⎠ ⎣
If r<g, then the external debt ratio grows at a decreasing pace through
time and reaches a finite upper limit ⎡1+ g ⎤ .
⎢ ⎥d
⎣g − r ⎦
If r>g then the external debt ratio eventually explodes.
An arithmetical example gives the flavour of this formula. Suppose

the real rate of interest on US external debt (averaged across all matur-
ities) is 2%, the growth rate of the US economy 3.5% p.a. and the trade
deficit (excluding interest payments) at 3% of GDP. (It is quite feasible
for the neutral real level of interest rate on riskless assets to be less than
the economic growth rate, even though in some simple growth models
r is set equal to g. In particular, once equity risk is introduced, the
growth models would have the average return to capital across equity
and debt equal to g. Allowing for normal risk premiums, this would
mean the riskless rate of return would be significantly below g). Then
the external debt to GDP ratio would eventually stabilize at just over
200%, at which point the deficit on investment income account would
have levelled out at 4% of GDP (meaning the overall current account
deficit would have grown to 7% of GDP from its initial 3% level). But
eventually means in practice around 100 years from now! After
10 years the net external debt to GDP ratio would be only 27% and
after 20 years 52%, meaning deficits on investment income account of
around 0.5% of GDP and 1% of GDP respectively.
Hence if real interest rates are much below the long-run growth rate
the build-up of debt servicing cost, relative to GDP, will be very slow.
Whether indeed the rise in servicing costs will eventually require some
interest and exchange rate adjustment to bring about a cut in the trade
deficit depends on the evolution of the underlying savings deficit in
the US economy and of savings surpluses in the world outside.
If the underlying US savings deficit tends to creep higher, relative
to GDP, and the foreign savings surplus (underlying) rises in step,
then there need be no influence on exchange rates. No divergence
would open up between the underlying US savings gap and the US
current account deficit. Of course savings would tend to be related to

national incomes (GNP) rather than GDP, and over time, given the
current account deficit, US GNP would indeed grow at a somewhat
slower pace than g (on account of the rising net interest payments to
foreigners). Thus there would be some in-built tendency for the
savings gap relative to GDP to widen slightly (on the assumption of
investment spending remaining a constant proportion of GDP).
In the above illustration, net national income at year 10 would be
0.5% less than GDP. If gross US savings stayed at around 25% of net
national income throughout, then at year 10 the savings rate as a pro-
portion of GDP would have fallen to 24.87%. If investment spending
remained at around 28% of GDP, then the savings-investment
gap would have widened out to 3.13% from 3%, short of the current
account deficit total of 3.5% of GDP, implying some element of
non-sustainability which had to be corrected.
The same type of calculations applies to the long-run build-up of
external wealth by the savings surplus countries. If the real return
which they earn on their external assets is far less than their economic
growth rate, then the growth in external wealth as a share of GDP will
be very slow and bounded, and the rise in the investment income
surplus, for a constant trade surplus, would be very gradual. It might
well be that a gradual rising in the underlying saving surplus would
mean that there was no built-in need for adjustment. And of course
here national income would be growing faster than GDP, and if
savings are related to the former and investment to the latter, then
there would be an arithmetic very slight widening of the savings
surplus through time. But this marginal widening would be less than
the formula-driven rise in the current account surplus (as a share of
GDP), meaning that if there is not some autonomous increase in the
savings surplus then some forces of adjustment would emerge so as to
bring the two surpluses – the arithmetic and the economic – into line
with each other.
There is one further arithmetic point to make. When it comes to
assessing the importance of external debt or net asset position, it
would be sensible to use as denominator not a flow measurement – in
this case GDP – but another stock measurement, the total capital stock
(excluding human capital and the government debt, but including
consumer durables) estimated at around 350% of US GDP. And so in
our illustration above, the net external debt as a proportion of national
wealth after ten years would have grown from zero to 7.5%. The even-
tual stabilized proportion would be at just over 50% of national
Sustainability 125
wealth. These are not in themselves eye-shattering proportions. And it

could be that the national capital stock is growing as a proportion of
GDP (consistent with the investment ratio remaining constant),
meaning that the rise of the external debt to capital stock ratios would
be even slower than suggested.
Economic concepts of non-sustainability

The arithmetic of net external debt or wealth growth through time
helps to set the dimensions of the economic discussion about non-sus-
tainability. But arithmetic is not economics! In the literature and
popular discussion there are two main economic concepts of sustain-
ability and its opposite – non-sustainability. The first concept has been
described well by Catherine Mann (2002). “A sustainable situation is
one where the stock or flow imbalance generates no economic force of
its own to change its trajectory. A current account deficit is sustainable
at a point in if neither it, nor the associated foreign capital inflows, nor
the negative net international investment position, are large enough to
induce significant changes in economic variables, such as consumption
or investment or interest rates or exchange rates”. Taking Mann’s
definition, it could be that the arithmetic illustrative path of a trade
deficit remaining at a constant say 3% of US GDP with r (the neutral
interest rate) less than g (the long-run growth of productive potential)
is sustainable, especially if the US savings deficit is tending to increase
slightly, as are savings surpluses abroad. Then there would be no in-
built requirement of adjustment (involving interest rate and exchange
rate change). Non-sustainability on Mann’s definition need not involve
any type of discontinuity or crisis – maybe just a modest turn in the
trajectory of the deficit with interest rate and exchange rate changes no
greater than already discounted.
The second type of non-sustainability is hinted at in a further sen-
tence of Mann’s definition (in italics). “Even if the current account deficit
is sustainable by that definition today, its trajectory could be creating risks
for the US and global economy.” Specifically a discontinuity might loom
ahead. Perhaps conventional wisdom up until now in the market-place
about the future long-run trajectory of the US and global economy is
wrong and there will be a sudden wake-up call, bringing shock changes
in exchange and interest rates. Or it may be that the task of powering a
continuing immense flow of capital from the saving surplus countries
into the savings deficit countries (and mainly the US) might prove to
be beyond the capacity of normal market mechanisms, and these will
suddenly snap or become impaired. This line of argument was implicit,

for example, in a speech given by Federal Reserve Chairman Greenspan
(November 19, 2004). To quote:
A continued financing even of today’s current account deficits as

a percentage of GDP doubtless will at some point in the future
increase shares of dollar claims in international investor port-
folios to levels that imply an unacceptable amount of concentra-
tion risk. –– The situation suggests that international investors
will eventually adjust their accumulation of dollar assets or, alter-
natively, seek higher dollar returns to offset concentration risk,
elevating the cost of financing of the US current account deficit and ren-
dering it increasingly less tenable. –– It seems persuasive that given
the size of the US current account deficit, a diminished appetite
for adding to the dollar balances must occur at some point. But
when, through what channels, and from what level of the dollar?
Regrettably no answer to these questions is convincing. This is a
reason why forecasting the exchange rate for the dollar and the
major currencies is problematic.
It is at first sight strange to find Alan Greenspan, a one-time disciple

of Ayn Rand (popular writer and philosopher who expoused an ex-
treme anti-state liberalism), questioning whether markets could
ultimately cope with huge US current account deficits. The free market
apologist for Greenspan could say that he is not explicitly repudiating
a market solution. Presumably when the mega current account deficit
becomes untenable, due to rising financing costs, exchange rates and
interest rates will shift so as to bring it down. And before the point of
un-tenability, when it becomes visible to many on the horizon, the
shift would already get under way. Notwithstanding this apology,
the tone of the remarks definitely seemed pitched to awaken some
anxiety amongst the audience, even if falling short of predicting
market failure. Understandably, though, Greenspan did not fall into
the trap of maintaining that a dollar decline was inevitable.
Satiation of foreign appetite for US assets?

A common concern of the sceptics about sustainability (in either form
of the definition) is that foreign appetite for US dollar assets may ulti-
mately be limited. And indeed Mr. Greenspan amongst others has
referred to the so-called Feldstein-Horioka research train (including the
Sustainability 127
original paper and subsequent re-runs by later researchers) which

implies that in much of the world there is a strong home bias by
investors (over-weighting domestic investments compared to what
simple principles of diversification would suggest), even though this
(home bias) is tending to decrease somewhat (see Obstfeld and Rogoff,
2000). (In fact the rate of decrease outside the US seems to be more
than in the US). The methodology of these studies is to examine
empirically the correlation of savings and investment rates across
countries. Strong home bias in itself would mean that savings and
investment rates would be highly correlated. High domestic savings
rate would tend to be invested at home rather than abroad even if
domestic rates of return were relatively low.
In assessing foreign appetite for US dollar assets a first point is sus-
tainability of foreign savings surpluses. Then we can look at how much
of these foreign savings surpluses would tend to go into dollar assets.
The arithmetic of asset accumulation above suggests that if the main
savings surplus countries were mature economies and the real rate of
interest on their holdings of foreign assets were higher than the rate of
domestic economic growth rate, holdings of foreign assets relative to
foreign GDP would rise without limit. And so at some point a process
of market adjustment would have to start – lower interest rates and
higher exchange rates (of the surplus countries) so as to bring down-
ward pressure on their trade surpluses (excluding investment income)
and savings surpluses. In turn, smaller trade and savings surpluses
abroad would mean that US deficits would have to narrow – with
adjustment being forced via some combination of higher US interest
rates and a weaker dollar.
The idea, just illustrated, of there being some constraint on the US
deficit path through time from foreign savings exhaustion, is not
robust, at least in the short or medium-run. Some of the savings
surplus countries have shrinking populations of working age and so
the domestic capital stock might eventually trend down also. As the
bulging population of pre-retirement age seek to boost their wealth,
it is inevitable that they would find themselves with a rising share of
foreign assets in their portfolio. Moreover, at prevailing low real
interest rates in the mid-2000s, and given the preference of many
foreign (non-US) investors for riskless or low-rate foreign assets
(rather than equities), it is not clear that the rate of return on US
dollar assets would be above the growth rate in the mature creditor
countries. Finally, an important part of the global savings surplus can
be traced anyhow to high-growth developing countries where the
rate of return on US assets is definitely much lower than the domestic

growth rate. Examples of the latter include China in particular.
Smaller (in economic size) examples include Singapore and Taiwan.
Moreover the group of countries in large savings surplus changes
composition through time. Certain advanced economies might at
some stage indeed enter an adjustment phase where their surpluses
shrink. But there is a new generation of fast growth economies with
large savings surpluses out there – including not just China but also
oil-rich countries. Further ahead, Brazil and India might joint the high
savings club. Savings surpluses in some advanced economies may in
fact have further upward potential – as would be the case if the present
recorded surpluses were below underlying equilibrium amounts. We
have already discussed in chapter four how the underlying savings sur-
pluses consistent with long-run international equilibrium in Germany
and Japan might be much larger than what is observed. (The lower sur-
pluses actually recorded are explained by incomes being well below full
employment levels and so savings rates are depressed below where they
would be in equilibrium).
Some commentators suggest that there is something artificial – or
out of line with equilibrium tendencies – for a large part of the savings
surpluses outside the US to be in rapidly growing developing eco-
nomies. Surely that is where the investment opportunity should be
greatest and they should be tending to import capital. This line of
argument, however, tends to understate the potential for high savings
rates in economies which are growing fast, where pension provision is
poor, and where resource wealth (in so far as it exists) is in the hands
of a political oligarchy. (And as mentioned in previous chapter, the
pre-retirement generation may be seeking to provide pensions for itself
at present much higher income-equivalents than what held through
most of their working life). Historically there are several examples of
countries enjoying miracle periods of economic growth and yet
remaining in overall savings surplus or near balance – including
Germany, 1957–63 and Japan, 1965–72.
In sum, the limit to the US being able to run huge current account
deficits from the side of foreign savings propensities does not seem at
all tight or imminent. But what about the constraint from concentra-
tion risk – that foreigners will in aggregate become concerned about
the rising share of US assets in their overall portfolio and require a
higher return at the margin on these to compensate for the resulting
impairment of overall diversification? It is best to look at this question
first without introducing currency risk – as would be the case if the
Sustainability 129
global currency regime were a stable fixed exchange rate system (US
dollar standard globally say) or an international gold standard.
Currency risk is introduced into the analysis subsequently.
As an arithmetic point, even if the accumulation of US assets
occurred as a constant and identical proportion of each country’s net
savings and current account surplus, the build-up in concentration
would be slow. Typically in the advanced economies, household sector
wealth as a share of GDP lies between 350 and 450%. Physical capital
stock in the private sector plus government debt lies between 300 and
400%. In creditor nations, household sector wealth is typically greater
than the value of the domestic physical capital with the net balance
matched by net investment abroad (external assets greater than exter-
nal liabilities for all sectors of the economy combined).
Ten year’s accumulation of savings surpluses running at around
5% of GDP in an economy growing at 2% p.a. and with 1% real
interest rates, would mean net external assets (all in the US in our
present example) growing by say 55% of GDP. Out of this amount
half might represent a build-up of financial and non-financial cor-
porate assets abroad (in the US). In the case of financial corporations
(mainly banks), the corresponding liabilities (for example domestic
bank deposits) would be regarded as domestic by resident house-
holds, even though a fraction of the matched assets were abroad.
Hence the build-up of US assets directly held in the portfolios of
foreign (non-US) investors (resident in the advanced economies)
might be no more than around 30% of GDP, versus overall wealth at
say 400%.
Another false alarm call on US concentration risk is too simple to be
true! This alarm is founded on the observation that the US current
account deficit is absorbing 85% of global savings – surely an unsus-
tainable high level. The fallacy here is equating national savings sur-
pluses with total national savings. Yes, as a matter of arithmetic, if the
US savings deficit accounts for 80–90% of the identified aggregate of
savings deficits in the world economy, then the US is absorbing 90% of
aggregate savings surpluses. But a large part of wealth accumulation
even in the savings surplus countries is in the form of domestic capital
– as the physical capital stock (and national debt) grows roughly at the
same rate as GDP. In the example above, Switzerland has a savings
surplus of more than 10% of GDP, meaning that its net external assets
grow by the same amount in any year. But if the economy is growing
at 2% and the capital stock in Switzerland is around 400% of GDP,
then total wealth (external and domestic) grows by around 18% of
GDP. Hence only slightly more than half (not 90%) of the wealth
increase would be going into foreign assets.
Another important fallacy in the alarmist accounts of concentration
risk is the failure to take account of turntables in the global flow of
funds, discussed already in the first chapter of this volume (see pp. 8).
Demand for US assets does not have to come from each country in the
rest of the world in proportion to their present net savings surplus. In
country A (outside the US) there may be a huge demand for US assets
by domestic residents, far in excess of its net savings surplus, matched
by inflow of capital from other countries. In country B, where resident
portfolios already include a large proportion of US assets, new net
outflows of capital into these might be much less than the size of the
net savings surplus, with the balance going into the assets of other
countries (including those where investors are rapidly accumulating US
assets). In country C, which has no significant savings surplus, the
inflow of foreign capital from country B (and other countries in similar
position) would put upward pressure on asset prices and encourage
domestic residents to switch some of their portfolios into US assets.
Both C and A would be example of turntables in the global flow of
capital.
As an example of country A (as turntable), we could imagine a big
developing economy, perhaps China or India in the long run. In both
there may be a pent-up demand (in the private sector) for US assets,
held back by capital flow restrictions. On top, the rapid growth of an
affluent middle class is likely to mean that demand for US assets (in
stock terms) could grow in absolute amounts each year by much more
than the size of the savings surplus. At the same time China or India
are popular destinations for direct investment. And so other countries
may be light buyers of US assets (where light is measured relative to the
size of savings surplus) and heavy direct investors in China (and India),
whilst the latter are heavy buyers of US assets. An example of country B
could be a mature creditor such as Japan, which started off its process
of international diversification (back in the late 1970s) by concentrat-
ing on US assets and is now broadening out its holdings. An example
of country C would be the euro-area, which in itself has no large
savings surplus – but is an end-destination for East Asian or Middle
East investors seeking to diversify their portfolios.
So far our discussion of foreign savings propensities as a possible
limit to the size of US current account deficits through time has been
in the context of zero exchange risk. It is time to drop this artificial
assumption. Evidently the introduction of exchange risk means that
Sustainability 131
the limit becomes tighter than otherwise. The limit might nonetheless
be very far-removed, especially if there is much scope for lifting
exchange restrictions globally.
As soon as we introduce substantial exchange risk, the banking
sector no longer functions as an important conduit for global capital
flow, except between countries in the same currency area or with
respect to foreign borrowers assuming the exchange risk of taking out
loans in the banking sector’s domestic currency. (An example of this
latter form of transaction would be East European countries borrowing
in euros from banks in the euro-area). This means there is less scope for
the banking sector to overcome home bias amongst domestic investors
by arbitraging in the form of issuing domestic deposits against the
acquisition of foreign assets. As a general proposition, exchange risk
means that foreign (non-US) investors would require higher returns
sooner if the process of US asset accumulation is to continue.
This general proposition, however, is subject to important qualifica-
tions. As we saw in Chapter 2, important grey and black areas of the
world economy are effectively on the dollar standard. And several coun-
tries in East and South East Asia have belonged to an informal dollar
bloc, with limited exchange risk between their own currencies and the
US dollar. Even in the world outside these areas (grey, black, and Asian
dollar bloc), the US dollar is a mainstream store of value and medium of
exchange. Accumulated dollar wealth in fast growing economies might
grow slowly as a proportion of GDP (the same arithmetic applies as
above). And whereas the appetite for additional dollar risk might be
slow growing in certain mature creditor economies, there is much scope
for turntables to spread the risk in very different proportion to present
net savings surpluses.
In particular, investors in China and India might rapidly build up
their dollar portfolios – with additions in any period far exceeding their
savings surpluses, the gap being financed by inward flows of direct
investment capital. And satiation of dollar appetites in some parts of the
world would create its own dynamic towards turntable creation else-
where. As illustration, if Japanese investors at the margin were under-
weighting the US dollar and overweighting the euro, this would trigger
downward pressure on expected returns from the euro relative to the
dollar which would encourage investors elsewhere (including those in
the euro-area) to take on dollar risk (towards earning more). Also global
borrowers would be induced by the widened expected cost spread to
reduce the share of their debts in dollars and increase that in euros.
Hence dollar satiation amongst some global investors would be offset by
a reduction in non-US supplies of dollar debt, freeing up more of world

savings in dollars to flow into the US.
Of course dollar risk, and the extent to which appetites may become
satiated for this around the world, does depend on the nature of the
global currency regime. In some respects there is less competition for
the dollar as the number one global investment money today (mid-
2000s) than in the 1970s, 80s or 90s. In these previous decades the
Deutsche mark and Japanese yen were important medium-size com-
petitors to the US dollar (as international money) even though they
were never serious contenders for the number one position. The euro
was meant – by its founders – to represent a serious new challenge for
the dollar’s role in the global economy. But eight years on from its
launch (effectively in Spring 1998), the euro’s growth as an interna-
tional investment money is handicapped by issues of existential risk or
regime risk (will it still be around in the long run, could the euro-area
shrink in size, could the ground-rules of European Monetary Union
change?). Whilst the creation of the euro has gone along with a deep-
ening of European capital markets, this new liquidity advantage (of
European currency assets) could be more than offset by a serious degree
of regime or existential risk.
As we have seen (see p. 95) some commentators have implied that
dollar risk might increase suddenly (in a discontinuous fashion) when
the US current account deficit reaches 5% of GDP or more. The ratio-
nale for this view is that a survey of historical experience suggests that
all other countries (than the US) have hit a crisis at this level. For
example Mann (2004) writes “for industrial countries, a current
account deficit/GDP ratio of somewhere between 4 and 4.5% appears
to be associated with the onset of economic forces (including a mone-
tary policy response, a reduction in income and, in some cases, a real
depreciation of the currency) that narrow the current account deficit.”
An OECD research paper (Brook et al, 2004) made a similar point.
“The US current account deficit has now peaked at its highest level
ever recorded – around 5.2% of GDP – and remains very high by histor-
ical standard. For a large economy like the US, a deficit of this magni-
tude absorbs a significant proportion of total world savings and implies
an increasing share of US assets in foreign investors’ portfolios. –– It is
uncertain for how long foreigners will continue to accumulate debt
and equity claims against US residents at the current pace.”
Ex-Treasury Secretary Summers made the same point in a speech at
Harvard in late 2004, “the US has never run such large current account
deficits and no single nation’s deficit has ever bulked nearly as
Sustainability 133
large relative to the global economy. At a minimum such a unique

imbalance deserves careful scrutiny”.
Obstfeld and Rogoff (2004) stress the relevance of benchmark experi-
ence from around the globe. “The latest end-2003 figure of US external
net liabilities amounting to 23% of GDP is close to the all-time high
level that the US is estimated to have reached in 1894, when assets
located in the US accounted for a much smaller share of the global
wealth portfolio”. The authors provide a graphic trajectory for the
same ratio over the long-run and show how in the medium-term it will
exceed various benchmarks reached by other much smaller countries
in many cases prior to major debt problems. “We do not anticipate the
US having a Latin-style debt crisis, of course, but these benchmarks are
nevertheless informative”.
Professor Padoa-Schioppa, then Italian board member of the ECB
with special responsibility for international affairs, was much less
guarded in his assessment (of the sustainability or otherwise of the US
current account deficit) and quite revealing of the attitude around the
council table in Frankfurt. In a November 15 (2004) interview with
Reuters, Padoa-Schioppa was adamant “The US must gear its economic
policy toward closing its anomalous current account deficit and it is
desirable that this occur quickly. The US current account deficit is an
anomaly in terms of its size and duration which no-one, even among
the US authorities, believes can go on forever without correction. Our
position in Europe is that this correction of policies – and not only of
markets – is essential, and it is desirable that it should take place in the
near future. The US should raise public and household savings by
increasing taxes and lowering public spending. Very rarely in the last
100 years has one of the main economies for numerous years had a
deficit of this size. It’s even rarer that this should be the case for the
world’s richest economy.”
The gist of all these statements, albeit well qualified, except in the
case of Pado-Schioppa, is that global investors should watch out when
the US current account deficit goes above the 5% of GDP benchmark –
a big discontinuity may lie ahead of which a sharp dollar depreciation
would be an important aspect. If indeed enough investors believe in
such a discontinuity, and they demand a much larger risk premium on
dollar investments (either in the form of higher interest rates or cheap
currency) to continue the same pace of accumulation, then a narrow-
ing of the current account deficit would indeed get under way once it
had grown into the danger zone (of above 5% of GDP). After all, as one
of Arthur Miller’s characters remarked “in the market-place if enough
people think it is Wednesday, then it is Wednesday never mind that it

is in fact Monday”.
As students of global capital flows we cannot let Arthur Miller have
the final word! The grounds for supposing that a discontinuity exists
around the 5% of GDP level are not convincing. Indeed in 2005 the
dollar was generally strong even though consensus forecasts had
the current account deficit at 6.5% of GDP and rising to 7% in 2006–7.
The US is not just another medium or small size OECD country. It is
the largest economy in the world with a currency which is a main store
of value through much of the globe. A large US savings deficit has to
go along with large savings surpluses elsewhere in the world. By con-
trast a large UK deficit tells us nothing about the state of savings sur-
pluses elsewhere in the world. As remarkable as the US savings deficit is
the savings surplus in the world outside.
The US current account deficit is not primarily a US but a global
affair. The new feature in global payments during the mid 2000s is not
in itself the size of the US current account deficit, but the huge diver-
gence between savings surpluses in key parts of the world economy
and the US savings deficit. There is little if any relevant historical expe-
rience to judge this against. The reference above to the US experience
as a debtor in the 1890s is far far wide of the mark. Crucially, any dis-
cussion of how the US savings deficit might narrow has to go along
with one of how foreign savings surpluses might also fall in step.
There may indeed be a growing asymmetry in the likely direction
of the dollar – up or down – as the US savings deficit reaches higher
levels. When the savings deficit is at 7% of GDP, it might seem more
likely that the equilibrium level of the deficit over the medium-term
would fall back to 5% than rise to 9%. The 7% of GDP deficit might go
along with symptoms of US household sector savings being at an
unusually low level or private sector investment at an unsustainable
high level – or the government deficit at too high a level. And most
probably (but not inevitably) a narrowing of the equilibrium level of
the US deficit does go together with dollar depreciation.
Hence as the current account deficit to GDP ratio rises, the expected
extent (the mean of the relevant probability distribution) of future
likely dollar depreciation increases. But of course a huge US savings
and current account deficit is most likely associated with real interest
rates on dollars which are high by international comparison. Forward
exchange rates (actual or implicit – as derived from interest rate parity
conditions) build in expectations of currency depreciation to come. A
bigger US deficit means most likely higher US real rates and a bigger
Sustainability 135
discounting of future depreciation – and so there is no obvious impli-

cation for the spot exchange rate or associated feed-back to the present
size of the deficit.
At some stage, however, expectations might become more pes-
simistic regarding future possible depreciation (even though the
current deficit remains unchanged) and that would bring some combi-
nation of a rise in interest rates and a fall in the spot value of the
dollar, implying some downward pressure on the current account and
savings deficit. That shift in expectations (due perhaps to a changing
consensus about trade or income elasticities or a whole range of other
factors, including foreign appetite for dollars in the long-term) could
be gradual or sudden.
Indeed the crux of the matter (the debate on sustainability) is the
issue of discontinuity. A gradually increasing prospect of dollar depre-
ciation (as a mathematic expectation) as the deficit expands is no
intrinsic problem for well functioning mechanisms driving global
capital flows. Nor is a gradual shift in consensus economic analysis
behind market forecasts cause for concern. The key point is whether a
discontinuity (a sudden shake of the kaleidoscope through which
investors perceive the range of future possible scenarios) could provoke
a shock which would maim the mechanisms. This question leads us on
to the whole subject of elasticity pessimism – referred to already in pre-
vious chapters when reviewing the so-called “transfer problem”. For
example, could a sudden shift (down) in the underlying savings sur-
pluses abroad or savings deficit (down) in the US require a very big
change (depreciation) in the dollar’s value to attain a new equilibrium
path for the international economy? This would be the case if very
large relative price changes – specifically of traded goods and services
relative to non-traded – were required (along with other changes) to
produce only a modest narrowing in the US trade deficit.
The elasticity pessimists

Elasticity pessimism extends in both directions. Just as a large deprecia-
tion of the dollar may be necessary to reduce the current account
deficit from 6.5 to 4% of GDP, a large appreciation might be needed to
increase it from 6.5 to 9% (6.5% is the estimated deficit size in 2005).
But let us say that markets rank the chances of underlying forces in the
global economy pushing the deficit up by 2% over the next five years
are significantly smaller than of pushing the deficit down by the same
amount. Then elasticity pessimism would justify expectations as to
future depreciation rising sharply as the deficit to GDP ratio moved

well above 5–6% of GDP. (Expectations are derived as the mean of the
probability distribution of dollar exchange rate change over the rel-
evant time period, here assumed to be long-run). But there would still
be a market solution (exchange and interest rates consistent with
global capital flows equal to underlying savings surpluses and deficits).
It may be that the pessimists on the US payments position, described
now in supranational parlance as the “global payments imbalance
problem”, are indeed making a cry from their heart about the harsh
nature of economic adjustment to possible (but not inevitable) big
changes ahead in savings surpluses and deficits across the globe. It is
far from certain, however, that these possible changes will be sudden.
And even if sudden change is a significant probability (as would be the
case in the much talked about US residential real estate market crash),
it does not mean that there should be pre-emptive official action so as
to reduce the extent of likely swings in underlying savings deficits and
surpluses. The pessimists seem sometimes to be arguing in favour of
action to limit any further rise in the US savings deficit so as to reduce
the probability of a subsequent big fall (in the underlying deficit) with
its associated adjustment costs further down the road.
The free market answer to these concerns is to stand firm against any
such macro-smoothing exercise which is in any case cast in probabilis-
tic terms. There is a significant risk that action to rein back the US
savings deficit in the present might be in the opposite direction to
equilibrium forces which in fact are driving the deficit to still higher
levels. If changes in savings surpluses and deficits through time are
sometimes sudden and sharp and produce large exchange rate changes
with their associated economic costs then so be it! In any cases there
are grounds for scepticism (as outlined below) about the extent of
inelasticity of US trade to a changed pattern of savings surpluses and
deficits around the world (and in particular to a smaller US savings
deficit).
Even if there is some inelasticity of US exports and imports with
respect to relative price changes the role of changed propensities to
spend themselves play a large role in any adjustment. A fall in the US
savings deficit would be coupled with a fall in foreign savings surpluses
meaning more foreign spending and thereby more US exports to the
rest of the world. As we have seen (Chapter 4), failure to incorporate
so-called income effects into the analysis of the transfer problem can
be traced back to Keynes’s claim that Germany would have to ration
beer consumption in order to pay reparations. And so today the asking
Sustainability 137
of the question as to how much the US dollar would have to fall to

bring about a given narrowing of the US current account deficit,
without considering the simultaneous boost to foreign demand and
fall in domestic demand taking place as part of the simultaneous global
shifts in savings and investment propensities, is a false question.
One eloquent exposition of elasticity pessimism has been made by
Laurence Summers, in the same address already referred to above.
Summers starts by noting that (in 2004), US imports accounted for
16% of GDP, vs exports at 11%. If both exports and imports were to
continue to grow at their long-run historic average of 6% p.a. and GDP
at 3% p.a., then the deficit widens by 1% of GDP every 5 years (see
Figure 5.2). But that is too optimistic (according to Summers). “Our
(US) growth sucks in imports faster than their (non-US) growth sucks
in our exports”. Summers is referring to the Houthakker-Magee effect,
the observed fact that the income elasticity of foreign demand for US
exports is estimated to be below the income elasticity of US demand
for foreign goods and services. (Income elasticity is defined as the
increase in import demand for a given increase in income).
16
exports of goods and services as % of GDP
15
imports of goods and services as % of GDP
14
13
12
11
10
6
80 82 84 86 88 90 92 94 96 98 00 02 04
Figure 5.2 US exports and imports of goods and services, 1980–2004

It is possible that the Houthakker-Magee effect is a statistical artefact.

The relevant income elasticities have been estimated over a long period
(two decades or more) in which the US savings deficit and foreign savings
surpluses have both tended to rise. Equivalently domestic demand has
been rising faster relative to income in the US than in many countries
abroad. The income elasticity is calculated with respect to national
income levels, not to domestic demand. This divergence in itself can
explain much of the Houthakker-Magee effect. In addition there may
have been some tendency during the past three decades for the rapidly
growing economies in East Asia to concentrate at first on developing the
US market for their products – on the basis of this being an easier market
to penetrate quickly than the more heterogeneous European market-
place. (France stands out as one of the European countries where the
growth in penetration by Asian exports has been particularly sluggish –
see Figure 5.3). But in a second stage of export development, businesses in
these (East Asian) countries are likely to make the greater marketing
efforts required so as to penetrate non-US markets.
3.5
US – imports from Asian developing countries*
Germany – imports from Asian developing countries*
3.0
France – imports from Asian developing countries*
2.5
2.0
1.5
1.0
0.5
–
80 82 84 86 88 90 92 94 96 98 00 02 04
Figure 5.3 US, Germany and France – imports from Asian developing countries*,
1980–2004 (as % of GDP)
* excluding Taiwan
Sustainability 139
A further problem with elasticity analysis in general, as an input to

determining the extent of relative price adjustment necessary to
accommodate a shift in savings and investment propensities globally,
is its dependence on weights determined by the present relative impor-
tance of different markets and for established products and services.
But the most rapid growth over the next 10–20 years might come in
areas of the globe which presently receive low weights and in these
new markets US goods and services might win a large share of the
total. Moreover the US may now have a comparative advantage in
many information technology products and services, and global
demand for these could be rising much faster than the size of the
global economy (see Mann, 2004).
Moreover the boundary between so-called traded and non-traded
goods and services is rapidly being re-drawn – in the direction of
increasing the traded share. The age of information technology and
lowered transport costs has made a whole range of goods and services
easily exchangeable around the globe whereas previously they com-
peted only in local markets. The pessimism of many economists about
the inelasticity of US trade adjustment in line with changed savings
and investment propensities in the US and abroad is based on prevail-
ing assumptions about low rates of substitution in consumption and
production between traded and non-traded goods and on a present low
share of traded goods in production.
Pessimism about low elasticity of US trade adjustment is prevalent
amongst economists at the OECD and IMF. As illustration of the
OECD viewpoint, Brook et al (2004) concludes that “even a modest
narrowing of the US current account deficit would require large
changes to exchange rates, fiscal policy or the non-price competitive-
ness of US exports”. And in a related piece published in the OECD
Economic Outlook (December 2004), the authors conclude that
reducing the US current account deficit by 2% of GDP over a 6-year
horizon, shocks of around the following magnitudes would be
required – either a 20–25% nominal effective exchange rate deprecia-
tion of the dollar, or a swing in the fiscal position of some 6% of
GDP, or an improvement in non-price competitiveness of US produc-
ers corresponding to an approximate 2 percentage point increase in
its share of world imports.
Thoughtful pieces on US current account adjustment put the subject
in the context of shifts in underlying savings surpluses and deficits
around the world and the need (as part of a general equilibrium process)
for matching changes in trade flows. The least thoughtful pieces start
with the command premise that something must be done about global
imbalances and in particular the US mega current account deficit must
be reduced. The authors of such pieces then carry out various simula-
tions about changes in effective exchange rates, budget balances, or
other key variables which could bring about an x% reduction (in the
deficit). But they ignore the specific impulses which are likely to be
source of pressure to reduce the global trade imbalances – a rise in US
household sector savings and a fall in private sector savings surpluses
abroad. And by implication they ignore the possibility that global
savings and investment patterns might move in a direction to require a
larger than present US trade deficit.
If there were indeed to be a world economic crisis emanating from
the extent of divergences between savings and investment propensities
across the globe its source would be market failure most probably
rather than low elasticity in US trade patterns. The mechanisms essen-
tial to the world economy finding endogenously a general equilibrium
solution where global divergences in savings surpluses and deficit are
matched by trade flows might in some circumstances fail. Two of these
possible failures have been examined already in the previous chapter –
first, the zero rate bound preventing a fall of nominal rates to the real
level which would be consistent with global and international equilib-
rium or second, central banks targeting a level of interest rates which is
in fact out of line with neutrality.
Monetary authorities as a source of non-sustainability

It is an old question of monetary economics whether central banks
should in fact peg money rates or allow these to float freely and instead
steer the monetary base along a targeted path. Both operating proce-
dures can in principle be used towards aiming for the ultimate target of
say price level stability. The advocates of monetary base control argue
that pegging interest rates, even over short periods, mean that the
bond markets are diverted from their task of forming an independent
assessment of expected neutral interest rates over long periods. Instead
they focus on where the central bank considers neutrality to lie.
Perhaps markets would make a better job of this than central bankers.
The advocates of tight rate pegging argue that the so-called money
multiplier – the relationship of monetary base to wider money aggre-
gates – is quite unstable, and the demand for broad money is itself
impossible to model as a stable function of a few variables, making it
inappropriate as an intermediary target for monetary policy. (For a
discussion of this point, see for example Kuttner and Mosser, 2002).
Sustainability 141
Ultimately the debate is an empirical matter – assuming that the high

volatility of short-run interest rates under the monetary base control system
can easily be hedged using modern techniques available. But one factor
usually ignored in the empirical investigations – in part because it is so
difficult to determine, but nonetheless crucial – is the extent of misalign-
ment of exchange rates which can come about through the central bank
proving to be very wrong in its assessment of neutral rate, and ignoring in
many cases the international dimension of neutrality. European authorities
may well have made such a mistake, as discussed below. In any case, they
together with their G-7 partners have concentrated their attention publicly
on an alternative third possible source of market failure (with respect to
international economic equilibrium as described). This is where one or more
important savings surplus countries (or deficit countries) are not playing
by the rules of the game – suspending or interfering with the market
forces which would bring about global equilibrium. Asian developing
countries are frequently singled out for criticism (see Figure 5.4).
200
Brazil, Mexico and Argentina

150
Asian developing countries
100
50
–50
–100
80 82 84 86 88 90 92 94 96 98 00 02 04
Figure 5.4 Latin America and Asian developing countries*– current account
balances, 1980–2004** (US$ bn)
* excluding Taiwan
** 2005 data as forecasted by IMF
Asian developing countries: Brunei Darussalam, Cambodia, China, Hong Kong, India,
Indonesia, Korea, Laos, Malaysia, Myanmar, Philippines, Singapore and Thailand
One example of that third type of induced market failure in the con-
temporary world economy has been the rising Chinese savings surplus.
Capital export restrictions in China have meant that the government
or central bank have instead acted as investor abroad (see Chapter 3,
pp. 78–9). There has been widespread speculation that this public
mimicking of private capital outflows is inherently unstable. Moreover
the lack of clarity about China’s currency regime has induced huge per-
verse capital flows (mainly local companies speculating on a change of
regime – involving an appreciation of the yuan – by borrowing foreign
currency and repaying yuan loans).
In principle markets have a better prospect of groping towards neutral
interest rates and equilibrium real exchange rates where there is certainty
about the currency regime. In the case of China that would mean becom-
ing either a fully-fledged member of the dollar zone or allowing the cur-
rency (yuan) to float freely, in both cases with no exchange restrictions
impeding capital flows. Until recently the China problem – of lying
outside the system of market-driven global capital flows – has not loomed
very large, given the historically small absolute size of the savings surplus
there. The extent of the problem has become much more serious with the
bulging of the Chinese savings surplus in 2005–6. According to some
forecasts the Chinese surplus is set to grow much larger in coming years.
(For example, the OECD secretariat in November 2005 estimated the
current account surplus of China in 2005 at just under $150bn and
forecast a surplus of above $200bn in 2007).
Currency diplomacy in recent years has had a large focus on China and
the lack of exchange rate adjustment more generally in Asia. There has
been a lot of talk in international forums about the need for reducing
global imbalances. The US mega current account deficit and its possible
non-sustainability looms large in the G-7 discussions. Misconceptions
abound as is well illustrated by a European Commission paper on the
topic (October 2005).
The purpose of the paper was to back the negotiating position (of the
euro-area currency diplomats) that the euro-area itself could play no
important part in the global adjustment process which would be the
counterpart to an unavoidable large reduction in the US current
account deficit over the long run. The question raised and then
answered negatively by the Commission analysts was whether a big
move into deficit (on current account) by the euro-area “should” be
part of the adjustment process.
The analysts at the Commission did not consider the hypothetical
equilibrium conditions under which a euro-area deficit might emerge.
Sustainability 143
In principle these could include heavy demand for euro-denominated

assets by global investors diversifying away from the US dollar, perhaps
on the basis of their appetite for further dollar risk shrinking beyond a
certain point. In turn the neutral rate of interest in the euro-area would
fall and the full equilibrium exchange rate of the euro rise. Investment
spending in the euro-area would be at a higher level and savings most
likely at a somewhat lower level than prior to the shift (in global
diversification patterns). In sum, accelerated euro accumulation by
global investors would have a counterpart in a swing of the euro-area
net savings balance from small surplus to modest deficit and in euro-
area investors putting a raised share of their portfolios into dollar
assets, attracted by their now raised yield advantage (over euros).
So what is there to object to in that hypothesized outcome? The
Commission analysts raise five points.
First, “if the euro-area contributes to a further accumulation of large negative
global net asset positions, the eventual global adjustments might be only
delayed rather than avoided altogether, and ultimately become more violent”.
This objection raises the spectre about a modest long-run deficit for the
euro-area proving to be unsustainable as the net liability position of the
euro-area became ever larger. But as we have already seen in the arith-
metic early in this chapter, in the case of a modest current account
deficit (say 1–2% of GDP) financed at low real rates, a built-in future
external debt crisis for the euro-area would be a dubious proposition.
Second, “it must be considered that the euro-area starting position from
which to create a current account deficit is not as comfortable as is often sug-
gested. While the situation is clearly not as menacing as that of the US, it
nevertheless limits the ability of the euro-area to borrow large sums over an
extended period.” Again the critical response is the implausibility of an
external debt crisis for the second largest currency area in the world
starting from a small net liability position and with a modest savings
deficit.
Third, “in terms of global allocation of resources it is odd that poor labour
abundant countries lend money to wealthy capital abundant countries (as
grouped together in the euro-area)”. In practice, though, most of the savings
surplus resides in either rich advanced economies (Japan, Switzerland,
Norway, Singapore), or oil-rich developing countries building some
reserves against revenue declines in the future, or poorer developing
countries where residents out of fully rational considerations are saving
hard (China, for example). Even if the euro-area were to move into
savings deficit overall, Germany (together with the Netherlands and
Belgium) would almost certainly remain in surplus – offset by larger
aggregate deficits in the South (Spain, Greece, Italy) and East (assuming
some of the new EU entrants in 2004 join the euro-area).
Fourth, “in order to prepare for the effects of an ageing society and the fore-
seeable need to finance pensions, it is economically efficient to build up net
assets in younger and more dynamic countries.” But it is surely possible for
the euro-area, in its new hypothetical equilibrium situation of modest
savings deficit induced by diversification into euros by global investors,
to sustain a larger export of capital than previously on the part of euro-
area investors. In effect there would be an enhanced turntable role for
the euro-area, as discussed above. Euro-area investors responding to the
sunken level of returns on euro money and debt instruments would
allocate a larger share of their portfolios to higher yielding US assets.
(And the US economy is indeed younger and more dynamic than the
euro-area according to many assessments). Moreover, a counterpart to
relatively high personal savings in the euro-area (reflecting fears about
pension under-provision) could be a robust pace of domestic capital
stock expansion (meaning a rising capital-output ratio). The fall in the
neutral euro-area interest rate (in response to foreign diversification into
the euro) would stimulate domestic investment – and the returns on
this would be substantially above the neutral interest rate in so far as
euro-area investors were ready to assume equity risk.
Fifth, “the fact that only a part of a euro area current account deficit actu-
ally improves the current account in the US means that there is a risk that
not only might it not prevent or significantly mitigate a disorderly unwinding
of the US imbalances, but might also leave the euro area worse prepared than
it otherwise would be.” This point appears to be based on a consideration
of bilateral trade balances. It is true that a swing to modest deficit in
the euro-area savings balance would translate into new net demand
mainly for goods and services from countries other than the US. But
these other countries would simultaneously be experiencing reduced
net demand from the US (corresponding to the shrinking of the US
savings deficit as the neutral rate rises there as a counterpart to a slower
build-up of global investment in dollars). The rest of the world (non-
US, non euro-area) experiences a rise in its trade surplus with the euro
area to match the decrease in its trade surplus with the US. Hence the
widening of the euro-area current account deficit is a key component
of the new equilibrium, even though the bilateral US-euro area trade
balance might adjust only to a much smaller extent.
In sum, the EU commission analysts hardly make a strong case as to
why the euro-area should not eventually move into substantial savings
and current account deficit (with a neutral level of rates far below
Sustainability 145
historical norms). But as we shall see, the game of currency diplomacy

is not won be economic argument. The conclusions of the EU study at
least provide a script for discussion between the diplomats – some
basis, however flimsy, for euro-area policy-makers to refute, for
example, US demands that the ECB or European governments should
play a role in stimulating growth towards reducing global imbalances.
It is only possible to understand what drives the diplomats if wider
political questions are tackled. The focus of many diplomats around
the table is not whether market processes are functioning well and
could be improved but whether loosely specified dangers which might
emanate from global disequilibrium can be used to advance a political
agenda. In this regard, economists employed in official capacities
can become the script-writers for a geo-political drama. Currency
diplomacy is the subject of our next chapter.
6
Currency Diplomacy
Currency diplomacy is defined as the conduct of international rel-

ations between governments (including inter-governmental forma-
tions, for example the EU) with regard to issues of currency policy.
There are three main types of issue – the choice of currency regime (for
example, fixed exchange rates vs. floating, regional currency blocs), the
level of any particular exchange rate (or set of exchange rates), and the
stance of monetary policy (in an international perspective).
Three main methods of currency diplomacy are identifiable – unilateral
(decisions taken by one government, whose diplomats then “explain”
them to other governments), bilateral (one government negotiating one
or more of the above issues directly with another), and multilateral (a
group of governments consulting each other via an international body –
for example, the IMF, or OECD – or a coalition of governments pressing a
particular policy preference on another government).
Illustrative distinctions
Some illustrations are useful to drawing out the distinctions just made.
As examples of diplomacy concerning currency regime we could
include much of the negotiations proceeding and them immediately
following the break-up of the Bretton Woods International Monetary
System (1970–4). Later examples include the construction of European
Monetary Union and the break-up of the Asian dollar bloc.
As regards exchange rate issues, there are the periodic examples of
Washington seeking to lower the value of the US dollar – a process
which has occasionally involved getting foreign countries to change
their currency regimes. Sometimes there is no regime issue – as for
example the so-called Plaza Accord (1985) (where the US successfully
146
Currency Diplomacy 147
obtained the co-operation of Japan and Europe in lowering the value of

the dollar), or the US efforts to obtain a higher value of the yen in the
early 1990s (as pursued by the First Clinton Administration). Non-US
examples of exchange rate diplomacy include the many examples of
discreet efforts within the European Monetary System (1979–97) to
obtain devaluation or revaluation of one or more member currencies.
When it comes to the third type of objective for currency diplo-
macy – the influencing of foreign monetary policy, examples are
much rarer. This might be in part because the concept is less clearly
understood (especially by diplomats who are not trained economists)
and in part because there is a clash of responsibility between govern-
ments and central banks on such matters. A clash makes a unified
diplomacy either impractical, or impotent.
The concept behind currency diplomacy directed at influencing
monetary policy relates to the possibility that a particular central bank
is pegging money rates at a level substantially different from neutral
(where neutrality has both a domestic and global meaning, as dis-
cussed in Chapter 3). In consequence of that non-alignment (of market
with neutral rates) another economy might find that its currency is
driven far away from long-run equilibrium value and correspondingly
its traded and non-traded goods and services sectors thrown off their
long-run sustainable expansion paths. (One sector growing too fast,
one too slow, from a long-run perspective). At various times US
officials have pushed for monetary easing in Europe and Japan (arguing
that rates are above neutral there) as a means of stimulating those
economies and allowing better balanced growth in the US (faster
growth of exports and more broadly of the traded goods and services
sector).
Implicit in most US currency diplomacy is a trade threat. If US
demands are not met at least in part, then Washington will have
recourse to US Trade Law to force change – generally in the direction of
the given country removing impediments to US enterprises doing busi-
ness in the given country. Action on trade was an integral part of the
most dramatic example of unilateral diplomacy by the US – the so-
called Nixon shock (August 1971). The US acted by first, slapping a
temporary emergency tariff on imports into the US from other
advanced economies, and second, making its removal contingent on
the agreeing of an acceptable new level of exchange rates between the
US dollar and the other major currencies, especially the Japanese yen.
In the more recent past, Washington has negotiated both on a
bilateral and multilateral basis. There has been the customary deal at
five minutes after midnight to avert the trade threat being acted
upon. Examples of bilateral diplomacy are most evident in the case of
Japan-US relations. As illustration there were the so-called Sakakibara-
Rubin negotiations culminating in the US support of a stronger dollar
against the yen in summer 1995. That followed many years (from the
mid-1980s onwards) in which successive US Administrations had
applied strong pressure on Japan to remove barriers impeding foreign
competition in its economy (see Lincoln, 1999) and in which US
negotiators had been willing to accept yen appreciations as a partial
substitute for real detailed progress. Then in late Spring (1995) there
was the sudden climb-down by both sides in the trade negotiations.
That climb-down occurred in the context of growing concern on
both sides of the Pacific about the deep crisis in the Japanese
financial system.
It has been a familiar strategy of US negotiators to multilateralize
currency diplomacy on the yen issue at various critical points. They
have done so to avoid the impression of pushing its close ally into a
corner. Transferring the currency diplomacy to a G-7 forum, with the
IMF chiming in support of the US position, allowed Japan to make
concessions to the US demands whilst saving face. In general, much of
what passes for G-7 diplomacy has in effect been bilateral US-Japanese
currency diplomacy, with the other five chief diplomats enjoying the
sun (if lucky enough for the summit to be somewhere warm!).
Occasionally though, multilateral has meant multilateral – and we
return to examples (including the Dubai G-7 summit) below.
In principle countries outside the US could pursue multilateral cur-
rency diplomacy by building coalitions so as to limit Washington’s
power (based on implicit trade threat) in a particular currency issue.
This would be a version of balance of power diplomacy, notorious in
19th century Europe (in particular). There have been weak examples of
such multilateral diplomacy – but this has usually remained more
hypothetical than real.
For example, at the time of the Nixon shock (August 1971), there
was some discussion of Japan allying with France to check US power to
dictate terms, but as we shall see below there is not much substantial
evidence of this having happened. During periods of large dollar
decline inspired in some degree by Washington, there may have been
discussions between Japan and Germany (or more recently between
Japan and the Euro Group) as to how to co-ordinate a defence (against
tidal waves of speculative capital pushing their currencies higher), but
these have rarely if at all led anywhere.
More recently some economic commentators have suggested that

China, Japan, and other Asian countries might co-ordinate diplomacy
so as to resist Washington’s pressure to impose a floating currency
regime on the area. The chances of any such co-ordination taking
place, however, have been slim given the frictions on other issues
between Tokyo and Beijing and the primacy of the US-Japan relation-
ship (see p. 178). There has also been some suggestion that the euro-
area (as represented by euro-diplomats whether from Brussels or
Frankfurt) might be seeking a role as intermediary in the at times shrill
diplomacy between Beijing and Washington over currency matters. We
shall see below what the trade-offs might be or have been (for Europe)
in following this diplomatic route.
Trade-offs between currency diplomacy, foreign policy and

other issues
Trade-offs are at the core of diplomacy. These trade-offs are not
confined to one particular area of diplomacy but can be made across
different areas – for example gains in security co-operation in exchange
for concessions on trade or currency matters. The US on occasion has
scaled back demands on issues such as human rights or economic
reform in return for progress (from the viewpoint of Washington) on
currency policy. In other contexts, Washington has sometimes moder-
ated its targets or aims in currency diplomacy in return for progress in
other forms of diplomacy, usually in the traditional foreign policy
arena of international security.
One speculative example (unproven) has been Washington’s going
easy on currency demands regarding the yuan. The US Treasury did
not cite Beijing as a currency manipulator in its November 2005 report
to Congress, despite much sabre-rattling during the year, in exchange
for Beijing’s co-operation in pressing North Korea to abandon nuclear
arms. Another speculative example is the possibility that Beijing might
yet buy more time on the currency issue by eventually agreeing to
action at the UN Security Council to deter Iran from building a nuclear
bomb.
More definitive evidence of trade-off was the cooling down of the cur-
rency spat between Japan and the US in Spring 1994 as the eruption of
crisis surrounding North Korea’s nuclear program made Washington put
greater emphasis on security co-operation with Tokyo (see Schoppa,
1997). A decade later, military support by the Koizumi government of US
intervention in Iraq helped to earn Washington’s forbearance of huge
intervention by Tokyo (through 2003 and early 2004) to hold down the
yen. In a European context, there is much evidence that Germany’s will-
ingness to go along with European monetary integration in the early
1990s was related to the EU’s endorsement of political integration
between West and East Germany (see Brown, 2004).
Trade-offs between currency and other forms of diplomacy requires
co-ordination at the highest political level. This is difficult but not
impossible to achieve in the context of the euro-area, given the lack of
political union. As we shall see below, for the euro-area to effectively
seek trade-offs there has to be deference within the union (EMU) to
one or two countries – most plausibly France or France-Germany.
Indeed, historically, the master of such trade-off has been France,
where the high officials in the Treasury and Foreign Ministry are of the
same stock (or more correctly, haut école).
Diplomatic trade-offs are constrained in a well-functioning liberal
order by the system of democratic accountability. If there is a high level
of transparency, trade-offs between different branches of diplomacy
might be a cause of embarrassment to the political élites. Moreover, how
can the central bank, which might have to be a party to the currency
diplomacy, justify a non-optimal outcome from a purely economic view-
point, when it gets no credits (democratic) for the concession, and may
even suffer a loss of reputation for independence?
Main players
In modern international economic history (1960 onwards) France has
indeed been the most active of the medium-sized advanced economies
on the currency diplomacy stage. Not only has its method of operation
been suitable to the task, but it has had clear aims to pursue. Tra-
ditionally France has been in favour of currency regime shift at a global
level as a component of its geo-political vision (a world of ultimately
declining US hegemony to be replaced by multi-polarity). The two
bigger and more important players (in terms of global economic
outcome) have been the US and Japan. The US, typically, has been
interested mainly in exchange rate and occasionally monetary issues,
with regime shift an intermediary and subsidiary objective. Japan has
played a re-active role – responding defensively to US negotiating pres-
sure – rather than ever formulating a preferred currency regime and
making this a centrepiece of its diplomacy.
Since the breakdown of the Bretton Woods international monetary
system, Germany has adopted typically a low-key profile in currency
diplomacy on the world stage (meaning in relation to Washington,

Tokyo, or more recently Beijing). That is in contrast to the adroit cur-
rency diplomacy pursued by Bonn (and later Berlin) within the context
of European Monetary Integration (and the associated structures,
including the European Monetary System). The independent status of
the Bundesbank has been a handicap to any diplomatic acrobatics.
(True, the Federal Reserve also enjoys independence, but this has not
stood in the way of currency diplomacy being pursued vigorously by
successive administrations in Washington based on varying degrees of
trade threats, as discussed below).
Germany, given its lack of geo-political power (no seat at the UN
Security Council and no independent nuclear deterrent, instead fully
tied into NATO) does not have much scope to offer trade offs except as
part of an EU-wide offer (which is notoriously difficult to frame, let
alone pursue, given the absence of political union in Europe). More-
over in the three decades of the mighty Deutsche mark, Germany was
quite content with the currency regime status quo. It is even possible
that Germany deliberately delegated some authority for currency diplo-
macy on the global scene to France (which unlike Germany has a UN
Security Council seat and its own independent nuclear deterrent) as a
palliative for the Bundesbank having such considerable monetary
power on the European stage. In similar vein Germany gave its support
to a long line of French appointments to top positions at the IMF and
OECD.
Britain has been generally inactive in currency diplomacy – even
during its brief foray into the exchange rate mechanism of the
European Monetary System. London has been content with the regime
of an independently floating pound and has had no interest thereby in
international monetary reform. There has never been any question of
London joining or helping to create alliances of countries under threat
from US trade action (if they fail to change their exchange rate policy).
In practice such alliances have never been considered explicitly even at
an EU level, so the UK is no exception in this respect. At G-7 meetings
Britain has not had sufficient weight to ever act even as intermediary
between the US on the one hand, and the target of US demands (Japan
or more recently China) on the other.
Amongst the other G-7 countries, Italian currency diplomacy
has been almost entirely concentrated on intra-European issues – in
particular navigating the lira in and out of the exchange rate mecha-
nism of the European Monetary System and then into European
Monetary Union. On the global scene if Italian currency diplomats
have been active at all it has been with respect to calming concerns
about the high level of indebtedness of the Italian government.
As regards Canada, its direct influence in G-7 diplomacy must surely
be considered peripheral, except in one respect. The Bank for Interna-
tional Settlements (an important forum for central bankers and also
with some influence of its own on evolving conventional wisdom) has
found itself with both a Canadian head and a Canadian chief econo-
mist. Both have taken a line on the “global imbalance problem” –
warning about the dangers of continuing huge US current account
deficits and Asian surpluses for global stability – which is not very far
from the French (see White, 2004). Indeed that is the dominant con-
temporary opinion (in the mid-2000s) within the Bank of Canada
where there is a strong tradition of asserting monetary independence
of the USA – and not bowing before US monetary hegemony.
The newest player on the stage of currency diplomacy has been
China. Beijing has been forced into participating (in the diplomatic
game) by Washington which since 2003 has shrilly demanded an
upward move of the yuan and an end to the fixed exchange rate
regime under which the yuan was pegged to the US dollar. Token
moves in both these directions announced (by Beijing) in Summer
2005 were hardly the end of the matter. Beijing has become an adept
player within a short time-period of experience. Its UN Security
Council seat and vital role in the Korean peninsula provides consider-
able leverage for trade-offs between currency and other forms of diplo-
macy. The importance of China to France’s vision of a multi-polar
world has made it possible for Beijing to multilateralize the diplomacy
of the yuan, rather than this issue becoming exclusively a matter of
Sino-US relations. Beijing has been able to turn currency diplomacy to
its own advantage by trading off democratic and human right issues, as
we shall see below. In all, China’s currency diplomats have earned a
reputation for consummate technical skill.
Regime shift – France’s role

France’s role in the G-7 diplomacy in 2003–6 concerning the Chinese
currency and more generally the future currency regime in Asia has
been indirect. The head of the ECB, Claude Trichet, is an old-hand
French currency diplomat. His climb up the greasy political ladder
through the French finance ministry and beyond under successive
Conservative, Socialist, and Conservative Administrations in the 1980s
and early 1990s, has left him entrenched firmly in the French eco-
nomic and foreign policy making establishment (see Brown, 2004). He

owes his appointment (as president of the ECB) to the notorious deal
between French President Chirac and German Chancellor Kohl on the
eve of the EU summit launching EMU (Spring 1998).
The Trichet-Chirac relationship had been cool at times, and indeed
was born out of treachery (Trichet deserting his long-time backer
Balladur for Chirac on the eve of a crucial electoral contest in Spring
1995 between these two leading Gaullists). It would be strange if there
were no pay-back expected by the Chirac Administration and indeed
rendered at least implicitly by Trichet. There is little doubt that for
France one prize of European Monetary Union has been its own man at
the head of the ECB able to deal on the world currency stage with little
control exercised by any democratic process.
If there have been any doubts about France’s valuation of the prize –
it is instructive to view the reaction to Beijing’s announcement on
July 22, 2005 that it was changing its currency system to an adjustable
peg, guided by a basket of currencies. The first official overseas reaction
came from the French Finance Ministry, welcoming the move.
Trichet’s position at G-7 summits on the Chinese currency issue was
fully in line with the analysis coming out of the French Finance
Ministry, the Banque de France, and the French Foreign Office (Quai
d’Orsay).
Superficially, at least, there seems something odd about France, with
its vision of a multi-polar world, and traditionally hostile to US hege-
mony, finding itself on the same side as Washington on the question
of Chinese currency regime change. In fact M. Trichet had ostensibly
been on the same side as the US through the various G-7 summit dis-
cussions and policy announcements relating to the Chinese currency
question from the Dubai Summit (September 2003) onwards. Before
providing possible explanations to that particular puzzle (similarity of
French and US views on the Chinese currency question) it is useful to
move several steps backwards in the history of currency diplomacy to
the early 1960s.
France entered the currency diplomacy stage in the post-war era
under the presidency of General de Gaulle. The general, advised by
Jacques Rueff (Mayer, 2004), saw the Bretton Woods system as operat-
ing in practice to confer considerable advantage on the US. In princi-
ple, US financial power was constrained by the obligation (under
Bretton Woods) of the US Treasury to convert foreign official dollar
balances on demand into gold at the fixed rate of US$35 per ounce. In
practice, such conversions were rarely made (until the mid-late 1960s)
and were constrained by wider political considerations. The US, mean-

while, (according to Gaullist propaganda) was buying up Europe and
living beyond its means by printing dollars. Rueff warned of a coming
global financial crisis due to the global accumulation of dollars – and
advised that the solution to the problem was a return to a system more
based on gold and less on dollars (meaning that central banks around
the world should hold less of their reserves in the US currency).
The purpose of the present chapter on currency diplomacy is not to
offer a detailed critique of de Gaulle’s view on the international mone-
tary system. Rather the object is to look at methods of French diplo-
macy. Initially diplomacy was by unilateral declaration, or thinking
aloud. In February 1965 the General made his famous speech. “We
consider that international exchanges must be established – as was the
case before the great worldwide disasters – on an unquestionable mon-
etary basis that does not bear the mark of any individual country.
What basis? Actually it is difficult to envision, in this regard, any other
criterion or any other standard, than gold”.
In fact the historical record shows that much earlier, already in 1961,
de Gaulle had alarmed the newly elected President Kennedy, who told
his advisers that the “two things which scared him most were nuclear
weapons and the payments deficit” (Gavin, 2002). Kennedy enter-
tained seriously (before provisionally but not finally rejecting) a pro-
posal from his Secretary of State that the US would help France develop
its independent nuclear deterrent (which up until then the US had
opposed) in return for France desisting from its pro-gold policy.
(Provisional rejection was based on Washington’s concern not to upset
Germany by furthering French nuclear unilateralism). Even so, Paris
had a rare opportunity to pursue bilateral currency diplomacy with
Washington There is no evidence, however, that de Gaulle was inter-
ested in any deal which would restrict his pursuance of an increased
role for gold.
The scope for France to pursue bilateral or multilateral diplomacy on
the gold issue in the early and mid-1960s was quite small. The French-
German friendship treaty (January 1963) – the so-called Elysée Treaty –
had been the high water mark of the close relationship between
Chancellor Adenauer and General de Gaulle. But the Chancellor had
been unable to carry through on his pledges given the strong pro-US
sentiment in his party (the CDU). His successor, Ludwig Erhardt, a
committed Atlanticist, turned his back on further overtures from
France The powerful Bundesbank had no interest in a greater interna-
tional role for gold. Leading Bundesbank officials were concerned with
a different problem – how to stem the inflationary tide from the US

that was bound to wash up in Germany if the mark remained pegged
to the dollar at an unchanged rate. Opinion amongst German officials
– both within the Bundesbank and outside – was slowly swinging
towards the view that a floating Deutsche mark, cut loose from the
dollar – might be the most effective way of insulating the German
currency from US-made inflation.
In any case, French potential influence in the international mone-
tary arena took a big setback with the social and economic turmoil
which erupted in May 1968. General de Gaulle resigned the following
year. Already in late 1967 de Gaulle had seen the way of the future for
French currency diplomacy by sending Raymond Barre to Brussels and
endorsing his work there on blueprints for European Monetary Union.
Europe, led by France, would defy US monetary hegemony.
This strategy looked increasingly fragile in 1971 as the Bretton
Woods System entered its death-throes. In May of that year
Germany set the mark free to float rather than accept further huge
speculative money inflows from the dollar. French policy-makers
were quick to realize the new parameters of international monetary
choice. First, there was the possibility of re-vamping Bretton Woods,
based on a higher gold price (in terms of US dollars). Second, there
could be a freely floating exchange rate system between the major
currencies, which would mean that the Deutsche mark would
emerge as the world’s powerful no. 2 money after the US dollar. Or
third, the dollar could indeed break its link to gold (as in the second
scenario), but Europe would form a regional fixed exchange rate
system as a forerunner to eventual monetary union.
The French policy-making establishment was adamantly opposed to
scenario 2 or anything which smacked of Deutsche mark “national-
ism”. Scenario 3 was not without risk, in that Germany could flex its
economic and monetary muscle to still come out effectively at the top
of the new arrangement. Hence in August 1971, when the US closed
the gold window and imposed a “temporary” import tax, France aimed
first at turning scenario 1 into reality. Paris remained steadfastly
opposed to floating the French franc. A free float of the French franc –
according to the viewpoint of French policymakers – would have
meant the Deutsche mark (itself floating) gaining dominance in the
European stage.
Instead the French government imposed a barrage of exchange
restrictions (on capital inflows) so as to maintain an unchanged parity
against the US dollar. Paris bargained hard for a rise in the official gold
price and a return to a global system of fixed exchange rates. But sur-
prisingly there is no evidence of France forming an alliance for this
purpose with Japan – the other major country which was then set
against a generalized float. (A negotiating alliance might have taken
the form of Japan joining with France in insisting on a change in the
gold price in return for France backing Japan’s claim that the revalua-
tion of the yen should be only modest.) Perhaps the perspectives of
French diplomacy had simply not evolved far beyond de Gaulle’s dis-
dainful description of visiting Japanese Prime Minister Hayato Ikeda as
“that transistor salesman”.
France persevered in its efforts to re-build a gold-based international
monetary order through the transitional Smithsonian Accord (December
1971), but when that burst apart in early 1973, Paris switched focus to
option three – a joint European float as a prelude to European Monetary
Union. In the following quarter century European Monetary Union was
the end-destination of French currency diplomacy. Of course there were
periods in the desert when French monetary affairs were in such a poor
state that Paris could hardly hope to make progress on its ultimate aim.
And in reaching the final destination, Paris had to make many conces-
sions to Bonn (and subsequently Berlin) – in particular giving up any
realistic prospect of an overweight French influence over monetary
policy in the soon-to-be-created monetary union.
During all this time France participated in G-7 currency diplomacy.
The strength of French-German ties did allow France at times to act as
a principal negotiator with German acquiescence – under strict over-
sight. That was the case with respect to the Louvre Accord in Spring
1987 (Brown, 2002). The French finance minister, Édouard Balladur, as
host to the G-7 finance ministers and central bankers meeting, helped
to broker a deal in which Washington would co-operate with Europe
and Japan in stabilizing the dollar after its sharp fall-back (of the pre-
ceding 18 months). Unannounced target ranges were agreed for the
exchange rates between the US dollar, Deutsche mark, and Japanese
yen (the French franc was tied to the Deutsche mark within the
European Monetary System).
It was only after the birth of European Monetary Union, and the
succession of Claude Trichet to the presidency of the ECB (Autumn
2003), that a grander and less constrained period of French currency
diplomacy on the global scene blossomed. The immediate focus was
on China and the looming “threat” to world economic prosperity
from the huge international payments “imbalances” (in particular the
mega US current account deficit and the huge current account sur-
pluses in East and South East Asia). The aims of the new involvement
of Europe in currency diplomacy were limited to two out of three pos-
sible objectives – currency regime change (in Asia) and steering
exchange rates (between the US dollar, euro, and Asian currencies).
The third possible aim – influencing monetary policy decisions
outside the euro-area – was largely rejected in that the ECB itself had
no inclination to receive advice from outside or even acknowledge
foreign influences on the determination of neutral interest rates in the
euro-area. Europe’s new assertiveness in G-7 currency diplomacy was
all part of the new soft euro-nationalism as described by Claude
Trichet in a somewhat loquacious answer to a question at a press con-
ference (July 1, 2004) regarding the possible influence of US money
rate decisions on ECB monetary policy).
“We all have responsibility, all over the world. Certainly across the
Atlantic the Federal Reserve has a very important responsibility, and it
is not my responsibility to elaborate on that. We have our own respon-
sibility – the US in the US and the euro-area in the euro-area. We are in
different universes with different fundamentals and different episodes
in the business cycle. Furthermore, we are both responsible for price
stability in these different universes. So we are not influenced in any
way by what has been decided across the Atlantic or what has been
decided in the past across the Channel, or what has been decided else-
where in the world. Because of our own analysis of the present situa-
tion in the euro-area, we have not changed our monetary policy
stance. Again, on the basis of European judgement and diagnosis we
have no bias and we remain vigilant.”
The blindness of Jean-Claude Trichet and his colleagues to the fact
that neutral interest rates are interdependent in a global economy
would have been a serious handicap to foreign currency diplomats,
especially US, seeking to bring about a better alignment (closer to
equilibrium) of monetary conditions internationally. As we shall see,
however, contemporary US policy-makers had no inclination to pursue
such negotiations.
For Washington, currency diplomacy = trade diplomacy?

Any student of US currency diplomacy finds pretty quickly that the
dominating theme has been the highlighting of foreign unfair trade
practices and the use of exchange rate change as a substitute for or
compliment to reforming these. All the other sub-themes, such as
international monetary reform or global monetary co-ordination are
largely background buzz, unless taken up forcefully by key foreign gov-

ernments. For example, back in the 1960s the question was largely
unasked in Washington about whether the US could gain from a grand
deal to salvage a dollar standard, albeit with some residual nominal
link to gold.
The contours of a deal would have been the US making a more
explicit and credible commitment to hold down inflation – meaning
that the US price level was indeed an anchor to low inflation globally.
Other countries – in particular Japan and Germany – would have had
to accept that during long periods their own inflation rate would be
persistently above or below the US inflation rate so that real exchange
rates between their own currencies and the US dollar would move in
line with equilibrium tendencies.
As illustration, in the 1960s very rapid productivity growth in the
Japanese traded goods sector meant that the equilibrium real exchange
value of the yen in terms of the dollar was on a rising trend. If the
nominal exchange rate between the yen and the US dollar was to stay
at an unchanged parity, then Japanese inflation would have to remain
well above US inflation (as indeed occurred in the first half of the
1960s but not the second half). That might have been a small price to
pay (especially from a Japanese but also a US perspective) so as to avoid
the costs of much larger and more volatile currency swings (certainly
in nominal and most probably also in real terms).
Convertibility of dollars into gold at a fixed price (defined within a
narrow range) could in principle have been the external discipline
forcing the US to follow a policy of low inflation. But so far had the
real price of gold fallen (in terms of say US purchasing power) since its
official nominal price had been fixed around 30 years earlier (1934) by
the Roosevelt Administration (at $35 per ounce) that a big revaluation
(rise of the official price) would have been essential to making full con-
vertibility of dollars into gold feasible. Such a large devaluation of the
dollar against gold, however, could have shaken confidence fatally in
the international monetary system (based on the dollar and a fixed
gold link). Hence a fully restored and operating gold link for the dollar
was a largely implausible option.
What was in it for Washington to offer its allies a re-vamped dollar
standard with a new commitment to low inflation? For a start, low
inflation might have been desirable from a domestic viewpoint. But in
the world of the late 1960s and early 1970s the conventional wisdom
was that some trade-off existed in the long-run between inflation and
unemployment. US policy-makers might have had a tough job per-
suading their electorates that lower inflation was to their advantage

overall. As part of a grand deal, however, Washington might have
sought to extract progress on international trade liberalization which
would help sweeten the overall deal to be sold (to Congress and the US
voters)? Yes – US diplomats could have argued – we will make the
dollar standard more acceptable to you (in terms of low inflation) but
you must accelerate the dismantling of trade barriers in the way of US
exports.
As a matter of counterfactual history it may be doubted whether
Germany or France would have gone along with such a deal. Germany
may already have been too distrustful of US commitments on inflation
and France may not have been ready to jettison its aim of a fuller role
for gold in the international monetary system. And as we shall see
below, Japanese currency diplomacy was still in a stage of underdeve-
lopment, where a grand deal was hardly likely to be proposed or even
negotiated by Tokyo.
In fact US currency diplomacy in the 1960s focussed on the terms
which Washington might demand for keeping the semblance of con-
vertibility between the dollar and gold, even though its substance
was draining away (for example, voluntary restraint by foreign
central banks with respect to converting dollar balances into gold,
and from 1968 a two-tier gold market). US currency diplomats (and
policy-makers) talked much about the so-called US balance of pay-
ments problem (Treaster, 2004). In modern terms the problem did
not lie with the trade balance (which in any case was in surplus or
small deficit) but with US interest rates falling below their neutral
level (as the Federal Reserve and bond markets miscalculated). In con-
sequence capital inflows were not sufficiently strong to balance the
external accounts, and so foreign governments had to pile up official
dollar holdings. The evident symptom of US interest rates being
below neutral was rising inflation pressure.
A succession of US Administrations saw the US balance of payments
deficit “problem” as an opportunity to demand trade reforms or
increased foreign payments for US military services. Yes, US diplomats
told their opposite numbers, we will keep the gold window open, but
you must help towards to solving of our balance of payments problem
by paying for our forces in Europe or accelerating trade liberalization.
These may have been laudable aims in themselves, either from a
domestic or global viewpoint or both, but they were not a substitute
for the grand system thinking which might have salvaged the existing
currency regime in the long-run.
Once the regime collapsed – with the immediate catalyst being the
Nixon shock – US currency diplomacy soon embraced the system of
floating exchange rates between the dollar, Deutsche mark and
Japanese yen, with intra-European exchange rate fixing being left to
the Europeans amidst benign neglect from Washington. Currency
diplomacy now was largely intertwined with bursts of trade policy
activism and occasional demands for more pro-cyclical economic poli-
cies abroad. The latter did not have to mean cutting interest rates
towards or even below what the US officials regarded as neutral (not a
term then widely in use but nonetheless the underlying concept was
familiar) but could involve fiscal policy stimulus.
A few examples illustrate the characteristics of US currency diplo-
macy through the first thirty years of floating exchange rates. In the
late mid 1970s (1977–8) as the US dollar came under serious downward
pressure and the US current account deficit widened (hardly far in
modern terms!) the Carter Administration piled the pressure on
Germany and Japan to take stimulatory action. (In effect, Washington
blamed Europe and Japan for the US dollar’s problems). The emphasis
was not on any demands for easing of German or Japanese monetary
policy, but rather for budgetary stimulus. Almost instinctively US cur-
rency diplomats kept away from recommending monetary policy
changes to their allies – perhaps seeing this as likely to strengthen the
dollar and making US deficits sustainable (hardly likely to appeal to
those powerful lobbies in Washington calling for trade action). In fact,
with the benefit of hindsight, the main source of disequilibrium in the
global economy in the mid-late 1970s was not German or Japanese
economic policies, but over-expansionary US monetary policy. That
was not a diagnosis made by economists close to the seat of power
whether in Washington or abroad. There were no strong voices from
Japan or Germany demanding US monetary tightening. Even if some
economists there made the correct diagnosis of the weak dollar (for
example within the Deutsche Bundesbank), currency diplomats (in
Europe or Japan) realized that the independent Federal Reserve under
Chairman Arthur Burns would hardly be taking or welcoming their
friendly advice.
In the mid-1980s there was a new round of US currency diplomacy.
The Reaganomics boom coupled with abnormally high US interest
rates (engendered in part by powerful disinflationary policies adminis-
tered by the Volcker Federal Reserve) had fueled huge capital inflows to
the US and these were matched by a correspondingly wide US trade
and current account deficit. The losers in the US traded goods sector
demanded action and their growingly vociferous Congressional rep-

resentatives piled up legislative initiatives (vetoed in the main part by
the President) against “unfair” foreign competition. The Second
Reagan Administration embarked on hectic currency diplomacy aimed
at lowering the international value of the dollar and thereby diffusing
the protectionist bombshell. The Plaza Accord was the diplomatic
coup. Japan agreed to temporarily tighten monetary policy so as to
raise the international value of the yen and there was a commitment to
joint foreign exchange intervention by the US, Japanese, and European
central banks (under instruction of their respective Finance Ministries)
so as to push the dollar lower.
In fact, the Plaza Accord is the most over-sold accomplishment in
the history of currency diplomacy. The US economy had already
entered a serious growth recession, and the coming sharp decline of US
interest rates would have meant a much weaker US dollar with or
without Plaza. The Reagan Administration if indeed concerned to take
the sting out of the protectionists in Congress should have concen-
trated its assault on inappropriately tight US monetary policy rather
than leaning on Japan to make a wholly inappropriate tightening of
monetary policy (not justified by contemporary Japanese economic sit-
uation). Foreign governments and central banks should similarly have
been arguing for easier US monetary policies as essential to global eco-
nomic equilibrium. But high inflation was sufficiently recent and the
record of the Volcker Federal Reserve so impressive in its defeat, that
scope for diplomacy concerning US monetary policy was at best very
limited. Indeed the Reagan Administration was quietly encouraging a
rebellion against Chairman Volcker within the FOMC aimed at secur-
ing bigger rate cuts. The Reagan appointees (increasing in number) on
the Board of the Federal Reserve were increasingly restive. Foreign pres-
sure on the FOMC might have had only perverse results (on monetary
policy).
That situation had changed already into 1986 as the dollar fell more
sharpy than anyone at the Plaza had expected or intended. Volcker
pressed for foreign rate cuts, particularly from the Bundesbank, track-
ing down its then President (Karl Otto Pöhl) on a visit to Israel to make
a personal appeal by telephone for a rate cut. In a rare example of
monetary diplomacy, the US was pressing another country to shift its
monetary policy with part of the bargain being that the Federal Reserve
would follow suit. Volcker feared that a unilateral easing by the FOMC
would trigger unwanted further dollar weakness. A year later (February
1977), within the framework of G-7 negotiations at the Louvre, the US
agreed to participate in a stabilization of the US dollar after its recent

steep fall (which went far beyond what had been envisaged at Plaza).
It was not spelt out (in the Louvre Accord) where the responsibility
for stabilization action lay, but critically Federal Reserve Chairman
Volcker was a party to the deal. Treasury Secretary Baker’s motive in
supporting a stabilization of the dollar at this juncture remains largely
speculative. Perhaps he was convinced that a halt to the dollar’s slide
would reduce the risk of an inflation shock and thereby of higher US
rates, a worthwhile prize given that the next Presidential elections
(at which his close friend George Bush Senior would be the likely
Republican candidate to succeed Ronald Reagan) was barely 18 months
down the road.
Volcker, an old hand at currency diplomacy through the crises of the
late 1960s and early 1970s, may have welcomed dollar stabilization as
providing ammunition against the growingly powerful opposition within
the FOMC which was seeking to block monetary tightening even though
signs of the economy pulling out of its growth recession were now multi-
plying. Volcker could now present rate rises if needed as essential towards
meeting the currency commitments made at the Louvre.
Both Volcker and Baker could not be right. As events unfolded in the
following months (Spring 1987 onwards), Volcker’s assumption (not
disclosed to the Administration during the negotiations leading up to
the Louvre Accord!) that US monetary tightening would be required to
prevent a new fall of the dollar proved to be correct, and Baker’s hopes
that stabilization would mean less reason for interest rates to rise were
dashed. Frustrated US currency diplomats under the command of Baker
used the Louvre Accord to beat on the door of the Bundesbank and the
Bank of Japan to ease monetary policy or at least desist from tightening.
Volcker’s hiking of rates in Summer 1987 (despite serious divisions
within the FOMC) may have been the final factor tipping Baker to rec-
ommend that he be replaced as Federal Reserve Chairman. Baker did
not mince his words about the backwoodsmen at the Bundesbank who
insisted in proceeding to raise interest rates in early Autumn 1987, not
withstanding the Louvre Accord. Meanwhile a change of personnel in
Baker’s team of advisers (crucially Richard Darman had resigned to take
a job on Wall Street in April) had left him now leaning on an official
(Charles Dallara) who was in tune with the weak dollar ideas of James
Tobin and his protégé Fred Bergsten. All of this demonstrates the
difficulties in the way of any serious international diplomacy with
solely the benign aim of edging interest rates in the major centres
closer to an ideal concept of mutually consistent neutral levels.
In any case, the chosen successor as Federal Reserve Chairman, Alan

Greenspan, had no interest in currency diplomacy. As a professional
economist back in the mid-1960s he had written an article for Ayn
Rand’s “The Objectivist” in favour of the gold standard (see Rand et al,
1966; Greenspan, 1966 and Walker, 1998). He had described efforts at
international monetary co-operation as flawed, quoting (in the same
article) the notorious example of 1927 when the US Federal Reserve had
been persuaded to ease policy by the Bank of England as part of an effort
to stabilize the foreign exchanges (and in particular to prop up Sterling)
and had so contributed to the speculative build-up of 1928–9 in the US
economy and stock market. He took no time to de-bunk the Louvre
Accord, and in an interview with Sylvia Nasar of Fortune Magazine (the
only interview he ever gave as Federal Reserve chairman on currency
matters) stated that he did not believe that there was a floor to the
dollar. (Earlier in the year, as an economic consultant, Greenspan had
sent an advisory note to his clients saying that the dollar should fall to
10% below the level at the time of the Louvre Accord).
One vocal critic of Alan Greenspan, Jude Wanniski, (see Wanniski,
2000) has written extensively on this episode as a very black mark in
the illustrious Chairman’s career. In effectively announcing the end of
the Louvre Accord – and the Fortune article appeared on the eve
(Friday, October 16) of the Great Crash (October 19, 1987) – Greenspan
effectively scared investors about the inflationary outlook and thereby
about the effective rate at which real gains would be taxed (given the
lack of indexation in tax liability calculation). Was the new Chairman
about to embark on a similar path to the now notorious Arthur Burns,
who appointed by Nixon in early 1969 proceeded to create the greatest
peacetime inflation, all towards the re-election of the President or of
his chosen successor? Wanniski may be over-stretching a point. But
throughout his long term of office Greenspan would have little truck
with currency diplomacy – neither giving advice to the leading foreign
central banks nor entertaining discussion on a so-called globally con-
sistent level of interest rates. (Right at the end of his last term,
however, Greenspan did participate in the Administration jawboning
of China, as discussed below – see p. 173).
On balance at critical periods of dollar weakness the Federal Reserve
Chairman was tight-lipped, offering little or no comment (other than the
mantra that currency policy is the responsibility of the US Treasury) or any
offer of monetary support (a temporary tightening of monetary policy for
example). The exception was during early days of the so-called strong
dollar policy in Summer 1995, which coincided with the looming decision
of the Clinton Administration as to whether to re-appoint him. Treasury

Secretary Rubin who had just negotiated an accord with Japanese chief
currency diplomat Sakakibara would have a big say in the re-appointment
decision. The Greenspan Fed arrested its rate-cutting initiated in Spring
1995 (the easing of monetary policy had been in response to an emerging
economic slowdown which proved to be short-lived).
During the Greenspan era (1987–2005) the main two episodes of US
currency diplomacy were first, the bilateral trade negotiations with
Japan (1988–95), which spilt over at critical junctions into exchange
rate discussions and second, the assault on the Asian dollar bloc, espe-
cially China, from 2003 onwards. In both of those episodes the Federal
Reserve was not an active participant in the diplomacy (with the poss-
ible exception of Greenspan’s one-day visit to Beijing in October 2005).
But its chairman was sufficiently astute politically to realize that his
smooth path through the Washington political forest with its many
potential trip-wires required that he make the appropriate nods, winks,
and speeches with suitable innuendoes. The two episodes are taken up
below under our discussion of Japanese currency diplomacy and the
Chinese currency question.
Tokyo-Washington dialogues
Tokyo was a comparative late-comer to international currency diplo-
macy. During the miracle years of the late 1950s and 1960s (continu-
ing to 1973 on most accounts), Japan had pegged its currency at the
unchanged 360 level to the US dollar, whilst allowing considerable real
exchange rate appreciation to take place in the first half of the 1960s
through tolerating a much higher rate of inflation than in the US.
Tokyo was not prepared for the assault of the Nixon shock, not fully
realizing that as now the world’s second largest economy with a
sudden bulge in its trade surplus (previously the tendency had been
towards deficit at cyclical peaks) it had become prime target of a new
force in post-war US politics – neo-mercantilism.
It is certainly possible to argue in retrospect that Japan might at least
have reviewed a diplomatic strategy aimed at salvaging the yen’s attach-
ment to the dollar standard at an unchanged rate, even if the gold
window were closed. Indeed that was the knee-jerk response of Japanese
policy-makers to the Nixon shock – to continue unchanged. But they
were forced to change tack within days by the flood of hot money
inflows. What would have been the main elements of a diplomatic plan
to salvage the dollar standard?
The core elements would have been some bold proposals likely to
appeal to the Nixon Administration plus some re-adjustment of domes-
tic policies to serve the priority of currency stability. The bold propos-
als could have included first, a package of economic reforms likely to
mean much improved access of US exporters to the Japanese market.
Second there would have been a commitment to aggressive monetary
ease towards helping to jump-start the US economy out of its weak
cyclical phase (1970 was a recession year and the recovery in 1971
appeared weak to contemporary observers). The Bank of Japan would
have had to swallow its concerns about inflation for now, accepting
that it had little choice in the matter if a dollar standard were to be sus-
tained, and offered impressive rate-cuts up front. Capital export con-
trols would have been scrapped to have allowed Japanese savings to
move into US assets – helping to alleviate the so-called US balance of
payments financing problems.
None of this occurred in time. Eventually, the Bank of Japan did
aggressively ease monetary policy, but only following the Nixon shock
and a big appreciation of the yen. Monetary overkill ushered in a
period of spectacularly high inflation. Passing through a series of short-
run stabilizations, the yen by the mid-1970s had becoming a fully
flexible currency. (In-between 1971 and 1976 there had been long
periods of stability versus the dollar, first under the Smithsonian
Agreement, and then, de facto stability from mid-1974 to mid-1976
following the First Oil Shock).
In 1977–8, Tokyo conceded a promise of fiscal reflation as part of the
G-7 deal with the Carter Administration (see pp. 160–1). The Bank of
Japan, still trying to bring inflation down from its disturbingly high
levels of the mid-1970s, was unwilling to make concessions as part of
the deal. The Ministry of Finance had to give way very reluctantly
(given that they were just restoring order after the bombshell of the
Tanaka fiscal policy excesses).
Why did Japan concede rather than laying the blame (for the weak
dollar and US “balance of payments problem”) at the door of the Arthur
Burns Federal Reserve? The presumption is that Japan by saying No might
have risked a repeat of the Nixon imposed import tariffs or equivalent. At
least that was the view of Japan’s currency diplomats. Meanwhile, to be
better prepared for future events, Japan moved full speed ahead in the
dismantling of its exchange restrictions, meaning a potential – and
indeed actual – surge in private capital outflows largely to the US.
There followed a golden period during which US disinflation (under
the Volcker Federal Reserve in the first half of the 1980s) went along
with huge private capital outflows from Japan to the US. The Ministry
of Finance managed to claw back its concessions and indeed the
budget balance moved towards surplus. And the Bank of Japan finally
brought inflation down to low levels (still positive). The dollar-yen rate
settled at a level where the Japanese economy could generate large
current account surpluses in line with its private capital exports and
now overall large underlying savings surplus. The main criticism of
Japanese diplomacy at this point was its lack of preparedness for what
was to follow and which should have been seen at least as a risk sce-
nario. The rising tide of protectionism in the US Congress through the
mid-1980s – a reflection of the manufacturing sector’s decimation by
the strong dollar – was there for all to see. What was to be Japan Inc’s
response?
One possibility was that Tokyo would seek to persuade Washington
that the present high valuation of the dollar was in part temporary –
due to the policy of disinflation meaning that US interest rates were
above long-run neutral level – and in part structural (a reflection of
buoyant US investment opportunity created by Reaganomics and
of savings surpluses in Japan and Germany). No fix was possible
through macro-economic tinkering on the part of Japan. Tokyo,
however, would be willing to fully participate in monetary talks with
Washington so as to mutually review estimates of consistent neutral
interest rates in the US and Japan (and other G-7 countries). Mean-
while Tokyo would offer up-front a long-run program of economic
reforms under which US (and other non-Japanese) enterprises could
hope to gain considerable access to Japanese markets and overcome
the so-called many invisible barriers.
Instead, Japanese currency diplomacy was driven by special interest
(domestic) politics and short-run placating of US demands, gaining a
reputation for never giving as much as had been promised, but never-
theless inflicting substantial harm on the Japanese economy overall.
One unfortunate component of the bad outcome was a lack of vision
or faulty vision on the part of the Bank of Japan, meaning that interna-
tional diplomacy on monetary matters was either ineffective or went
totally in the wrong direction.
As we have seen, at Plaza itself (Autumn 1985), Japan agreed to
tighten monetary policy towards playing its part in lowering the value
of the dollar. That was a totally bizarre offer, given that the Japanese
economy at the time had no serious inflationary symptoms and was
growing at a below-par pace. Anyhow the tightening was soon reversed
as US monetary easing in the context of US growth cycle downturn
brought a sharp decline of the US currency. At that stage the obvious

monetary response would have been continued aggressive interest rate
cuts by the Bank of Japan – if necessary all the way down to zero. The
international case for such action centred on the large private sector
savings surplus in Japan. The neutral level of interest rates there was
likely well below that in the US. But Japanese monetary policy did not
take that aggressive course. The Japanese call money rate was still at
4% p.a. in late 1986. Instead the Ministry of Finance sought to stimu-
late directly (not via the interest rate mechanism) a credit boom –
accelerating the liberalization of the Japanese banking system and
encouraging an incipient construction sector upswing.
That choice of credit stimulation at a higher-than-otherwise level
of interest rates (meaning a higher-than-otherwise international
value of the yen) may have been induced in part by wariness
(amongst Japanese officials) about the resurgence of US trade pres-
sures on Japan which came to a head during the Bush (Senior)
Administration. Towards stopping Congress from mandating trade
sanctions against Japan, the Bush Administration entered into the so-
called Strategic Impediment talks with Tokyo. A stronger-than-other-
wise yen would be helpful to keeping protectionist pressures at bay
and smoothing the talks. Concessions on Japanese fiscal policy
(Washington demanded an easing) would be helpful. (In principle,
easier fiscal policy would mean a higher equilibrium value for the
yen, in that it lowered the national savings surplus).
From the viewpoint of the ruling Liberal Democratic Party, over-
turning Ministry of Finance guidelines on fiscal authority towards the
greater purpose of reaching agreement with the US offered immediate
vote gains. (The recipients of public spending largesse tended to be the
backbone of LDP support, whether the construction companies, or more
generally the non-metropolitan regions which are over-represented in
the Japanese electoral system and which have benefited from the high-
ways and dam developments fittingly described as “cathedrals in the
desert”). In general, Japanese negotiators were willing to give ground on
public spending and on a stronger yen but were most resistant when it
came to removing impediments from which their special interest groups
derived advantage.
Perhaps even without Ministry of Finance prodding a real estate
bubble would eventually have got under way in Tokyo. Then the yen
would have strengthened as the private sector savings surplus fell and
interest rates in Japan started to move higher from their depressed
level. We cannot be sure. But we can be certain that once the bubble
burst, the ensuing rounds of currency diplomacy which followed

helped to dig Japan into the hole commonly described as the Lost
Decade. As the US economy floundered in a long growth recession
(including a period of actual recession) from late 1989 to early 1992,
Congress and the Administration saw the political advantage of
turning the trade pressure up on Japan, even though that country’s
huge financial contribution to the Gulf War (early 1991) was a temper-
ing influence. As Japan’s current account surplus bulged in the after-
math of the Tokyo market crash (January 1990), US Congress members
and Administration officials thumped the table and demanded action
from Japan to reduce its trade surplus and open up its markets to
greater US participation.
In principle Japan had a strong and pervasive counter-case to make.
In the post-bubble situation, the savings and current account surpluses
were bound to rise, especially given the severity of the emerging real
estate market downturn. Japan would be acting in its own best inter-
ests and fully in line with global economic equilibrium principles by
aggressively easing monetary policy and allowing rates to fall to their
very low post-bubble neutral levels. Huge capital exports from Japan
would absorb the savings and current account surpluses. Japan’s contri-
bution to US and world economic recovery would come through its
depressing influence on global interest rates and bond yields.
Japan’s failure to make that case can be blamed at least in part on
the then Bank of Japan Governor, Yasushi Mieno, who seriously mis-
understood the economics of the new situation. Educated in the old
principles of current account balances determining equilibrium
exchange rates, Mieno viewed the rising post-bubble current account
surplus as implying a higher equilibrium value for the yen. He was an
enthusiast of a hard yen, in any case. US officials were certainly not
inclined to make the argument just outlined for a weaker yen by
default. From Washington’s perspective a stronger yen, helped along
by massive fiscal easing, would sway the most number of votes by the
key election date of November 1992. (In principle, according to the
Mundell-Fleming analysis, an easing of fiscal policy for a given mon-
etary policy means a higher equilibrium real exchange rate. A bigger
fiscal deficit sustains a higher neutral interest rate and a stronger
capital account in the balance of payments).
Bill Clinton, the winner of that election, had fought the campaign
under the slogan “it’s the economy, stupid”. A get tough trade agenda,
especially versus Japan, was a main point of his international economic
program. In principle the Japanese government could have met the
new Administration in Washington head on with a counter-program.

The Bank of Japan, still ultimately under the control of the Govern-
ment, could have been ordered to shed its qualms about a new bubble
appearing and engage in aggressive monetary expansion. The US,
Japanese negotiators could have pleaded, would surely gain from rapid
Japanese economic recovery. Japanese diplomats might have gained
some ground from rallying wider support within G-7 for their action.
(The IMF, however, was hostile to the large and growing Japanese
current account surpluses). Towards meeting US demands, Tokyo could
have offered a list of accelerated market-opening measures, and
demonstrated how they would be introduced effectively and promptly.
Japanese officials might also have hinted that any unilateral trade
action by Washington against Tokyo would be met with determined
response – referral to GATT and counter-action by Tokyo.
Instead Japanese negotiators re-trod past paths. They offered massive
fiscal reflation which the LDP party bosses welcomed. The yen was
talked up from time – often just around the time of a crucial Japan-US
summit and there was sporadic G-7 intervention helping to underpin
its rising trend. In return for the stronger yen, Washington became less
insistent on the extent of required economic reform, leaving special
interest groups close to the LDP substantially unscathed.
The tide of Tokyo-Washington currency diplomacy came to a
turning point in mid-1995 as the full extent of the deflationary hole
into which Japan was falling and the associated banking sector risks
became evident. Moreover key changes in the diplomatic ranks on
both sides were important – MoF careerist Matsushita replacing Mieno
at the BoJ, Eisuke Sakakibara becoming the top yen diplomat, and
Rubin taking over from Bentsen (a Texan, close to the neo-mercantilist
current) as US Treasury Secretary. The new deal in Summer 1995 was a
further monetary easing by the Bank of Japan, a permanent truce in
the trade conflict (with the US side being able to claim some sort of
victory in time for elections the following year) and G-7 intervention
to bolster the US currency. Federal Reserve Chairman Greenspan made
some rare pro-dollar strength remarks and desisted from any further
rate cuts (see p. 163). (Cynics might argue that early evidence of the US
economy emerging from its brief growth recession might have argued
against additional monetary easing anyhow).
A new powerful card had come forward for Japan to play in the game
of currency diplomacy – deflation – and the need to overcome this not
only from a domestic economic standpoint but also for the sake of
the global economy. Unfortunately the card was not to be used to its
maximum effectiveness and was indeed sometimes lost from view in the
following years. Part of the problem again was a change of guard at the
BoJ, from Matsushita to Hayami in early 1998. (The hast change was
related to a corruption scandal within that institution). Hayami was a
throw-back to Mieno in terms of his enthusiasm for a strong yen and
miscomprehension of how equilibrium exchange rates are influenced by
huge underlying savings surpluses. Moreover also in 1998 the BoJ gained
independence from the Government, and Hayami was determined to
demonstrate that independence in practice even if in consequence there
was some non-optimality in macro-economic policy-making. Hayami
was concerned that participation of the BoJ in the framing and imple-
mentation of currency policy would dilute the new independence. BoJ
officials argued strenuously that currency policy had nothing to do with
their institution, even though there was a growing literature that under
conditions of deflation where the zero rate boundary prevented rates
falling to their neutral level, the only type of monetary policy was
currency policy.
In any event, the slide of the yen through 2001 and early 2002 in
the aftermath of Japan’s brief equity market bubble of 2000 (and subse-
quent crash) met no resistance in Tokyo or Washington. Japanese cur-
rency diplomats had an amiable reception in Washington where the
economic supremo under the new Bush Administration, Lawrence
Lindsey, understood fully the grounds for yen weakness, despite the US
itself being in an economic downturn (see Lindsey, 1999). Indeed
media accounts stated that Lindsey had given the green light to yen
depreciation in excess of what actually occurred, but Tokyo diplomats
failed to force the window of opportunity further open.
The next chapter in Tokyo-Washington currency diplomacy opened
with the enunciation of the so-called Bernanke doctrine in early 2003,
when the Federal Reserve launched its new policy of “breathing low
inflation” back into the US economy, where the concern had now
become that inflation had fallen so far as to mean that conventional
monetary policy might not be usable in the next economic downturn.
The implementation of the new US monetary policy meant that the
dollar slid in global currency markets – and also against the yen. In
response the government of Japan embarked on a massive program of
foreign exchange market intervention, defending successfully its
actions in Washington on the special grounds of persistent deflation
and the need to overcome this.
That is why it came as such a bolt from the blue when the G-7
Finance Ministers meeting at Dubai in September 2003 issued a com-
muniqué to the effect that there was now a preference for “more flexi-
bility in exchange rates for major countries or economic areas to
promote smooth and widespread adjustments in the international
financial system based on market mechanisms”. Parallel statements left
little doubt that the target for increased flexibility was both the yen
and the yuan. Again, a change in the diplomatic cast played a role.
Treasury Secretary O’Neil (not amenable to taking orders from the
White House) and Lawrence Lindsey were out (sacked or resigned in
December 2002), and Snow, an ex-railroad company CEO with a prior
public service record in transportation, was in. The ailing Japanese
Finance Minister, Masajuro Shiokawa, was due to be replaced the fol-
lowing Monday in a Cabinet re-shuffle (Prime Minister Koizumi was
concentrating his attentions on an LDP leadership election taking
place the same day as the Dubai Summit). The euro-area was rep-
resented by the anointed ECB President-elect, Jean-Claude Trichet (the
retiring president Duisenberg taking a back-seat).
Washington-Paris-Beijing-Tokyo diplomacy
The emergence of the euro-area as a serious element in currency diplo-
macy was a key new fact revealed by the Dubai Summit (September
2003). Also striking was the fact that the euro-diplomats, led by ECB
President-elect Trichet, appeared to be siding directly with Washington
in demanding a change of currency regime in Asia. Was this an unholy
alliance? After all, relations between “old Europe” and the US had
become seriously strained by the US-led regime shift in Baghdad
(Spring 2003). How could the same governments be so close on the
currency issue especially given the lead role (albeit not explicit) of Paris
in the new euro diplomacy? Of course this was not the first time in
history in which a surprise alliance emerged suddenly between govern-
ments which had previously been on bad terms with each other. What
was the catalyst on this occasion? In fact, was the new friendship
between Washington and Old Europe in matters of currency based on
a mutual feeling that each had got the better of the other in the
unfolding bargain? How important anyhow was euro-support at G-7
for the new US currency policy towards Asia? Did the euro diplomats
simply have an inflated idea of their collective importance?
The sudden attack by Washington on the Asian dollar bloc was
indeed puzzling. With the US in huge savings deficit and the Asian
countries in large savings surplus, there were surely considerable
advantages for the US in a currency regime where exchange risk was
only a small impediment at most to the flow of capital between the

two. Low exchange risk meant lower-than-otherwise US interest rates
and a higher-than-otherwise US dollar. From the viewpoint of the
Asian countries in large savings surplus, low exchange risk with the
dollar meant that they could reach external equilibrium with a higher-
than-otherwise level of interest rates. This was important if indeed the
neutral level of rates under a floating currency regime would be below
zero meaning a deflationary disequilibrium situation could develop.
The lower-than-otherwise real exchange rate for the Asian countries’
currencies (under a continuing dollar bloc rather than a free float)
could be important in itself to maintaining the dynamism of their
export sector. (This last point is controversial, see p. 75).
The country targeted foremost at Dubai was China, and as yet that
country was in only small savings surplus. Many long-run projections,
however, suggested that the saving surplus would become huge over
coming years and indeed that was already apparent in 2005. If China
were to break its link with the dollar, some of the other Asian countries
(excluding Japan, considered separately), themselves in huge surplus rel-
ative to economic size (Hong Kong, Taiwan, Singapore), might be forced
out of the quasi-dollar bloc to which they belonged. (Speculative flows
and policy action would contribute to that outcome). The G-7 state-
ment (at Dubai) appeared to welcome that possibility. As regards Japan,
that country was not in a dollar bloc anyhow, but because of its
deflationary situation, had been long seen as a special case (see p. 169),
in which heavy intervention rather than free floating was often the
appropriate currency mix. Surely Washington was not really about to
abandon that view?
The predominant view amongst analysts was that the Bush
Administration and its political advisers had seized upon the Chinese
currency issue out of purely domestic political calculation – with
Congressional and Presidential elections looming within a year and
where the state of Ohio with its rust-belt industries subject to Asian
competition, could crucially affect the electoral outcome. Banging the
drum against unfair Asian competition and getting China in particular
to make a move could all be good politics. On a balance of electoral
risks, the gains in Ohio from tough action on China and “unfair” Asian
competition apparently outweighed the loss of votes from any rise of
US interest rates attributable to a break-up of the Asian dollar bloc.
That cynical view carried considerable plausibility, but did not explain
why the Bush Administration persevered with the policy into 2005
well after the election had been won. Again there may have been a
new range of primarily political considerations. In particular there was

strong support in the Senate for trade moves penalizing China. The
Bush Administration had already suffered serious setbacks to its legisla-
tive programme on the Senate floor, with key appointments and initia-
tives blocked. The attempt to move the Administration’s agenda on by
offering up the fig-leaf of long-run currency adjustment had obvious
appeal to the White House.
The Bush Administration collected some surprising support (in
Spring 2005) along the way for its Asian currency policy from Federal
Reserve Chairman Greenspan and Governor Bernanke. The interven-
tion of Alan Greenspan – in the form of remarks to Congress during
testimony (April 21, 2005) – was all the more remarkable given his
usual silence on currency topics. Cynics suggested that the interven-
tion in the case of Greenspan was to help gain him influence in the
selection of a successor (his retirement fixed for January 2006) by
establishing good will with the Administration. In the case of Ben
Bernanke, his remarks came in the context of a Senate Hearing (April
25) on his appointment as chairman of the Council of Economic
Advisers. It was understandable that he would reach out to the neo-
mercantilist Senators, especially as a whole series of Bush nominees
to various offices were having a hard time of winning Senate
approval.
The ostensible case for a change in Chinese currency regime pre-
sented by these Federal Reserve officials was that an independent mon-
etary policy in Beijing would be beneficial both for China and the
world economy. For China, breaking the peg to the dollar would allow
the Bank of China to tighten monetary policy to prevent a build-up of
inflation. The present combination of a large and growing current
account surplus and upward pressure on prices suggested that the yuan
was undervalued. A real appreciation could be obtained without high
inflation through a currency adjustment. In broad terms, the officials
suggested that the Chinese economy would follow a more stable path
if monetary policy were anchored to a domestic variable – whether the
price level or money supply – rather than to the yuan-dollar parity.
The world economy would surely gain from a more rather than less
stable Chinese economy, now that it had reached the same size as
France (using nominal exchange rates as converter) and would be the
same size as Germany within 5–10 years.
At his Senate Budget Committee hearing (April 21, 2005), Alan
Greenspan took the opportunity to give Beijing some unasked for
advice on currency policy.
“The sooner they (China) move off this fixed (rate), the better off for
China’s economy ––. Their present policy of sterilizing monetary inflows
is creating imbalances which suggests, sooner rather than later, they’re
going to have to, for stability purposes, move their currency. –– As far as
I’m concerned, it’s very much in their interest to move. –– And as you
can well imagine, we in the US government have been in conversations
with them to indicate that in our judgement and in our experience they
should be moving sooner rather than later.”
At best it was ingenuous for Messrs. Greenspan and Bernanke to
suggest that the object of Bush Administration currency policy was to
make the Chinese economy better for the Chinese and its business
cycle less violent (with benefits for the world economy). In any case,
with no knowledge on how an independent monetary policy would
operate or on how stable it could be, it was a stretch for these Federal
Reserve officials to suggest strongly that this would provide the most
stable outcome. Both ignored the latest evidence that inflation in
China had fallen to barely 1% year-on-year, suggesting that the rising
current account surplus was symptomatic of an underlying savings
surplus rather than a disequilibrium situation.
Neither official put emphasis on the severe exchange restrictions in
place and the case for removing these. Then the savings surplus could
flow out to the global economy in a smooth fashion rather than in
the form of eye-catching reserve accumulation by the Bank of China,
likely in itself to inflame neo-mercantilist opinion in Congress and
elsewhere. Both officials were silent on the bigger question of whether
US pressure on Beijing over currency policy might not in fact mean
less pressure on the political regime there with respect to a range of
alternative issues – slave and prison labour, general abuse of human
rights, non-fulfilment of ILO standards as required by the WTO access
agreement, and piracy of intellectual property rights.
In fact there was an alternative policy which Washington could have
been following altogether with respect to the Chinese currency issue.
Yes, if you (Beijing) want to keep the yuan at an unchanged parity to
the dollar, so be it. But you must play according to the rules of the
game of the dollar standard. Remove exchange restrictions. Stop steril-
izing money inflows or outflows and so permit real exchange rates to
move in line with the requirements of global economic equilibrium.
There should be no presumption that the real exchange rate of the
yuan will indeed rise, given the emerging huge savings surplus and
probable surge in private capital outflows. If there are differences of
view concerning trade matters, these should not be solved or appeased
through currency moves but by direct action, if necessary through

multilateral agencies (the WTO, or ILO for example). And when it
comes to issues of human rights, use of prison labour, infringement of
intellectual property rights, we (Washington) will negotiate hard on
these and take retaliatory action as consistent with domestic and inter-
national law. We do not intend to accept the sop of an exchange rate
change as a substitute for progress on these issues.
It seems unlikely – and there is no public evidence of the fact – that
the Bush Administration (including the US Treasury) or the Federal
Reserve ever explicitly considered the full alternative scenarios for
Chinese currency policy including the continuation of a dollar bloc in
revised form as just described. Perhaps there was an awareness amongst
some foreign policy officials that by pressing for currency regime
change, Washington had lost leverage on other issues. Perhaps in
terms of the political calculus of the Bush Administration there seemed
more prospect of measurable progress and votes to be gained from
scoring a success in currency diplomacy than from insistence on wide-
ranging human rights and labour conditions reform.
Indeed the Bush Administration seemed to be offering an implicit
deal to Beijing in the form of you make us concessions on our currency
demands, and we will go easy on taking trade action against you or
making referrals to the WTO and ILO. (The partial analogy was in the
yen diplomacy of the 1990s where the currency rate became a trade-off
for general economic reform). We will also co-operate with you to
block the efforts at the UN of the “coalition of four” (Japan, Germany,
Brazil and India) to gain seats in the Security Council, even though we
believe that this body should be expanded by two members to include
Japan. But we realize that you cannot accept Japan in the Security
Council. In any case we appreciate your support at the UN as a
member of the Security Council for our Iraq policy, albeit that you
could do a lot more to help resolve the nuclear crisis in North Korea
and desist from preventing a referral (to the Security Council) of the
Iranian nuclear programme.
The French government presumably also conducted a review of the
issues and alternative strategies for dealing with the Chinese currency
question before endorsing Trichet’s entry on to the stage of currency
diplomacy at Dubai. At one extreme, the euro-area (represented by the
Jean-Claude Trichet and by Finance Ministers from France, Germany
and Italy) could have refused to go along with the US initiative on
Asian currency policy at Dubai, and there would have been no joint
communiqué. That would not in itself have prevented the US pursuing
its currency objectives in Asia (and in China especially). Instead there

would have been harder bilateral bargaining (between Washington and
Beijing). The intervention of the euro-area in support of the US at G-7
in fact made the bargaining process softer on China.
Some direct evidence on this point comes from an interview of the
IMF Managing Director, Rodrigo Rato with Reuters on July 29, 2005.
This senior IMF official, an ex-Spanish Finance Minister, stated “we
were insisting all along through the summer and the winter that China
should change its currency system, but we never accepted the argu-
ment that there was a case for retaliation against Chinese exports.
I know some groups and people thought otherwise. I think there was
no case for that and action would have been unfair and a mistake”.
Historically the IMF has been headed by a Continental European and
sensitive to the current of French-German thinking on currency
matters. (Indeed French has been the dominant nationality of IMF
managing directors – including Pierre-Paul Schweitzer (63–73), Jacques
de Larosiere (78–87) and Michel Camdessus (87–00)).
The outcome of the Dubai summit meant that euro-area diplomats
were part of the negotiating process (with respect to the Chinese cur-
rency issue) and could press Washington to give multilateral diplo-
macy space and time. It would surely be best (so the euro diplomats
could argue) if the IMF gave its blessing to the change in currency
regime. In turn the euro-area diplomats presented themselves to
Beijing as mediators between the hard-liners in Washington and them-
selves (the Chinese diplomats). The euro-area diplomats could impress
upon Beijing the case for compromise. Anyhow this should mean
fewer problems (with Washington) on other fronts (human rights,
etc.). Moreover the French contingent (of euro-area diplomats) would
have hinted at their country’s interest in increased military equipment
business once Paris could succeed in getting the EU arms embargo
lifted (imposed in the aftermath of the Tiananmen Square massacre) or
even before. For France, the driving force behind the diplomacy,
cosying up to China was consistent with the advancement of its grand
aim of multi-polarity rather than US hegemony.
France and the euro-nationalists saw clear advantage for themselves
in the break-up of the Asian dollar bloc. After all, a principal purpose
behind the formation of European Monetary Union was to challenge
US monetary hegemony and gain increased independence (of the US)
for Europe in particular. A break-up of the dollar bloc would surely
mean just that – a decrease of US monetary power in Asia and an
increased global role for the euro. Economists at the Bank of France
trumpeted the view that the US mega current account deficit was a
serious long-run menace to the global economy. So as to avoid much
greater trouble down the road, balance of adjustment should start
early. So long, however, as Asia remained on a dollar standard, Europe
would bear an unfair share of the adjustment cost. Burden sharing
required that Asia revalue their currencies. The same line of argument
was broadcast by ECB officials from President Trichet downwards.
Implicitly, euro diplomats were working with a command-type
model of balance of payments adjustment. The stated problem was to
reduce the US current account deficit by say X% of (US) GDP. For that
to occur there had to be a y% real effective exchange rate depreciation
of the US dollar. If the Asian countries remained on a dollar standard
and somehow prevented a real appreciation of their currencies (via
sterilized intervention) from taking place, then European currencies
would have to adjust upwards by a very large amount. If, by contrast,
the Asian currencies were forced to appreciate, then the European cur-
rency appreciation could be less. The argument was deeply flawed but
nonetheless it was repeated forcefully and apparently with some
success in the world of currency diplomacy.
Whether the US deficit had to fall by X% of GDP depended not on
command but on the evolution of savings surpluses and deficits
throughout the globe (especially in the US, Europe, and East Asia).
Where the offsetting changes in surpluses had to take place to match
any reduction in the deficit would be determined by market forces and
depended on how savings propensity and investment opportunity
changed relative to one another in Europe, Asia, and the Middle East.
The extent of exchange rate change which accompanied the fall in
the US deficit would turn on whether the downward shift in savings
surpluses abroad (outside the US) occurred autonomously (for example
due to a sudden flourishing of investment opportunity) or had to be
induced (via interest rate falls). Induced falls would mean larger
exchange rate change (see Chapter 8, p. 224 for a discussion of the
various exchange rate scenarios possible). Moreover, just because
the Asian countries were on a dollar standard did not mean that they
could not experience considerable real exchange rate change over
the long run. This could stem from cumulative differential inflation.
Finally, forcing the dollar bloc to break up might stimulate diversifi-
cation out of the dollar by Asian investors which could push the euro
to a higher level than it might otherwise have reached.
In principle the break-up of the dollar bloc would mean in the long
run smaller Asian savings surpluses, lower Asian interest rates, smaller
US savings deficits and higher US interest rates. That would be a direct

consequence of an increased barrier in the form of exchange risk
between the savings surplus countries in Asia and the savings deficit
countries, principally the US. The impact on the euro-area savings
balance (small at present) and equilibrium exchange rate would be
ambiguous, depending on a number of factors, including the elasticity
of capital flows from the euro into the dollar in response to a widening
rate spread between the two currencies (higher US interest rates) and
the extent to which Asian investors would see benefit in diversification
into euros now that they were no longer much riskier than dollars
(from an Asian perspective). This diversification by investors would be
offset at least partially (in its effect on the euro) by diversification on
the part of borrowers (away from dollars and towards euros).
One country which might have been expected to have a strong view
on whether the Asian dollar bloc should continue and what its break-
up might mean for currency movements was Japan. In practice
though, Tokyo largely followed Washington’s line, albeit winking to
Beijing that somewhat smaller gestures than those demanded, and at a
slower pace, might be sufficient. Even if some Japanese policy-makers
might have sympathized with the view that an Asian dollar bloc was in
Japan’s interest (providing stability of trading conditions for Japanese
direct investment in these countries and reducing the likelihood of
Tokyo’s own intervention tactics coming under attack), they could
hardly reckon that a Japan-China coalition would be any stronger than
Beijing on its own in protecting the status quo. What had Tokyo to
gain from introducing a point of tension (Asian currency policy) into a
generally close relationship to Washington, when Chinese-Japanese
relations were themselves in near-crisis state (the proximate cause
being Prime Minister Koizumi’s continuing annual visits to the
Yasukuni Shrine)? After all, long deflation had made Japan a special
case when it came to currency policy.
The outlook for currency diplomacy

In sum, the diplomacy of the yuan became very murky – and the main
players had fairly cloudy vision concerning both their strategy and
where it would all end. Certainly it was significant that the euro-area,
driven by France, had entered the game. Not for the first time its diplo-
mats had lost sight of the forest for the trees.
Are there lessons from the China example – and other recent history
– for how diplomacy might or should evolve in coming years?
A first point is a disturbing lack of quality or democratic check even

with respect to US currency diplomacy. Could there not have been a
higher quality debate in Congress on the issues? In particular why were
there not more probing questions concerning the economic conse-
quences of currency regime choice in China and other broader related
questions, such as the impact of the chosen path of currency diplo-
macy on human rights, labour practices, and indeed any potential
conflict over Taiwan. (For example, perhaps the building up of massive
holdings of US dollars by Beijing might increase its potential to wage
psychological or actual war against Taiwan).
Secondly, European currency diplomacy was made with even less
democratic check than in the US, unless we treat France as speaking for
Europe. Chinese currency policy was a subject which the French
Finance Minister sometimes had to address at press conference. But
there is no record of parliamentary questions concerning this. Going
forward, euro-area members have yet to address how currency policy is
to be formed and how it is to be vetted. Presumably it is not a long-run
stable situation for this to be sub-contracted to France. In any case the
next President of the ECB (Trichet’s term expires in 2011) is hardly
likely to be French. Without any progress towards political integration
in the euro-area it is open to doubt whether currency diplomacy
should be undertaken at all (from the viewpoint of democratic legiti-
macy). That might mean some loss of potential advantage for Europe
in some situations – but in much of the currency diplomatic game the
sum is zero or negative, and it is not obvious Europe should expect to
be on the winning side.
Third, currency diplomacy concerning monetary policy alignment
from a global standpoint (discussing whether perceptions of neutral rate
levels as held by the major central banks for their own money are glob-
ally consistent) remains highly underdeveloped and intermittent. In a
world in which interest rates as pegged by central banks can stray far
from neutral levels where these are defined in a global sense, could there
not be a better mechanism for exchanging views – for the US to influence
Europe and Japan, and conversely. It is a farce for G-7 central bankers to
meet twice a year simply to discuss generalities or exchange rates, but
without reviewing the global consistency of their monetary policies (in
the sense of their groping towards estimated neutral rate levels which
would stimulate sufficient capital flows to match underlying savings
surpluses and deficits).
Monetary diplomacy as just described has got a bad reputation in the
past due to its having been linked to specific episodes of exchange rate
targeting (as under the Louvre Accord) which were untenable. In fact
monetary diplomacy need not be related to specific exchange rate
targets – even though the determination of neutral rate levels globally
does assume that exchange rates are on an equilibrium path (see
Chapter 3, p. 69). Most of the time it would not be unreasonable for
central banks to assume that the market perceptions of the equilibrium
path as reflected (not necessarily 100%, due to the possibility of market
interest rates being above or below neutral level) in actual market rates
are as good as any likely to emerge from supranational institutions.
The present isolationist standpoint of the Federal Reserve and ECB,
where any interference from outside would be ill-regarded, is surely
sub-optimal. If indeed monetary diplomacy is impossible to implement
or of essentially poor quality, then that would be an argument for
allowing markets a greater role (and national – including currency area
– bureaucracies, such as the Federal Reserve or ECB, less) in the setting
of market interest rates (as outlined in Chapter 5, p. 141). Markets in
making their assessment of neutrality have no qualms about introduc-
ing global elements of consistency into their analysis – but are discour-
aged from doing so if the game has become predicting where the
national bureaucracies will guide their pegs to short-term money rates.
Fourth, Japanese currency diplomacy has remained typically myopic
– focussed on agreeing at times of stress an unofficial acceptable range
of foreign exchange market intervention with their US opposite
number. There has been no big picture. Indeed there might be consid-
erable advantage from both the Japanese and global perspective in
Japan moving away from a fix-it approach to currency diplomacy to a
contingency approach. According to this, Japan would explain that
when short circuits develop in the global flow of funds, possibly
because of the zero-rate barrier in Japan preventing an equilibrium
outcome from emerging, then large-scale official intervention in the
currency markets is a stabilizing necessity. Rather than Japanese diplo-
mats agreeing a target range for the yen/dollar rate with Washington,
they would state a likely amount of reserve accumulation over a period
of time. US and Japanese diplomats would review those targets for
reserve accumulation in line with the progress of deflation and the
duration of any short-circuit. Markets would be left to set the currency
rates but with the knowledge that a given volume of official operations
would be taking place over a given time period.
From the perspective of early 2006, when Japanese deflation is
widely seen as fading away, the need for any re-vamping of the
framework of currency diplomacy vis-à-vis the US might seem
remote. All the talk (and eventually action, March 2006) coming out
of the BoJ has been about preparations for a reversion to conven-
tional monetary policy and a scrapping of the exceptional arrange-
ments in place since 2002. As we have seen, however, earlier in this
book (Chapter 4), it is plausible that in the next global or Japanese
economic downturn the zero rate barrier could again become effec-
tive. It would be a pity if Tokyo had meanwhile scrapped its special
status enjoyed in G-7 whereby it can pursue substantial intervention
as a non-conventional tool under situations of deflation. Instead,
pro-active currency diplomacy by Tokyo would have ensured that ter-
mination of the present abnormal ease was accompanied by a new
framework of policy agreed with Washington. In this, contingency
use of unconventional tools including foreign exchange intervention
would be possible should the deflation threat return.
Fifth, there is the question of new players. As we have seen, Beijing,
through no choice of its own, has had to enter the game of currency
diplomacy, and as a player has been able to take advantages of its geo-
political position and euro-ambitions (for a multi-polar world) in Paris.
Could there be further new players in coming years? India, Brazil and
Russia are all possible candidates, especially if they achieve the contin-
uing rapid economic growth rates which optimists on those countries
project. The other new game of currency diplomacy is likely to be
within the European Monetary Union, as national governments claw
back the power which has been delegated to technocrats in Frankfurt,
or by default to France. The flow of capital within a monetary union
and between the union and the world outside, together with its impli-
cations for international relations within Europe, are the subjects of
the next chapter.
7
Dysfunctional Union
Throughout this volume a recurrent theme has been the power of

divergences in savings propensities and investment opportunities
between countries to drive global capital flows. A key line of inquiry
has been how neutral interest rates vary relative to each other (across
currency frontiers) and how equilibrium exchange rates shift in
response to the power source (international divergences between
savings or investment propensities) being turned up or down. Within a
monetary union the power source driving capital flows between the
member countries and between them (the union as a whole) and the
rest of the world is the same (as for the case of sovereign monetary
areas). The possibility of virtually riskless arbitrage, however, keeps
nominal interest rates (measured with respect to assets of identical
credit risk) at identical levels to each other in all member countries (of
the monetary union). The analyst of capital flows focuses on how the
underlying divergences (in savings propensities and investment oppor-
tunities) influence the determination of the neutral interest rate for the
whole union and the movement of national price levels relative to
each other (within the union).
Within the monetary union international trade and capital flows are
unimpeded by exchange rate risk or currency transactions costs. There
is one common (to all member countries) credit and capital market.
Though in principle the same nominal interest rate (for a given matu-
rity and credit risk) throughout the union can translate into distinct
(and different) expected real rates for each member country in line
with divergent expectations regarding national price level trends, there
is no sense in which these real rate spreads become a driving force
behind capital flows. The real rate spreads are wholly dependent on the
residence of the investor (or more exactly on where the investor
182
Dysfunctional Union 183
intends to purchase goods and services), not on any national differen-

tiation of the particular money and bond market instruments.
As illustration, take the situation of a long-run expectation that the
price level in Spain will rise faster than in the rest of the euro-area, on
average. That expectation might be based on the so-called Balassa
effect, found where productivity growth in the traded goods and ser-
vices sector of a converging economy is running far ahead of that in
the non-traded sector (see Chapter 3, p. 80). (Convergence refers to the
process of an economy catching up with more advanced economies).
Real interest rates on euros (or indeed on any other money) would be
lower from the viewpoint of Spaniards or any other euro-area investors
intending to spend their money in say, Spain, than from the viewpoint
of investors who concentrate their spending in Germany.
This spread of real rates (dependent on where in the union the
spending is to occur) does not create any type of arbitrage opportunity,
risk free or risky, in the form of exporting capital from one member
country to another (Spain to Germany in the illustration given).
Equivalently, real interest rate spreads between member countries in
monetary union play no role in bringing about external balance –
defined as the situation where the underlying savings surplus (or
deficit) equals net capital outflows (or inflows) for each and every
country. They do however play a role (not always constructive as we
shall see below!) in the achievement of internal balance (where aggre-
gate demand, including net exports, is equal to productive potential).
In fact, one criticism of the operation of monetary unions is that
they may give rise sometimes to a spread of real interest rates (mea-
sured according to the perceptions of investors in each member
country) which is more out of line with neutrality than what would
occur under a regime of sovereign monies (for each country). As illus-
tration, if the underlying savings surplus increases in Germany at the
same time as falling in France, a process of adjustment would get under
way in which the German price level would tend to fall relative to that
in France. During this adjustment period, likely to stretch over a period
of years, real interest rates as perceived by German investors (or bor-
rowers) would be greater than as perceived by their French counter-
parts – a perverse situation, given that higher savings in Germany
should mean lower real interest rates there in the long run.
Under a regime of sovereign monies, German real interest rates (and
nominal) would have fallen at the same time as the savings surplus was
recognized by markets (and the relevant central bank) to have moved
on to a rising path. (The lags in recognition might of course be long!).
The relative price level adjustment in France and Germany (accom-

plished by nominal exchange rate change) would indeed have been
more rapid (under the case of sovereign monies) and cumulatively less.
It is not always the case that the process of relative price level adjust-
ment in a monetary union pushes real interest rates as perceived by
residents in the given countries (where adjustment is occurring) in the
opposite direction to neutral (during the adjustment phase). Take the
example of where one member economy is enjoying a productivity
surge in its export sector (or a buoyant market for one of its main
exports, perhaps a primary commodity). Its price level would adjust
upwards, and during the period of adjustment, real interest rates (as
perceived by domestic residents) would fall. The same (in different
degrees) would happen under a regime of floating exchange rates (see
Chapter 3, p. 80). The national currency would jump (in international
value) in anticipation of rising export revenues, and interest rates
would fall to offset the dampening influence on aggregate demand (on
the assumption that the rising revenues are some considerable time off
in arriving). The lower real interest rates in both cases (monetary union
and sovereign money) induce some bringing forward of domestic
demand (and so a widening of the savings deficit or narrowing of the
savings surplus) ahead of the future rise in export revenues.
The issue of possible perverse movements in real interest rates is rel-
evant to the assessment of the benefits and costs which flow from
monetary union. But that is not the aim of this chapter. Rather, the
purpose here is to analyze the mechanisms which facilitate the flow of
capital both between member countries (in monetary union) and with
the world outside. Are these (mechanisms) well-functioning enough to
allow full equilibrium to be achieved in all countries of the union even
where there are widely divergent socio-political, economic, or demo-
graphic conditions prevailing? Finally we take a look at how these
same mechanisms might be maimed by the outbreak of speculation on
the survival of monetary union itself.
How big is divergent price level risk?

The creation of monetary union extinguishes exchange rate risk as a
factor in trade or capital flows between the participating countries. But
relative price risk – the possibility that the price level in one member
country might move far up or down relative to in another member (or
members) – might loom large when cumulated over long periods of time
and be more serious than the exchange risk which has been dispelled.
As illustration, if Germany were still a sovereign monetary area, the

emergence of a large underlying savings surplus (in that country)
would go along with interest rates there (in Deutsche marks) falling in
nominal and real terms relative to elsewhere. A new equilibrium would
come about, where lower German interest rates contained the widen-
ing of the savings surplus and at the same time stimulated the outflow
of capital. The lowered level of interest rates would mean that the price
level in Germany would not have to fall by as much relative to foreign
price levels (or its exchange rate fall by as much) so as to sustain inter-
nal balance (characterized by aggregate demand, including net external
demand, being equal to productive potential). By contrast, in a mone-
tary union, the whole offsetting stimulus to aggregate demand (to
match the initial fall in domestic demand stemming from a rise in
underlying savings surplus) has to come from relative price level
change (and its influence on net external demand).
Furthermore, the process of relative price level change without the
help of nominal exchange rate shifts might be intrinsically more eco-
nomically painful than where sovereign monies at adjustable or fully
flexible exchange rates to each other still exist. As illustration, suppose
the flourishing of investment opportunity in Spain coupled with a
rising savings in Germany means that for both countries to reach a
new equilibrium the Spanish price level must increase cumulatively by
10% and the German price level fall by 4% compared to the euro-area
average (which increases by say just under 2% in line with the ECB’s
objective). In the context of monetary union, there is no financial
instrument which provides a means for Spanish households to hedge
their monetary savings (in euros) against high inflation (in Spain) over
an interim period. And for foreign corporations which have made
direct investments in Spain there is no instrument for protecting their
economic exposure to a big rise in relative labour and other costs there.
In fact, for both households and enterprises the obvious hedge might
be Spanish real estate – but the extent of basis risk (ups and downs of
Spanish property in real terms where the Spanish price level is used as
deflator) should not be underestimated.
By contrast, where relative price level change takes place mainly
through the swings of exchange rates, both the household sector and
enterprise sector might be less at risk over long periods of time (than
where the change occurs via price levels themselves adjusting). In the
Spanish example, a jump in its currency (the peseta) would compen-
sate for the lack of cumulative rise in the price level, but leave many
(Spanish) investors better off (especially small and medium-size savers
in whose portfolios money, bonds, and other nominal claims –

including pension funds – rank high). Enterprises could hedge in part
by taking forward exchange positions and rolling these over (short
foreign currency and long pesetas). Rolling over short-maturity
forward contracts provides a hedge against unanticipated real
exchange rate movements (identical to relative price level changes) at
the cost of assuming some inflation risk (on both sides of the deal).
Cumulative inflation risk (inflation different from expectations as
reflected in nominal short-maturity rates) tends to diminish when
summed over long time horizons as the market’s errors even out.
The extent of relative price level change over time (whether in the
context of a monetary union or floating exchange rate system) can
depend on the mobility of labour. In some examples, labour mobility
adds to the potential size of relative price change. For example,
suppose one country in the union is enjoying an investment boom. If
the labour supply (in that country) is fixed, then rising real wages
might soon erode the profit opportunities and so the marginal rate of
return on new investment falls to the average level across the entire
monetary union. By contrast, if labour inflows are highly elastic in
response to real wage gains, the profit opportunities would persist for
considerably longer – and the amount of cumulative capital inflow
could be much larger (meaning a more substantial relative price level
change).
As a general point, the extent of relative price level change, and the
consequential risks (for economic agents) are larger in the case of a
small member of the monetary union than large. For changes in the
underlying savings surplus position of a large country are reflected to a
greater extent (than is the case for a small country) in the common
interest rate level (for the union as a whole), meaning that less relative
price change is required (than for a small country) in the process of
restoring internal balance.
The amount of cumulative real effective exchange rate change and
the potential shifts in the underlying savings surplus (of deficit) for the
monetary union as a whole are not obviously larger, when considered
over long periods of time, than would be the case where sovereign
monies still existed for each member country. By contrast, the size of
notional real effective exchange rate change for each member country
considered on its own (where this is defined to mean a shift in the
domestic price level relative to the say trade-weighted average of those
in foreign countries, including union and non-union) and swings in its
underlying savings surplus (or deficit) are potentially enlarged.
As illustration, suppose there is an autonomous rise in the underly-

ing German savings surplus (due to some combination of rising house-
hold sector savings and of falling investment propensities – perhaps
linked to the increased availability of cheap labour resources across the
border into Eastern Europe). In the context of European Monetary
Union, that increased level of German savings surplus means a down-
ward pressure on the euro interest rate – greater than the downward
pressure which would have borne on non-German interest rates within
the boundaries of the present euro-area if each member nation still
issued its sovereign independent money.
Hence the German savings surplus remains at a higher level, and the
deficits (surpluses) in the other euro-area countries at a higher (lower)
level, than would be the case under the sovereign money alternative.
As a corollary the real effective decline in the German price level rel-
ative to those abroad (including union and non-union countries)
would be greater than the real effective exchange rate decline of the
mark in the case of monetary union. But the overall level of the euro-
area savings surplus and the average level of euro-area interest rates
(equal to the euro-rate in the case of monetary union) might be little
different in the two cases.
The German problem in EMU

The hypothetical discussion of a rise in the underlying German savings
surplus corresponds in some degree to the reality of the situation
within European Monetary Union. Already at its formation, perhaps
with the benefit of hindsight, the underlying German savings surplus
was tending to increase. The construction boom which got under way
following German political unification (1990) had already started to go
into reverse (from the mid-1990s onwards) (see Figure 7.1). And
growing concerns about the long-run solvency of public sector pension
provision (meaning that present commitments would have to be scaled
back) was tending to put upward pressure on the savings rate – espe-
cially given the bulge in the pre-retirement decade of workers in
Germany’s rapidly ageing population.
Into the early years of the next decade (2000–10) there were new
downward influences on the business investment spending rate. These
came from the growing perceived burdens (from the viewpoint of
entrepreneurs) of Germany’s Rhenish capitalist model (high degree of
worker protection, meaning inflexible labour markets) in a world
where it had become much easier (by virtue of the information
15
savings
14 construction spending
13 other investment spending
12
11
10
4
95 96 97 98 99 00 01 02 03 04 05
Figure 7.1 Germany – savings, construction and investment, 1995–2005 (as %

of GDP)
technology revolution) to shift production abroad to locations where

labour was cheaper and less protected. Several of these new locations
were just across the frontier (in Central and Eastern Europe) and were
particularly easy for German (as compared to say French) entrepre-
neurs to utilize. This comparative advantage of German entrepreneurs
(in taking advantage of the integration of ex-communist countries
into the EU) stemmed in part from geography and in part from long-
established commercial relationships.
Simultaneously with the rise of the underlying German savings
surplus was a tendency for savings deficits (surpluses) in other impor-
tant parts of the euro-area to increase (decrease) due to the structural
financial changes which accompanied European Monetary Union. In
particular, the traditional high interest rate countries of the EU, where
the old sovereign monies had been of low quality (subject to high
inflation risks), found themselves with a new low rate international
money (the euro) and financial market innovation simultaneously
bounded ahead.
It was hardly surprising that these countries (Spain, Italy, Portugal,

Greece, Ireland) experienced a plunge in their savings surpluses or a
widening of their savings (and current account) deficits as the house-
hold sector in particular took advantage of the new consumer borrow-
ing or real estate mortgaging possibilities (see Figures 7.4 and 7.5). It
could not be clear whether in aggregate the downward forces on aggre-
gate savings in these countries matched in amount the upward forces
in Germany – in which case the average neutral interest rate level
across all member countries would have been unchanged. It was
certain, however, that a substantial relative price level adjustment
would have to take place (down in Germany, and up in Spain, Portugal
etc.) (see Figures 7.2 and 7.3).
The attitude of the ECB towards all this was to focus on the average
price level for the whole of the euro-area and how this was evolving
relative to target. ECB officials cited the example of the US, where the
Federal Reserve monitors the inflation rate for the whole of the US and
is not greatly concerned by the process of relative price adjustment
between the regions or states. That nonchalant attitude (on the part of
the ECB) was open to question. The extent of relative price adjustment
122
120
Germany France Italy
118
116
114
112
110
108
106
104
102
100
98 99 00 01 02 03 04 05
Figure 7.2 Germany and France – CPI levels, 1998–2005 (Jan 98 = 100)
135
Netherlands Spain
130
Greece Portugal
125
120
115
110
105
100
98 99 00 01 02 03 04 05
Figure 7.3 Spain, Netherlands, Portugal and Greece – CPI levels, 1998–2005
(Jan 98 = 100)
90
80
70
1998 2001 2004
60
50
40
30
20
10
0
– 10
– 20
Germany France Netherlands
Figure 7.4 Germany, France, Netherlands – current account balances, 1998–2004

(Eur bn)
30
20 1998 2001 2004
10
–10
–20
–30
–40
–50
Italy Spain Greece Portugal
Figure 7.5 Italy, Spain, Greece, Portugal – current account balances, 1998–2004
(Eur bn)
under way in the euro area at the start of the new union was surely
beyond the normal experience within the US. The extent of political
tolerance for the costs of relative price level adjustment might well be
less in the group of sovereign states that made up European Monetary
Union than in the United States of America, bound together in a
federal political union with an extensive system of fiscal burden-
sharing between the states. Moreover there was no big theme behind
relative price level adjustment in the US to which the Federal Reserve
could pay attention. There were no forecasts of big relative price
adjustment say between New York and California.
In the case of the euro-area, a key issue was whether the ECB, in its
formulation and conduct of policy, should take account in any way of
the big projected relative price level movements within the union,
particularly vis-à-vis Germany? The issue was in some respects blurred
in the policy discussions. The blurring occurred in consequence of a
tendency of policy-makers focussing on past measures of relative price
levels (before the union was formed) and present measures (according
to national income data) of savings surplus, rather than searching
for appropriate new benchmarks (of relative prices) and for estimates
of the underlying savings surplus. In particular, econometricians

working in the ECB or Bundesbank quoted data to show that with the
price level adjustment which had occurred so far, Germany was now
(2003) as competitive as before unification. But the question went
unasked as to whether under present circumstances, and within the
context of monetary union, Germany had to be much more competi-
tive than in the past so as to generate an export surplus equal to its
underlying savings surplus, which might now be much larger than in
past periods (of surplus).
The grounds for suspecting that the underlying surplus was indeed
larger than in the past and than the actual realized surplus (whether
taken from the national income data or as proxied by the current
account in the balance of payments) included first, the creation of
monetary union itself (which as we have seen means that interest rate
differentials between the countries participating in union can no
longer emerge and play a role in moderating savings imbalances).
Second, the recessionary or near recessionary conditions in the
German economy – explained in part by the rigidity of prices and
wages and hence the slowness of relative price level adjustment to
take place – went along with savings being depressed below their equi-
librium level (as households to some extent would maintain their
living standards by saving less than they would in a situation of
normal prosperity).
Despite ignoring these sophistications, the ECB was still aware of the
substantial relative price level adjustment within the monetary union
which most likely was under way and in line with equilibrium tenden-
cies. Some monetary critics argued that the ECB should have used that
knowledge to be somewhat more tolerant of near-term overshoots of
its inflation target. The above-average rates of inflation in Spain,
Portugal, Ireland, and Greece, which were adding to the euro-area wide
CPI inflation rate, would come down of their own accord once the
process of relative price level change within the union was complete.
(The sources of downward pressure on inflation in those countries
would include an eventual weakening net external demand which
would stem from the erosion of price competitiveness. In addition real
estate markets might cool down after their buoyancy in the early years
of monetary union). The German rate of inflation would most likely
not come under coincident upward pressure, given the extent of
inflexibility of prices there (Germany) in a downward direction during
the period of relative price adjustment and the large amount of slack
which had developed. Once the process of relative price level adjust-
ment was complete, there could be a long period during which the
German price level would remain stable, even though the German
economy had pulled out of its period of sub-par growth.
National socio-economic choice – is it suppressed by monetary

union?
One theme to emerge – not totally new – from the German experience
in monetary union is whether individual countries can pursue their
own distinctive socio-economic model. Is it possible for Germany to
stick with its Rhenish capitalist model, reinforced at first in some
respects by the SPD-Green government which came into power at end-
1998, and then gradually modified, in the new world of European
Monetary Union? If we were to listen to the clamouring from the
Bundesbank, the ECB, and the OECD secretariat, the obvious answer
would be negative. There is no alternative (according to this chorus) in
the context of union to discarding Rhenish capitalism. On closer
examination, however, the “third way” does still exist as an option,
even if the cost-benefit analysis in favour of or against its adoption or
retention has been altered by the reality of monetary union.
By “Rhenish capitalism” we mean a system of protection for labour
against shock – most importantly redundancy or sudden changes in
terms of employment. The system comes at a cost which bears on
enterprises. That cost has most probably increased in recent years due
to the information technology revolution. The harnessing of the new
technology to goods and services production is easier to achieve where
there is considerable flexibility in labour inputs. In principle, there is
an equilibrium solution – in which Germany would be in full internal
and external balance. The German wage level would have fallen to a
level (relative to that abroad, on average) such that the increased cost
of labour protection was largely shifted to employees, and the rate of
return to capital (taking off the implicit cost to enterprises of comply-
ing with the Rhenish model) was the same in Germany as elsewhere in
the union. In the case of Germany’s experience so far with European
Monetary Union an impediment in the way of reaching such an equi-
librium solution has been the inflexibility of nominal wages in a down-
ward direction – meaning that the process of relative labour cost
adjustment (to take account of the increased burden of the Rhenish
capitalist model) has been painfully slow.
In some respects, though, German labour has more scope to shift some
of the cost of the Rhenish model to owners of capital throughout the
euro-area (instead of this being paid for fully by labour in Germany)

than would be the case for labour in a small country in the euro-area.
This greater scope stems from the fact that the neutral level of interest
rate in the euro-area as a whole reflects investment opportunity and
savings rates across all member countries and Germany is an important
part of the (weighted) average. Hence the adoption or reinforcing of the
Rhenish model in Germany would tend to depress the neutral rate of
interest in the euro-area (and more broadly the marginal rate of return to
capital in the euro-area). As long as the euro is freely floating against
outside currencies, and there is a significant impediment in the form of
exchange risk to global equalization of rates of return, it is possible for an
equilibrium solution to emerge in which expected rates of return on euro
assets are somewhat low (reflecting costs of the Rhenish model) by
international comparison.
As part of the process (of reaching the equilibrium outcome), real
wages in the union countries not applying the Rhenish model would
tend to rise somewhat (compared to those in Germany). That follows
from an increased capital intensity of production there (relative to in
Germany) as capital costs fell (in line with the neutral interest rate). In
the long-run, growth of labour earnings could be retarded in Germany
by a lowering in the rate of domestic investment (the corollary to
greater net capital exports) and so eventually in the capital-output ratio
– relative to the hypothetical level of these aggregates (domestic invest-
ment and capital-output ratio) if the Rhenish capitalist model had
been discarded. (See Chapter 3, p. 86, for a related discussion of the
(cheap labour” “neighbour next door problem.”).
If Germany were not part of monetary union, but retained and even
reinforced its Rhenish model, then the equilibrium solution would be
characterized by interest rates (and marginal rates of return generally)
in Germany falling to a lower level (than in the case of monetary
union), real wages sustaining a higher level (at least in the early years
before the depressing influence of a continuing lower-than-otherwise
level of capital investment sets in) and net capital exports from
Germany to the rest of the world running at a greater pace. German
savings would be somewhat lower in response to lower rates of return,
and the domestic rate of capital spending more sluggish (by a larger
margin), than in the case of Germany belonging to monetary union.
(We are comparing here full equilibrium outcomes).
So far we have been considering the Rhenish model only in terms of
the labour market regime (the extent of protection there against
shock). There may also be other attributes, however, more generally
associated with a “third way” socio-economic model, including fairly

onerous taxation of capital compared to the low-tax regimes in other
parts of the union or elsewhere. This would result in some increased
momentum of capital flight as domestic investors sought to put an
increased share of their portfolios in offshore centres and other low-tax
jurisdictions (protected by effective bank secrecy or non-co-operation
in tax matters). Under a floating currency regime (in which Germany
would issue its own sovereign money, the Deutsche mark), the veering
of taxation towards the “third way” would mean higher-than-other-
wise interest rates (on marks) and a lower exchange rate (for the
Deutsche mark against other currencies). The extent of the rise could
be moderated, as we saw in Chapter 3 (p. 73), by foreign inflows of
capital, if indeed foreign investors are exempted from the new higher
tax regime. Another moderating influence would come from any ten-
dency of German investors to buy Deutsche mark-denominated assets
in the selected foreign centre (rather than foreign currency assets,
including non-German equities).
The higher rates (on Deutsche marks) would be consistent with a
lowered rate of capital spending in Germany, increased net exports (of
goods and services), and a larger overall savings surplus. (The latter
would correspond to a fall in capital spending offset only in part by a
possible decrease in savings – if indeed some households reacted to the
increased taxation of income by reducing their propensity to save and
if this influence were not wholly balanced by the influence of higher
rates). In the new long-run equilibrium path the capital-output ratio in
Germany would be increasingly below the alternative path which
would have been followed without the socialist tax measures, meaning
some depression in real wage growth. (In turn, if labour is mobile, that
decrease in wage growth might give rise to net emigration, which in
turn would arrest the fall of wages relative to abroad).
How does that equilibrium outcome differ from what would occur
under a currency union? Here there would be no rise in union interest
rates unless for some reason the capital flight went to a large extent
into assets denominated in foreign currencies. This would be unlikely,
given the large range of assets available in the union currency. By con-
trast, in the case of Germany with its own sovereign money, the range
of assets available offshore in the German currency (Deutsche mark) is
smaller and so the incentive for the fleeing capital to move into foreign
currency assets is correspondingly greater.
The outflow of domestic (German) capital into union (euro) cur-
rency assets in foreign banks (outside Germany) would not have any
consequence for relative prices between Germany and the rest of the
union, as there would be perfect round-tripping. With no exchange
risk as impediment, foreign capital (from other countries in the
union) would flow into Germany to offset any capital flight, all at the
same level of interest rates (as prior to the increase in taxation). This
would be on the assumption (in line with present prevailing practice)
that foreign investors in Germany would not be subject to the higher
tax regime (at least with respect to their placement in money and
bond market instruments). And so a shift in tax regime – towards
penal taxation, say, on wealth – should have little or no effect on
exchange rates or the growth of real wages and the capital output
ratio (in the German economy) through time.
Before the creation of monetary union in Europe, tax flight did have
an influence on the equilibrium solution for the affected country. An
illustration comes from the brief socialist experience in France during
1981–3, ushered in by the election of Francois Mitterrand as President,
and the victory in parliamentary elections of his socialist-communist
coalition. Interest rates rose in France as the counterpart to a massive
export of private capital. Domestic investment by French enterprises
plummeted. Through a succession of devaluations the franc’s interna-
tional value reached a new record level of cheapness in real terms
(vis-à-vis foreign currencies).
In Spring 1983 came the turn, when the Mitterrand Administration
ditched socialism in favour of “Europe”. Mitterrand had been convinced
by his advisers that even with a floating exchange rate for the French
franc (if it had been pulled fully out of the European Monetary System),
socialism was not possible in France alone (see Brown, 2004). Jacques
Delors, his finance minister, announced that socialism in France could
only be advanced as part of a European-wide movement. First there had
to be economic and monetary integration. Then the European Union
with France as an integral part could embrace the social market economy.
In fact, Delors was wrong on both scores. France could have pursued
the social market alternative on its own with a floating exchange rate
regime (as we have discussed above for the case of Germany). If instead
the choice were made to pursue European monetary integration first,
and the end-goal were reached, France could still embrace socialism on
its own, without other union members following suit. Delors would
have had a point if he argued that unilateral socialism (but not Rhenish
capitalism) would be less costly for France in the context of monetary
union than under continued national monetary sovereignty. The basis
of that hypothesis, as in the German example, is that capital flight
would not push up interest rates and the capital-output ratio should
continue along the same path, rather than falling. In consequence real
wage growth should not suffer over the long run.
In sum, the economic logic of monetary union points to consider-
able diversity being possible between socio-economic choices in the
member countries. In monetary union capital flight from France would
largely return in another form. Indeed, if the French socialist state were
attractive to fellow Europeans, an increased pace of intra-European
labour migration into France could pull in capital alongside. (Some
transitory downward pressure on the real wage rate, in consequence of
the increased foreign supply of labour, would bring some upward pres-
sure on the rate of profit in French industry. And the extinguishing of
currency risk within monetary union might in itself spur intra-union
labour migration).
Real estate market speculation as driver of capital flow within

union
Germany rather than France provided the first testing ground for
whether a unilateral lurch towards the “social market economic
model” carries an extra or lesser price tag within the context of mone-
tary union (rather than monetary sovereignty). The problem – as with
any test of economic principle – is that much else has been occurring
at the same time! Disappointing German economic performance in
2001–5 could be explained in large part by the very different condition
of its real estate market and construction sector from elsewhere in the
union (see Figure 7.6). Flat or declining real estate prices in Germany
contrasted with a hot real estate market in France and even a possible
bubble in the case of Spain and previously Holland.
Indeed the divergence of real estate market behaviour across the
euro-area has been one of the surprise features of experience with
European monetary union to date, and certainly not discussed in clear
terms by academic economists or economic commentators in the run-
up to its launch. Perhaps the assumption was that monetary union
would bring a closer correlation of asset markets, including real estate
markets, across intra-union political frontiers. That might indeed be
the case in so far as divergences (across the European countries) in
the basis of valuation (risk premium on real estate versus other assets,
benchmark yields on bonds or equities) were the main factor behind
previously observed (prior to union) differences in real estate market
behaviour. For now, in the context of monetary union, there is no
300
280
260
France
240
Spain
220
Germany
200
180
160
140
120
100
80
96 97 98 99 00 01 02 03 04 05
Figure 7.6 Germany, France and Spain – national indices for house prices,
1996–2005 (Mar 96 = 100)
currency risk impediment to the arbitraging of real estate risk premi-

ums. The bond yield benchmarks used in valuations are the same in
each member country. And the relevant equity yield (to be used in
assessing the level of the real estate market) is most probably that
derived from a euro-area wide index (of stock) rather than a national
index.
In order to derive lessons from experience so far (of real estate
market behaviour in the European Monetary Union) it is necessary to
start by reviewing the process of price formation in residential real
estate markets.
There are two components to the expected rate of return on residen-
tial real estate. First there is the net rental return, which can be
imputed (in the case of the owner occupier) or contracted (between
owner and tenant) and second, expected capital gain. The net rental
return should be calculated net of costs (these include maintenance
costs, expressed as an annual equivalent of normally lumpy outgoings,
and in the case of rental properties, agency costs). Expected capital

gain should take account of an obsolescence rate for even well main-
tained properties. As an alternative formulation we can say that the
present value of residential real estate is the discounted stream of
present and future net rents, where the growth rate (of rents) takes
account of the expected obsolescence rate.
Let us say, as illustration, that the long-run expected rate of real
capital gain in an economy growing at say 2% p.a. is around 0–1% p.a.
(explained by some upward trend in real land prices even though
building costs in real terms might be flat or even falling, taking
account of technological progress in the construction sector). Obsole-
scence should not be underestimated as a factor in calculating expected
capital gain. For example, many old properties are not suitable for the
incorporation of air-conditioning, or are badly designed to incorporate
other new technological features. Also tastes in design are likely to
shift. And suppose the total expected return, to be consistent with
expected returns on other asset classes (in particular a total real rate of
return on equities of say, 6% p.a.), would have to be around 5% p.a.
Then the net imputed rental yield would be approximately around
4.5% (allowing for the 0.5% p.a. contribution from capital gain).
The heterogeneous tax position of different categories of real estate
owner adds some complexity to the price formation process. Owner-
occupiers usually enjoy tax-free imputed rent, but they typically pay
large taxes on the purchase of their home. Even if that tax is spread
over the average holding period (say seven years), the net annual
imputed rent would be reduced by a significant amount (say, 10% in
the case of the UK). Investor-owners pay a similar purchase tax to
owner-occupiers (albeit that they might be able to spread it over a
much longer holding period in that their ownership is not tied to indi-
vidual work or life cycles) but in addition they pay tax on the rental
income (net of property maintenance costs). The investor-owner could
nonetheless enjoy a similar overall rate of return to the owner-occupier
if rents in the contract market are substantially higher than the
imputed rental levels in the owner-occupier market. Alternatively it
could be that the total expected rate of return in the owner-occupier
market is somewhat elevated to compensate most households (owner-
occupiers) for the poor diversification of their portfolios once they
include their home. Institutional investors holding residential real
estate to let would normally be able to achieve a superior level of
diversification in their portfolios and might therefore be ready to
accept a lower level of overall yield (than the owner occupier).
In any case the imputed rental levels and contract rent markets
cannot be fully arbitraged. Households, in deciding whether to rent or
buy the space which they occupy, consider first of all whether to put
favourably taxed real estate into their portfolio at the expense of other
assets (some of which, for example holdings in the black or grey areas
of the global economy, might also enjoy a specially low or zero rate of
taxation). Then they assess as consumer whether the rent which they
would pay in a lease contract would be less or greater than their esti-
mate of imputed rent. If greater, they may nonetheless take the option
of contract renting if their expected period of occupation is short
(meaning purchase tax weighs heavily on the arithmetic). A particu-
larly strong aversion to real estate risk (perhaps because their portfolio
would become very undiversified and indeed highly leveraged), or
pessimism on real estate market prospects would be reflected in a high
estimate of imputed rent. By the same token, some potential investor-
owners might be ready to hold real estate and collect rent, even with
contract rents at or below imputed rents, because they have a particu-
larly optimistic view about prospective rental (or equivalently capital
value) growth. One symptom of an overheated residential real estate
market is a large overhang of space in the rental market due to the
supply from investor-buyers having very optimistic views about growth
and overestimating imputed rents (held down by expectations of
capital gain). The fall in contract rents encourages some households
who would normally be owner-occupiers to switch into the rental
sector, perhaps because they can find such a good deal, perhaps
because they are wary of a bubble.
There are practical problems in applying the above framework of
analysis to real estate market values. We cannot observe imputed rents.
There is no accepted benchmark for normal risk premium in the real
estate sector (how much more should the normal total expected rate of
return on real estate be than on indexed government bonds, and how
much less than on equities?). It is difficult or impossible to obtain con-
sensus views on rental (or capital) growth, unlike for the equity
markets where the investor can turn to surveys of expectations for cor-
porate earnings growth and relate these in the long run to views on
profits share in GDP and the growth of GDP.
As illustration of the problem consider the situation in the over-
heated central London residential real estate market of 2003–4. Net
rental yields for investor-owners of prime property were said to be 2%,
compared to say 5–6% in the mid and late 1990s. It is surely likely that
general expectation of real (inflation-adjusted) rental or capital growth
had moved above the normal say 1% p.a. It is also possible that
investors (home-owners) in their collective wisdom had decided that
real estate should be moved into a lower risk class relative to equities
(having just experienced the bubble-and-burst of 1999–2001). All of
this would suggest that imputed rental yields had also moved down
albeit most probably by a smaller amount. As illustration, mainstream
estimates of imputed rental yields might have fallen to 2.5% (from the
normal 4.5%) and capital growth estimates risen to 2%, meaning that
total expected returns in residential real estate (to the owner occupier)
were now down to 4.5% (from the normal 5.5%).
Would such a fall in expected yields (and total rate of returns) in
the real estate sector of one country in a monetary union trigger a
greater flow of capital towards less heated sectors in other countries
of the union than if each country had its own sovereign money? As a
first point it should be noted that risk-arbitrage between residential
real estate markets in different countries is the preserve of a small
number of large international institutional investors or a few foot-
loose wealthy households. There may also be some direct contagion
effects – illustrated by French investors becoming persuaded by pre-
vailing practice in the UK or US to insert a lower risk premium than
previously into their valuation arithmetic. It is implausible that such
contagion effects should be stronger within a monetary union than
between the union and the outside world. In particular, French
investors in real estate are surely not likely to adopt valuation arith-
metic used in Madrid or Amsterdam without regard to what occurs in
London or New York.
In principle a fall in expected total rates of return to real estate
investment in one part of the union would trigger some capital flow
into higher yielding alternatives within the union. Such flows are likely
to be stronger in the case of commercial than residential real estate,
given the wider span of potential arbitragers (which would include
multinational companies deciding where to locate industrial plant or
offices). Real estate transactions are inherently long-term in nature,
and so over the likely horizon of the investor relative price level risk
(between union countries) could be an impediment to arbitrage, even
though exchange risk or relative price level risk over short periods is
now zero or much less (in the case of relative prices) than under a
floating regime.
The Spanish investor (whose own local market might appear to be
overheated), for example, in looking at the depressed German real
estate market, has to reckon that when eventually a recovery phase sets
in there, the German price level might still be falling relative to that in
Spain. And how can he be so sure that the expected total rate of return
obtainable in the German real estate market is indeed now higher than
in Spain? The low rental yields in Spain might be symptomatic of high
growth expectations, and so the total rate of return likely still larger in
Spain than Germany.
In the actual experience so far of European Monetary Union there is
little evidence if any of arbitrage capital flows between overheated real
estate markets (whether in Holland or Spain or even France) into
cooler or even recessionary real estate markets, as in Germany. Indeed,
the direction of flow has been in the opposite direction – Germans
buying second homes in Spain! The fact that the German real estate
market failed to attract capital inflows could be explained by contem-
porary pessimism about the economic outlook (in Germany) and the
extent of previous over-building. Higher net rental yields obtainable on
German real estate evidently did not translate into higher overall
expected rates of return, but reflected expectations of zero or negative
capital gains. Divergent real estate market conditions across the mone-
tary union apparently did not reflect valuation differences that could
be arbitraged away but fundamental economic factors.
The divergence of real estate market conditions has been a factor
driving broadly defined capital flows within the European Monetary
Union, even though not between the real estate sectors. Booming resi-
dential real estate markets tend to go along with downward pressure
on the national savings surplus whilst weak residential real estate
markets have the opposite influence. As illustration, the hot Spanish
real estate has been widely seen as one force pushing Spain’s savings
deficit to new peaks (an estimated 9–10% of GDP in 2006–7). The
boom of the Dutch real estate market in the late 1990s and early 2000s
caused that country’s traditional savings surplus to shrink. There were
the corresponding large relative price level movements – with the price
level in the countries with the booming real estate markets and falling
savings surpluses rising relative to elsewhere.
The relation between real estate market conditions and savings
surpluses or deficits is not, however, as strong theoretically as it might
have seemed in practice. Moreover, there has been a tendency amongst
commentators to use labels such as overheated or bubble-like, without
convincing foundation, for describing real estate market conditions.
There are two broadly used definitions of a bubble which do not
always overlap. The first is the economist definition. According to this
a bubble exists when the price level in a given market reflects a near
100% certainty being given to one highly optimistic scenario (relevant

to the particular asset or commodity) about the future, when in normal
rational mode a probability of much less than 100% would be
attached. Apply the economists’ definition of bubble to the residential
real estate market that would describe a situation where prices were
determined on the basis of a highly optimistic scenario for rental
growth having almost 100% likelihood of becoming reality. That situa-
tion cannot be demonstrated without question even in London’s expe-
rience, as we have seen above.
The second definition (of bubble) stems from behavioural theorists
(see Schiller, 2000). The trend is creating the trend. Investors expect to
see large capital gains and rental growth in the near and long-term
future just these have been realized in the recent past. Such behaviour
is of course inconsistent with rational expectations, and the problem
for behavioural psychologists and economists is to provide sufficient
evidence in favour of their hypothesis.
In any case, let us assume provisionally that periods of overheating
or speculative excess, even bubbles, do occasionally characterize real
estate market conditions (see McCarthy and Peach, 2004, for a general
discussion of real estate bubbles). What are the links between this and
the overall savings surplus of the economy?
The usually cited connexions are credit market effects (rising home
values allow households to borrow more against their total wealth
including human capital, given that real estate is readily usable as
collateral) and wealth effects (the rise in wealth relative to income
means that households can save less out of current income – and
spend correspondingly more – and still achieve their given eventual
wealth target).
The second channel (wealth effects) is perhaps more questionable
than the first (credit effects), as owner occupiers are also payers of
rent (to themselves). A rise in residential real estate values due to a
fall in the risk premium (used in the valuation arithmetic) would add
to wealth unambiguously. If, however, the rise in real estate values is
related to an upward revision of expectations regarding future rent
levels, then many households would suffer an offsetting loss as long-
time consumers of space. In broad terms, owner-occupiers who
intended soon to slim down their present space requirements (or
move them to a cheaper location) would be unambiguously better
off. But those who would maintain their space requirements
unchanged for a long time, or even add to them, might even lose out
(in terms of overall economic welfare).
Population ageing and relative price change

The high and rising German savings surplus and the associated
adjustment problems within EMU have also been related by com-
mentators to the question of population ageing (see Bloom and
Canning, 2004). It is possible that the growing concerns about
pension provision – whether the public sector can keep to its present
scale of payouts in the face of a big rise in the share of the post-
retirement population over coming decades – have been an upward
influence on the German household sector savings rate. Those still
in the labour force and working could be raising their savings rates
to make more provision for old age, and this tendency could be
more than offsetting the downward influence on the aggregate
savings rate from the rising number of retired households (the
retired population is overall a net dissaver).
In Italy and Japan – the two other G-7 economies where ageing is
occurring on a similar but more severe profile to in Germany (immi-
gration provides the greatest relief to the ageing trend in the German
case) – the consensus economic view is that dissaving by the retired
population is more than offsetting additional saving by the working
population. Any view about Italian trends, however, is highly tenta-
tive, given the extent of other simultaneous changes, especially the
transition to the low interest rate environment of the euro from the
high-interest rates of the lira.
There are some general principles that can be stated for the rela-
tionship between population ageing and net capital flows, albeit that
how these are applied in any particular example can lead to differing
results as above (see Bryant, 2004). The hypothetical conclusions can
be seen to depend in part on the nature of the currency regime in
place – whether floating rates for sovereign currencies or a monetary
union. For example take the often quoted case of Japan, which
faces the most acute pattern of ageing (rise in the share of the post-
retirement population) in the next two decades. It is possible that
depletion of savings by the old will be less than expected, and retire-
ment-related saving by the working population more than expected.
In any case, Japanese data on household savings has been distorted
by a growing surplus in the financial corporate sector – which in
other countries would be attributed to the household sector.
Moreover, household and corporate sector saving have to be consid-
ered together. Some of the fall in household savings recorded in
recent years in Japan could well have been due most of all to the
increase in corporate wealth, matching large-scale debt repayment

out of retained profits (see Chapter 8, p. 229).
Even staying with the hypothesis of Japanese household sector
savings, correctly measured, falling under demographic influence, the
question is whether that fall would be more or less than the decline of
the investment rate (also under demographic influence). A declining
population of working age would go along with a slower growth in the
capital stock (as there are fewer work-places which have to be equipped
with capital). So it is possible for the underlying savings surplus to
increase or decrease depending on whether the investment rate (invest-
ment spending as a share of GDP) falls by more or less than the savings
rate.
A more complete analysis would include trends in non-business
investment – in particular public and residential investment. Here the
demographic influence, however, is less obviously in one direction or
another (than is the case for business investment).
If we take the case of a rising savings surplus, that would tend to put
downward pressure on the neutral level of interest rates in Japan, mean
a higher momentum of capital exports, and an increased capital inten-
sity (capital-output ratio rising) in the Japanese economy (which would
be reflected in turn in enhanced labour productivity and real wages).
By contrast in the case of a falling savings surplus, there would be
upward pressure on the neutral level of interest rates in Japan, a
decreased momentum of capital exports, and a decreased capital inten-
sity (meaning slower productivity growth and a lower-than-otherwise
path of real wage growth).
These conclusions about demographic influences depend on the
neutral rate of interest in Japan moving significantly in one direction
or another relative to the neutral rate (on average) in the world
outside. Within the context of a monetary union, the cost of capital is
the same throughout all the member countries (subject to the
qualification made earlier for the situation where there are strong
expectations of a long-run trend change in relative price levels) – irre-
spective of whether a particular country is in a special situation with
respect to population ageing.
Suppose demographic influences are indeed imparting an upward
influence on the overall German savings surplus. Then there would
be some downward pressure on the euro-area neutral rate, but less (as
the influence of higher German savings would be diluted throughout
the monetary union) than what there would have been on the
German neutral rate if the Deutsche mark had still existed. A bigger
part of the adjustment to the rising German savings surplus would

come through relative price change (a decline in the German price
level relative to that elsewhere on average in the monetary union).
Productivity and real wage gains in Germany induced by ageing
would be less under the regime of monetary union than under a
sovereign Deutsche mark. (There would be some spill-over, however,
of real wage and productivity gains to other members of monetary
union as a corollary to the lowering of the euro-area wide cost of
capital or equivalently neutral rate level).
In any overall consideration of demographics and capital flows, the
question of immigration is important. In the analysis presented so far,
immigration is a given amount – determined presumably by quota,
and not affected by the choice of currency regime (monetary union or
independent sovereign monies). In principle labour migration can be
incorporated into the analysis. In the Japanese illustration, if indeed
the demographic influences are bolstering the saving surplus and so
real wage growth – then there would likely be increased political
demands (from business leaders) for restrictions on immigration to be
eased. The rationale for these calls would be to ease upward pressure on
wage costs and downward pressure on profitability. By contrast if the
demographic influence were to decrease the savings surplus – then the
political pressure to ease immigration restrictions would be less.
In the case of Germany, there is a virtually unrestricted inflow of
labour from other EU countries (subject to transitional limitations in
the case of new EU entrants in 2004). In so far as the rising savings
surplus puts upward pressure on wage levels and downward pressure
on profit margins that would induce increased inward flow of labour
(from other EU countries). As we have seen however, the fact of mone-
tary union reduces those pressures (in that there is a greater tendency
for an emerging savings surplus to seep out as capital exports). And so
the German savings surplus could induce less immigration in the case
of monetary union than in that of an independently floating Deutsche
mark. Further, under either currency regime, whether the inflow of
labour would add to or subtract from the underlying savings surplus is
ambiguous. The investment rate would rise as enterprises tooled up the
new additions to the labour force. The new immigrants, however,
might themselves be intensive savers.
Changes in the profits rate and cost of capital are only one element
in the combination of economic forces affecting immigration into the
rapidly ageing society. Another element is the price of land. A down-
ward trend in the working population would most likely go along with
falling rents on many types of commercial real estate – whether ware-

houses or offices. Some long-term fixed business capital in the form of
machinery or other installations would become underutilized. The
marginal cost of bringing them back into operation would be small. In
so far as there were rational pricing in the public sector, charges (to the
public) for under-subscribed schools and universities would be cut
(perhaps in a tailored fashion, taking account of price-discrimination
possibilities between different categories of student) and congestion
taxes would fall. The fall in rents and charges as described would
provide incentive for greater immigration.
Energy bonanza – Alberta, Canada, Holland and UK compared

The influence of demographic trends on capital flows – whether
within the context of monetary union or more broadly – is inher-
ently slow. It is quite different with respect to energy bonanza. Here
an economy experiences a big new gain in comparative advantage
in the form of discovered energy resources or previously known
energy resources which now become highly profitable to exploit
due to an upward jump in energy prices. A recent example of
energy bonanza in the context of a floating exchange rate is
Canada, where vast tar-sand deposits in Northern Alberta became
commercially viable as the oil price spiralled higher in the years
2003–2005. Some analysts project that non-conventional energy
output in Canada could reach as much as 5–10 million barrels
per day (bpd) over the next 20 years. That compares to stable
conventional oil output of around 1.25 million bpd.
In fact, the case of non-conventional energy production in the
Canadian province of Alberta incorporates some aspects of both a
monetary union and floating currency case. Alberta belongs to the
federal political union and monetary union called Canada. But the
Canadian dollar is itself floating against other currencies. It is that
latter aspect on which we concentrate first, rather than looking at rel-
ative price level adjustment between the province of Alberta and the
other Canadian provinces.
Let us take the scenario of another 3.5mbpd of tar-sand oil output
at $60 per barrel coming on-stream within 10 years. That translates
into around US$70bn of extra energy exports, or around 10% of
Canadian GDP. This is not all a bonanza. The cost of extracting non-
conventional energy in this form is very high, $40 per barrel, accord-
ing to some estimates. The actual bonanza (pure rent element) might,
as illustration, amount to around 22% of present GDP. The rest is an

investment opportunity with normal returns.
The fact that this new investment opportunity is in Canada in itself
means a big swing of its savings balance over the medium-run from
surplus (as in the early mid 2000s) to large deficit – though this (swing)
may be offset in some degree by increased savings out of the rental
element of the energy bonanza. (Canadians would save some share of
their increased wealth corresponding to the discounted value of future
rents). The fact that the investment opportunity has emerged in the
traded goods sector of the Canadian economy could mean that its cur-
rency comes under long-run pressure upwards on account of the so-
called Balassa effect (see Chapter 3, p. 80). (This describes the long-run
shift upwards in the national price level relative to foreign price levels
necessary to maintain economic balance in a situation of much more
rapid productivity growth in the traded than non-traded sector). The
extent of the Balassa effect in the Canadian case would depend on the
import-intensity of the extraction process of oil from the tar-sands. If
the process is very import intensive – then there would be less of a
Balassa effect.
In total, what can we say about the influence of the Alberta oil
bonanza on the equilibrium level of the Canadian real exchange rate
and Canadian interest rates? In itself, the flourishing of investment
opportunity, substantial relative to the size of the Canadian economy,
puts upward pressure on the neutral interest rate. This (pressure) could
be offset by increased savings out of enhanced wealth and by specula-
tive inflows of capital. (Anticipations of a long-run real exchange rate
appreciation in line with the Balassa effect could be reflected in an
immediate up-front jump of the Canadian dollar, itself putting down-
ward pressure on the neutral rate level – see p. 82). It is not possible in
principle to say whether the balance of forces described would amount
to net upward pressure on the neutral rate. In any case the extent of
any net upward shift in the neutral rate would itself be tempered by a
corresponding gain in momentum of foreign capital inflows. That gain
in momentum would depend on the degree of risk aversion towards
the Canadian currency on the part of foreign investors.
As regards the Canadian currency, the influence of all the factors
considered is almost certainly upwards – with some dampening
influences coming from an increased propensity to save out of
increased oil wealth, from very long-run expectations of a bulging
deficit on Canada’s investment income account as dividends and
interest payments are made to the foreign investors who financed the
energy extraction, and from expectations of eventually a diminishing

inflow of capital (the extraction process would presumably involve
heavy up-front capital spending). In fact we could project a profile for
the equilibrium real exchange rate which is at first sharply higher and
then tends to fall as the savings deficit decreases in the very long run.
Indeed eventually (as capital spending winds down and rental income
reaches peak levels) the savings balance would move into large
surplus. At that stage, the neutral interest rate in Canada could fall
relative to that abroad.
How different would these conclusions be if Canada were in a mone-
tary union with the US? The scope for the neutral interest rate level (in
real terms) to rise in Canada would be less – but it is not clear how
much of a rise would occur under the floating currency regime in any
case. All of any real exchange rate appreciation would have to come
through a rise in the Canadian price level relative to the US price level.
The total real exchange rate change might indeed be greater in the case
of monetary union than under a floating currency regime. That would
be so if indeed the (real) neutral rate level would rise in the floating
currency case (as against remaining unchanged under monetary
union), meaning that less of the adjustment to the energy bonanza
would have to be borne by the real exchange rate. In the eventual pay-
back period, when Canada moves into large savings surplus, the real
exchange rate decline would be more under monetary union if simi-
larly the real neutral rate level would shift downwards in the floating
case (but would remain constant under monetary union).
It is the hypothetical experience of Canada within a North
American Monetary Union (with the US) which is partly relevant to
the direction of change for Alberta’s price level relative to the price
level in Canada’s other provinces. The extent of upward relative price
movement in Alberta’s case, however, may be very modest. Much,
indeed most, of the equipment and labour resources to extract the oil
from tar sands has to be imported from other Canadian provinces,
the US, or elsewhere. Hence the Albertan underlying savings and
current account deficits might increase pretty well in line with each
other, without much requirement for neutral interest rate or relative
price level changes. Most of the increased spending by Albertans out
of their energy bonanza is likely to be directed towards imports from
other Canadian provinces or from the rest of the world rather than
from within Alberta. Overall the Balassa effect in the case of Alberta
(upward pressure on its price level relative to elsewhere in Canada)
might indeed be small. Moreover, the rental element from the energy
extraction has to be shared to some degree with the other Canadian

provinces.
Canada’s experience with energy bonanza is but the latest of a his-
torical record. Previous examples amongst the advanced economies
have included the UK, the Netherlands and Norway. The UK stands
out as having achieved the various stages of adjustment (to energy
bonanza) under a floating exchange regime. The Netherlands operated
for most of the time under a fixed exchange rate regime (vis-à-vis
Germany and later within the European Monetary System). Norway
has been under a controlled floating regime with its government
pursuing a vast capital export policy – a public pension fund which
allocates a share of the oil revenues to foreign assets. In the UK’s case,
the currency rose powerfully during the second oil shock (1978–9) and
beyond into the early years of rapidly rising output. But as in so many
other real world examples of economic phenomena, many other
changes were going on at the same time (a huge monetary squeeze
from 1980–1, the Thatcher economic revolution, the abolition of
exchange restrictions).
In the case of the Netherlands, there was an unmistakable tendency
for Dutch costs and price level to rise relative to that in Germany (and
other countries in the ERM) during the first two energy shocks
(1973–80) – explained by the huge indigenous production of natural gas
(whose price was closely indexed to the oil price). The tendency of
rising costs to erode competitiveness of traditional exports from
Holland came to be described as the “Dutch disease”. The extent of rela-
tive price adjustment between Holland and Germany was less than the
huge swings in the floating pound. And the inflation experience of the
UK was worse than that of the Netherlands. Those two facts on their
own do not in themselves support the hypothesis that energy bonanza
can be more smoothly accommodated within a monetary union or
fixed exchange rate system than a floating currency regime. There were
so many important other developments occurring alongside.
Divorce of monetary union

In principle energy shock combined with the new potential in one
country of a monetary union to produce huge amounts of natural gas
or oil at sky-high prices could threaten the survival of a monetary
union. The given country might see so much inflation danger from
remaining inside (a big rise in its price level relative to that outside),
that it would opt to restore its independent sovereign money. Such a
course of action might well be politically popular if the electorate

becomes fully aware that a significant share of their monetary savings
and pension entitlements could be wiped out within the context of a
monetary union.
In practice, according to the present state of geological knowledge,
there is not much chance of such an energy-induced shock to
European Monetary Union (EMU). Much more discussed, as a possible
scenario, is a forced withdrawal of Italy. If this scenario were to move
into the centre of the screen of probabilistic vision, what would be the
influence on capital flows within EMU and between the euro-area and
the outside world? Towards answering this question, it is necessary first
to hypothesize how an Italian withdrawal from EMU would take place.
General scenarios for shrinkage or total break-up of EMU have already
been sketched in Brown (2004), but a more precise version can be
sketched for the case of an Italian separation.
There are two main possible triggers to an Italian withdrawal. The
first is the spectre of default on the public debt, already projected by
some estimates in 2005 to reach 110% of GDP by end-2007, with the
budget deficit in 2006 at 5% of GDP. The second is electoral revulsion
against the economic costs of a long period of price decline (in Italy).
This decline might be necessary towards establishing a new relative
price relationship between Italy and the rest of the euro-area which
would be in line with full equilibrium, taking account of the growing
competition faced by the Italian export sector in its traditional areas of
comparative advantage from low cost suppliers in Asian developing
countries (see Ciocca, 2004). Corresponding to these two main triggers
are the scenarios of forced withdrawal (debt crisis) and voluntary with-
drawal (deflation).
A forced withdrawal is where the Italian government has no choice
but to make an immediate exit from EMU – or else the banking
system would collapse. This could be the situation if Italian govern-
ment debt prices spiral downwards (in a default crisis) and in turn
funds flee Italian banks (given their huge holdings of Italian govern-
ment bonds). The only way out would be for the government of Italy
to re-gain control of the money-printing press – albeit with the
inevitable consequence of emitting inflation shock.
A voluntary withdrawal is where an economic policy debate takes place
about the benefits and costs to the Italian economy of exiting from EMU
and an action program is decided upon. In principle, voluntary with-
drawal could take a slow staged form or a sudden form. In practice when
the rationale for withdrawal is to bring down sharply the relative price
level in Italy (compared to the rest of the euro-area), meaning that it is

totally clear that the reincarnated sovereign money will start off at a
much cheaper level than the euro, only a sudden form withdrawal is
possible – similar in mechanical form to what takes place under the
forced exit. Indeed what begins as a process of voluntary withdrawal
could turn into a forced withdrawal – if speculative outflows of capital
threaten to engulf the national banking system in bankruptcy.
The mechanics of a sudden withdrawal, whether voluntary or forced,
would be as follows. The Italian government would freeze euro
deposits held by Italian banks with the Italian central bank (Banca
d’Italia) – except for that part which represents reserves against non-
resident euro deposits with Italian banks. Italian banks could no longer
transfer resident euro deposits (now called “Italian euros”) on a 1:1
basis into euro deposits outside Italy or non-resident euro deposits in
Italy. The 1:1 convertibility of euro banknotes into resident euro
deposits (“Italian euros”) or conversely (deposits into banknotes)
would be suspended. Italian euros could be used freely to fulfil euro-
denominated contracts between Italian residents (for example, invoices
for goods and services, wage agreements) and to repay euro loans by
Italian banks to Italian residents. There would be a new category of
euro deposits, termed “free”, which Italian residents could open. Funds
from these could be transferred on a 1:1 basis into non-resident euro
deposits and foreign euro deposits (outside Italy). Euro banknotes
would remain convertible on a 1:1 basis against free euro deposits (but
not Italian euro deposits). An exchange market could start up between
Italian euros and free or foreign euros.
In this case of Italian euros opening at a much depreciated level
against free and foreign euros, euro banknotes would go to an immedi-
ate premium against Italian euros, only available so far in the form of
bank deposits (no banknotes). The premium would be determined by
the exchange rate between Italian and free or foreign euros. Italian res-
idents in obtaining cash (still euros) from automatic teller machines
would be levied extra charges based on the rate of premium. In the
retail economy, dual pricing would occur – one price for payment by
check or card and a lower price for payment by cash. Eventually the
Italian euro deposits would be re-denominated as Italian lira deposits
and euro loans by Italian banks to Italian residents as lira loans. (Free
and foreign euro deposits would become again simply euro deposits).
Newly printed lira banknotes would be obtainable on a 1:1 basis
against the lira deposits. Italian residents would freely determine when
to dispose of their euro banknote holdings and acquire lira banknotes.
As this process got underway, central banks in the euro-system would

find themselves with a flotsam of euro notes and this would have to be
dealt with under a seigniorage agreement between Italy and the other
countries still in EMU (otherwise Italy would have reaped a fiscal
advantage at the cost of the others).
In general terms, the switch to the new currency (liras) would occur
largely by decrees, but these would not apply to non-residents of Italy.
Thus bank deposits and other debts outstanding to non-residents in
euros would not in general be subject to forced conversion. (The ratio-
nale for this exemption would be to prevent a wholesale withdrawal of
foreign business from the Italian banking system during the inevitable
period of uncertainty preceding the decrees. Up front there would be a
commitment that whatever happened foreign deposits and loans
would not be affected). Italian government bonds, however, and other
bonds issued in the Italian domestic market, would be payable in
Italian euros and later liras, even if held by non-residents.
Exit by sudden decree would create windfall losses or gains most par-
ticularly for Italian financial intermediaries. Italian resident deposits in
euros with Italian banks and Italian bank loans (in euros) to Italian res-
idents would not have been in balance except by chance at the time of
exiting EMU. If deposits are well below loans and the Italian euro falls
immediately against the euro, then the banks would experience net
loss. There is also the question of interest rate exposure.
Long-term interest rates might jump immediately on Italian euros
and inflict loss on banks’ holdings of long-maturity loans at fixed inter-
est rates. The loss would be diminished by the presence of long-
maturity fixed-rate liabilities also transformed into Italian liras (for
example Italian bank bonds or long-term deposits/savings plans out-
standing). Some prior interest rate hedges, however, would be ineffec-
tive. For example, euro interest rate swaps entered into originally to
protect profits against unexpected euro rate rises would not be helpful
in the case of a change in monetary regime, on the assumption that
the decrees did not include a re-denomination of swap contracts.
As part of the exit plan, the Italian government would compensate
Italian financial intermediaries for windfall losses in excess of a stipu-
lated percentage of capital. There might also be a windfall profits tax
on more fortunate institutions. (There could not be 100% compensa-
tion, as this would set up moral hazard, meaning that Italian institu-
tions would take no prudential steps to minimize their exposure to loss
from a change in monetary regime). It is likely that the financial inter-
mediaries would also have suffered some loss in the inevitable period
of speculation ahead of the exit from EMU. At that time, Italian banks
would have scrambled to retain Italian resident euro deposits fleeing
for safety into foreign euro accounts (where they could not be forcibly
transformed into Italian euros).
The premium interest rate that the Italian banks would have then
offered might have been offset only in part by loan rate surcharges
passable on to some Italian borrowers. Indeed, rising losses for the
banks during periods of speculation on exit might force an emergency
withdrawal, which in principle could be reversed later if indeed the
democratic process brought a decision in favour of continued Italian
membership in EMU. In practice, reversal would depend on the good-
will of Italy’s EMU partners. At best they would accept Italy back as a
full EMU member almost immediately with Italian liras re-converted
into ordinary euros at a 1:1 rate.
In sum, within monetary union large hot money flows are indeed
possible if its future ever came into serious doubt. In the example
given, and in particular given the announced exemption of non-
resident deposits from compulsory re-denomination, there would be
huge round-tripping. Resident deposits would flee Italy and be replaced
by non-resident deposits, probably largely from the international inter-
bank market. The pressure of speculation on a change of monetary
regime would be evident in a spread between interest rates of resident
Italian euro-business and in the global euro markets (outside Italy). The
growing un-hedged position of the Italian banking system to risk of
regime change (from EMU back to a sovereign lira) and rising interest
rates on domestic lira loans (putting Italian corporations at a competi-
tive disadvantage so long as the feared change in regime did not take
place) would be one factor tending to accelerate the decision of
whether or not to stay in EMU. So far, despite much talk in the market-
place and in market-commentaries about a possible eventual Italian
withdrawal from EMU, neither phenomenon – a flight of domestic
deposits and the emergence of a risk premium on Italian rates – has
become evident.
8
Currency Speculation
Capital flows between countries or areas with independent monies

occur in the context of exchange risk. A key issue in the study of global
capital flows is how rational investors (and borrowers) deal with such
risk. Currency risk is not always a source of friction (or in economics
jargon, disutility). In some cases investors can gain protection against
specific bad “states of the world” by deliberately assuming currency
risks. An illustration is the once renowned role of the Swiss franc as
safe haven – rising at times of global financial distress or raised interna-
tional tension. In other cases, investors can expect to bolster their
returns considerably by increasing their exchange risk exposure even
without possessing the proverbial crystal ball. Borrowers might simi-
larly expect to reduce their financing costs (by assuming currency risk).
Finally there are a range of players who believe that for some reason
they possess special insight which will enable them to make profits at
the expense of less skilful players in the game of currency speculation
(or at the expense of non-players who have embraced a so-called
passive strategy, discussed below).
Players in the game deliberately assume exchange risk beyond what
could be justified on the basis of normal balancing of risk and return
where there is no special knowledge or skill (including market intu-
ition) on the part of the investor or borrower. As illustration take the
situation at end-2005. Looking at the 5-year swap rates in various cur-
rencies – 5.1% in US dollars, 0.9% in Japanese yen, 3.1% in euros, and
2.2% in Swiss francs – these could be translated into real rates (sub-
tracting expected core inflation in each respective country or currency
area) of around 3.3%, 0.8%, 1.6%, and 1.4% p.a. respectively. The
investor or borrower, on the basis of generally available knowledge,
could determine that none of the given currencies were far away from
215
USD real effective exchange rate Euro real effective exchange rate
216
130 150
EURO real effective exchange rate
US dollar real effective 140

120
exchange rate
130
110
120
100
110
90
100
80 90
71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05
Yen real effective exchange rate Swiss Franc real effective exchange rate
120 120
110
100 110
90
100
80
70
90
60
50
80
40 Swiss franc real effective
Yen real effective exchange rate exchange rate
30 70
71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05
Figure 8.1 Real effective exchange rates – US$, euro, yen and Swiss franc, 1971–2005
Currency Speculation 217
their long-run average level of the previous 20 years in real effective

exchange rate terms (see Figure 8.1).
It would also be reasonable to assume that the US dollar had some-
what greater likelihood of moving down than up over the long run (in
real effective exchange rate terms). This asymmetry was related to the
substantial probability that the underlying huge US savings deficit
would tend to diminish (through endogenous influences emanating
from within the US economy), most likely bringing downward pressure
on US neutral interest rates relative to those abroad. But allowing for a
part of that depreciation in real terms of the dollar to take place via
high inflation in some dollar-zone emerging market-economies (espe-
cially in East and South-East Asia), it could be that the trend real depre-
ciation of the dollar versus the yen and euro would be very gradual
(say, no more than 1% p.a. on average). That would leave a significant
real income advantage (cumulated over five years) in favour of holding
US dollars compared to yen, and an only slightly smaller advantage
compared to euros and Swiss francs. Risk over a 5-year period is much
less in annualized terms than over short periods given the tendency of
white noise around the trend to diminish as an influence on perfor-
mance the further ahead is the horizon date.
Hence investors worldwide at end-2005 would hold a larger propor-
tion of dollars in their portfolio and a lower proportion of yen, euros,
and francs than in earlier periods (for example 2002) when there had
been a much smaller (if any) real income advantage (in the dollar’s
favour) and when the dollar had been considerably higher in real effec-
tive exchange rate terms. Precision in strategy formulation (what share
to award the dollar for example in the overall portfolio) is not possible
given the lack of an objective probability distribution of possible ex-
change rate changes over the next 5-year period. But purchasing power
parity (the hypothesis that real effective exchange rate movements are
constrained by arbitrage in goods and services trade), diminishing
white noise over time, and the concept of some tendency for reversion
towards the mean (overshoots to be corrected) , form the foundations,
albeit fragile, to the building of portfolio strategy (whether as borrower
or lender).
In a world of constant rate of return differences between currencies
(adjusted for expected exchange rate change) and unchanging risk
parameters, there would be little occasion for the passive investor or
borrower to review the neutral weights used in portfolio composition.
(Passive means unguided by any strong view on market prices – spot or
forward – being out of line with those which would hold in a general
equilibrium solution). Once, however, we introduce the real world

assumptions that rate of return differentials between currencies,
adjusted for expected exchange rate change, vary through time, and
that these (differentials) are apparent even to investors or borrowers
without special knowledge, then so-called passive portfolio strategy
should be reviewed on a continuous basis. This has nothing to do with
the end-of-year bonus for the biggest currency trading profit, or
coming top of the survey of foreign exchange rate forecasters, but judi-
ciously altering portfolio weights (for the different currencies) so as to
better balance risk and return over the long-run.
An analogy can be drawn from equity market portfolio balancing.
Once we drop the convenient assumption made by some researchers in
the early years of modern portfolio theory that expected rates of return
(on equities and on so-called riskless assets) are constant through time
and that the various probability distributions (of possible returns in
each period) are stationary, then the efficient passive investor should
reappraise continually the portfolio weights for equities versus bonds.
(In the context of equity markets, the passive investor is not trying to
out-guess the market as to where its level will be at given date or in a
given time period in the future). The investor should seek to estimate
where the equity risk premium now lies (the spread of the expected
return on the market portfolio over the riskless rate of return) and the
extent of risk.
The estimation of risk premium is superficially easier in the case of
equity markets than currencies, in that there is a direct comparison pos-
sible between earnings yields and the riskless rate (usually taken as
the yield on inflation indexed government bonds). That comparison,
however, is misleading in its simplicity. Only in a special – albeit useful –
benchmark situation does earnings yield (estimated on the basis of ana-
lysts’ forecasts of corporate earnings for the next 12 months) correspond
to the overall expected rate of return (dividends plus capital gains).
This is where capital gain in any period equals the newly retained earn-
ings per share, as would be the case if all growth in earnings per share in
fact comes from returns (within the corporation) on the new internally
generated capital (retained earnings).
More generally, estimation of equity risk premium is a rough-and-
ready process – similar in some respects to that of currency risk
premium. As illustration, the 1-year forward earnings yield on the S&P
500 (based on consensus estimates of earnings 12 months from now
and assuming the market would then be at the same level as now) at
end-2005 was at just under 7%. That compared to a 10-year yield on
US inflation indexed Treasury bonds of just above 2%. But the true risk
premium could have been substantially less than the difference
between the two (say 4.75%), often taken as a crude basis of measure-
ment. With corporate profits at end 2005 above the peak level relative
to GDP of early 1998 there could well have been a long-run expecta-
tion (in the market-place) of profits growth beyond the next year
falling behind economic growth. Indeed there were widespread fore-
casts of a cyclical slowdown in the US economy, led by a deflating resi-
dential real estate market, starting within a year or so. And so earnings
per share excluding returns on reinvested profits might well shrink at
some point over the next few years. On that basis, the risk premium
derived from just considering the next 12 months would be inflated.
The investor seeking to balance his or her portfolio through time in
response to first, the evolving estimates of risk premiums (adjusted to
take account of longer-term considerations as just described) for equi-
ties or other asset-categories and second, the shifting parameters of the
human condition (in particular age and health) is not aiming to win
the annual beauty contest amongst fund managers. Rather, the
investor accepts that even without special trading ability, judicious
shifts in weights are optimal. These (the shifts) are necessary towards a
better balancing of risk and return through time. The investor, though,
has grounds for caution, not least because the estimation procession
for risk premiums is so imprecise. It is quite a different set of calcula-
tions guiding the speculator.
The speculator is seeking to profit from a supposed special talent in
investing. In terms of the currency markets this talent might consist of
skill in economic analysis (concerning such topics as business cycles,
global flow of funds, monetary trends, savings surpluses and deficits),
or an ability to tear away from the strong consensuses which build
about the economic and market outlook and not be blinded by the
conventional wisdom from using his critical faculties, or a special
insight based on contemporary and possibly historical knowledge into
how policy, including international currency diplomacy, is likely to
evolve. Another form of talent could be special intuition or expertise in
assessing or modelling market psychology (this would include so-called
technical analysis, so long as a relationship can be drawn between the
esoteric price pattern and investor behaviour).
It is very difficult to ascertain by results whether the particular
investor in fact possesses the supposed skills. For quarter-by-quarter or
even year-on-year outcomes will bear the large imprint of white noise.
The investor’s analysis of available information might have been the
best around, but new information pushed the recommended or actual

positions into loss. Over long periods of time, bad and good luck
should tend to cancel out, and skill shine through. That is true across a
large number of speculators with genuine talent, but it may not be the
case for one unfortunate skilful speculator!
All of this is not totally different from other examples drawn from
economic life. Only the balance between luck and skill and the
difficulty of providing objective measures of talent are qualitatively
different. In general skill and training or entrepreneurial gifts tend to be
associated with higher-than-otherwise earnings. But there is an element
of luck or fortune as to whether the training or gifts can be used to big
advantage – or to any advantage at all. In practice measurements to
reveal whether a particular individual has talent include training, job
history, and record of success (or failure) to date. In the case of specula-
tive talent, training and employment history reveal a little but not
much (this is also the case with entrepreneurship). Past performance is
more heavily influenced by luck in the case of speculation than of
entrepreneurship (albeit that even for the latter luck looms large). A
careful in-depth examination of past speculative strategies can provide,
nonetheless, some insight into the degree of talent. The hindsight
investigation might also help focus the particular speculator on the
possibilities of self-improvement.
Take for example John Maynard Keynes’s huge bet against the mark
in Spring 1920 (see Brown, 1986). Keynes had grounds to be pes-
simistic about the long-run future of the German currency – which
indeed ended worthless in 1923. In early 1920, however, a powerful
recovery of the mark got underway (from an already very cheap level
in real terms) as some optimism spread that the Allies would provide
Germany with credits to help finance reparation payments. Keynes
could be faulted for assuming that market opinion was bound to agree
with his own diagnosis – that Germany could not pay the reparations
bill and would be forced into bankruptcy – and for failing to realize the
huge potential volatility of the mark albeit around a downward trend.
There were other respectable views (later presented formally by Ohlin
and Rueff, see p. 97) “out there”, after all, that Germany could indeed
pay if it could re-gain access to international credit markets.
Undoubtedly Keynes did learn from the mistake, but seems to have
resolved not to speculate on currencies again!
One example of successful speculative calculation comes from the
profits reaped by contrarian traders (provided they kept to their course
into 2005 rather than losing their nerve) during the episode of serious
weakness of the US dollar in 2004. It was obvious then to most market

participants that huge speculative positions against the US currency
had built up – not least of which was the widely reported short posi-
tion of the renowned stock market investor, Warren Buffet. A chorus of
wailing comments about the dollar emanated from an array of editorial
writers, and from a wide span of officialdom, including the G-7, the
IMF, OECD, BIS, the US Treasury and eventually, albeit in muted form,
from Alan Greenspan himself (see Greenspan, 2004).
Yet any self-disciplined market-practitioner should have realized that
the dollar could not have become a one-way bet. Unless there was
some type of market failure, it must be the case that prospective
returns on the dollar, taking account of expected exchange loss or
gain, were not far out of line with those on other currencies – indeed
probably somewhat superior given the likelihood that the US mega
savings deficit originated to some degree from forces (low savings
propensity in the household sector, in particular) within the US (rather
than just being a response to global demand for US assets). Even
though real interest rates on dollars were not yet obviously well above
those in other currencies, the dollar had surely sunk to such a low level
that a rebound was more likely than a further fall.
Speculation on the US dollar

The illustrative speculator, reviewing the dollar in late 2004 (then at
1.33 and 105 against the euro and yen respectively) and estimating its
equilibrium path through time could have proceeded usefully by con-
structing a range of scenarios. The construction process would have
helped to highlight under what circumstances the full equilibrium
value of the dollar, consistent with interest rates at neutral levels in the
US and elsewhere, could rise or fall. The equilibrium path of the dollar,
which joins up those estimates of full equilibrium value for different
points in time, is itself a probabilistic concept (see p. 69) calculated as a
weighted average over the full range of possible scenarios.
The speculator, drawing upon the constructed scenarios, would have
undertaken a comprehensive analysis of first, how far present interest
rates were out of line with neutral; second, how far the dollar exchange
rate now or at various dates in the future (as reflected in actual or
implicit forward rates) diverged from the equilibrium path (due to
factors other than present market interest rates being different from
neutral level); third the likelihood of various divergences (actual vs.
neutral interest rates, actual exchange rate vs. equilibrium path –
adjusted for differences explained by interest rates out-of-line with

neutral) widening or narrowing by the time the bet matures. (In
Autumn 2004, the dollar may well have been judged by some specula-
tors as being well below its equilibrium path, especially as it was near
the lower end of its 30-year range in real effective exchange rate terms).
Fourth, the speculator would have the job of assigning probabilities to
each scenario used in the analysis.
The key details to be filled in for each scenario would be whether
underlying savings surpluses in and outside the US would tend to rise
or fall from present levels (opposite tendencies possible) and the impli-
cations for the full equilibrium value of the US dollar. Of course in an
accounting sense the movements of savings deficits in the US and sur-
pluses in the world outside would have to be in equal and opposite
directions, but from the viewpoint of analysing currency direction it is
crucial to assess where the primary shifts in savings or investment
propensities will most probably take place (and how those shifts would
in turn induce via exchange and interest rate changes offsetting
changes if required in the rest of the world).
Scenario 1 is where savings surpluses in the world outside the US
rise. In particular, with faster economic expansion, could the savings
surpluses in Germany and Japan rise (as households there attempted to
build up savings after the years of economic stagnation) and could a
bursting of the speculative bubble in the Chinese economy bring a big
rise in China’s savings surplus (primarily from a decline in its ratio of
capital spending to GDP)? Already in the first four years of the decade
(2000–4), the German overall savings surplus had risen from near zero
to almost 4% of GDP, as business investment (especially construction)
had fallen sharply. Given the lure of cheap wage costs across the
borders to the East and the rigid structure of the German labour
market, it was not difficult to imagine further trend declines in the
German investment spending ratio (see p. 188). And with mounting
concerns about public and private cut-backs in pension benefits, a
further big rise in the German savings surplus was feasible – perhaps
even to the 10% of GDP level which characterized the UK economy in
the two decades before World War One.
One counterpart to a rising German savings surplus could be an
increased investment spending ratio in the cheap labour economies to
the East (or South East). But those same economies are likely to be
experiencing a tightening of fiscal policy in coming years and there is
scope for their household savings rates to rise under demographic pres-
sures in particular. Elsewhere, within the euro-area, a further decline in
the French household savings surplus is unlikely if the real estate

market there were indeed to cool and the socio-political malaise to
increase. Spain’s huge savings deficit would narrow sharply if its estate
market eventually cooled. Hence a doubling of the German savings
surplus would mean most probably a large increase in the overall
savings surplus of the euro-area.
As regards the Japanese savings surplus, upward pressure could come
also from fiscal tightening (on the assumption that the so-called
Ricardo effect – whereby public savings promotes private dissaving – is
less than perfect) – given the long-run likelihood of serious efforts
being made to bring down the structural general government deficit
from 6–7% of GDP and so arrest a snowballing net government debt to
GDP ratio already at an estimated 83% of GDP in 2006.
If the rise in savings surpluses outside the US came about, as
described, then there would be further downward pressure on the
neutral level of global real interest rates – most of all in the savings
surplus countries and least in the savings deficit countries. In principle,
so long as market rates move in line with neutral rates, and so long as
the fall in neutral rates had not already been discounted in the term
structure of market rates, a stronger US dollar would be the result,
brought about by a gain in the momentum of capital inflows to the US.
But in practice, as we have seen already in this volume (see Chapter 4),
market rates may well be out of line with neutral rates (where these are
defined with respect to two dimensions, national and international). In
particular, in some savings surplus countries there are barriers to
market rates falling to the neutral level, if indeed the zero rate barrier is
effective. (For example in the case of Japan where rates were already at
zero and underlying deflation evident, it would be impossible for
market rates to fall to neutral level if this were indeed sub-zero). In this
case the rate spread in favour of the US dollar might not rise
significantly and there might be no gain in its international value.
In the second scenario, foreign (non-US) savings surpluses decrease. For
example, consumerism takes greater hold in the main present savings
surplus countries – both the advanced economies and the emerging
market economies. In addition, demographic influences in Japan and
Germany might put net downward pressure on national savings – if
indeed dissaving by the post-retirement generation more than outweighs
any downward shift in capital spending (related to shrinking labour
forces) and increased saving by those still working (see Chapter 7, p. 206).
That would put upward pressure on the neutral level of global interest
rates, most of all in the savings surplus countries. In consequence the full
equilibrium value of the dollar would fall (again subject to the condition
that the shift in neutral rates were not already discounted in the term
structure of market rates at the point in time when the speculative strat-
egy was considered, meaning that the equilibrium path of the dollar
would not shift).
Suppose instead the starting level of market rates in the savings
surplus countries were well above neutral (meaning that the actual
exchange rate of the dollar would be below its “full equilibrium
value”). Then as the savings and current account surpluses fell in the
world outside the US and the US savings and current account deficits
contracted in line (under the influence of higher US rates), the interest
rate differential between the US and foreign countries would not
shrink. Indeed it would be possible that the rate spread in favour of the
US rose – as higher export demand pushed US rates higher with no
corresponding rise in foreign rates. And so a fall in foreign savings
surpluses could mean a lower US current account deficit, higher US
interest rates, a wider rate differential in favour of the US and a
stronger dollar.
In scenario 3 an autonomous (not interest rate induced) narrowing
of the US savings and current account deficits takes place. This puts
downward pressure on the global level of neutral interest rates, most of
all in the US. Hence the full equilibrium value of the dollar would fall
(again on the assumption that this pattern of fall in neutral rates is not
already discounted in the term structure of market rates). But suppose
the starting level of market rates in the US were below neutral and so
they did not decline. Then the dollar might rise as a consequence of
the narrowed current account deficit coupled with an unchanged or
improved rate differential in the dollar’s favour. (An in improved rate
spread would be the consequence of foreign rates falling whilst US
rates stayed still). Alternatively, however, market rates abroad might be
blocked from falling by a zero rate boundary under conditions of
deflation, whilst US market rates fall in line with neutral. Then the
decline of the dollar could be particularly severe, whilst some foreign
countries (where interest rate adjustment is blocked) would fall into
deflationary disequilibrium as their currencies spiralled upwards. (The
upward spiral would bring about a lowering of the current account sur-
pluses but not the underlying savings surpluses consistent with full
employment).
Scenario 4 is where an autonomous (not interest rate induced)
widening of the US savings and current account deficits takes place.
(Most likely this would come about through a flourishing of invest-
ment opportunity in the US economy or a reduction in the required

risk premiums there on new investment). This puts upward pressure on
the global level of neutral interest rates, most of all in the US. Hence
the full equilibrium value of the dollar would rise (subject to these rate
moves not already being discounted). Suppose, however, that the start-
ing level of foreign market rates were above neutral. Then they might
not go up. And so the market rate spread in favour of the dollar would
rise by more than the neutral rate spread. The dollar could climb far
(by more than the full equilibrium value). The only sub-scenarios in
which the dollar could fall in consequence of a widening of the US
savings deficit would be where US rates (across the term structure)
started above the neutral level or where the sheer size of prospective
capital flows into the US triggered anxiety amongst international
investors about “sustainability” (meaning whether markets could cope
with flows on the given scale).
Then there are four further scenarios in which there is a simultane-
ous shift in the savings deficit in the US and savings surplus outside
the US.
In scenario 5, the US savings deficit decreases and the foreign savings
surplus decreases (both autonomously). The neutral level of US rates
falls, whilst that of foreign rates rises. In principle that means a fall in
the full equilibrium level of the US dollar. But suppose that at the start
US market rates are below neutral whilst foreign rates are above
neutral. Then there may be no change in the market rate spread
between the US and foreign countries, whilst the size of the US current
account deficit narrows. That could mean a stronger dollar.
In scenario 6, the US savings deficit decreases and the foreign savings
surplus increases (autonomously). Under this scenario, the neutral level
of US and foreign rates both fall. Whether the full equilibrium value of
the US dollar falls or rises depends on which shift is greater. If the shifts
are equal, there is no significant influence (on the full equilibrium value).
At a lower level of interest rates globally, the savings deficit of the US and
the foreign savings surplus would remain unchanged. But suppose
instead that interest rates abroad cannot fall to the new lower neutral
level. Then only US interest rates fall, and so does the dollar. Non-US cur-
rencies rise sharply in value and the US current account deficit shrinks.
The world outside the US falls into a deflationary disequilibrium.
In scenario 7, the US savings deficit increases and the foreign savings
surplus increases (autonomously). In this case, the neutral level of inter-
est rates in the US rises and that abroad falls. The full equilibrium value
of the dollar rises. In principle, only if foreign market rates cannot fall
(in line with neutral) and US market rates are already above neutral
(and so they do not rise further) would a depreciation of the dollar take
place. But in practice if there is an actual or feared market failure
(inability of markets to cope with net global capital flows beyond a
certain scale), then the dollar could also fall.
In scenario 8, the US savings deficit increases and foreign savings
surplus decreases (autonomously). Under this scenario, the neutral level
of interest rates rises both in the US and abroad. If the shifts in the
savings deficits and surpluses (underlying) are equal, then the neutral
level of rates moves up by a similar amount (in the US and outside) and
there is no implication for the full equilibrium value of the dollar.
However, it could be that market rates abroad were above neutral levels
at the start. And so the dollar would come under some upward pressure.
We can see from the range of scenarios, and the imprecision of esti-
mates concerning the present divergence between market and neutral
interest rates or between market exchange rates and full equilibrium
exchange rates (whether at the start or end of the speculative trade), that
speculation is very much a shot in the dark. (Note in particular that the
illustrative speculator has been focussing on changes in savings balances
as a possible catalyst to shifts in the equilibrium path of the exchange
rate. But there are other catalysts – for example new information on or
reassessments of trade elasticities or currency preferences and appetites).
The more the potential speculator realizes the extent of the darkness, the
less likely he or she is to take big bold positions – or any position at all.
In fact the most serious basis for taking a speculative position in late
2004 was as first, a market critic and second, a prophet of US monetary
policy. A weight of current evidence suggested that huge negative sen-
timent had built up against the US currency based on two or three of
the scenarios (negative for the dollar) above only, with the others (in
which the dollar would rise) virtually excluded from consideration. It
was reasonable to assume that there was a substantial probability of
one or more of the positive scenarios coming into view before long, as
market frenzy faded. Alternatively it could become apparent that US
interest rates had been well below neutral and were now moving up or
that foreign rates had been far above neutral and were now moving
down (or some combination of the two).
Tools of currency speculation and examples of their use

Given the key (but far from exclusive) role of how the global pattern
of savings surpluses and deficits evolves in the determination of full
equilibrium exchange rates, an obvious question is what tools can the

speculator use to grasp whether a shift (in the pattern) is taking place.
The main data set is indeed the savings and investment tables
produced by large and some small advanced economies. As illustration
we can take the US savings-investment table, re-produced below (see
Table 8.1). This is a snapshot of realized savings and investment
during the specified time periods. It cannot reveal directly the under-
lying equilibrium amounts of savings and investment (where equilib-
rium is determined globally). The table could include a variety of
unintended savings or investment and of course at a level of output
which is not consistent with non-inflationary production at full
capacity throughout most of the globe.
Table 8.1 US Savings and Investments, 2001–5
(US$ bn) 2001 2002 2003 2004 2005 H1*

Gross Saving 1658 1489 1474 1572 1651
Gross Private Saving 1400 1560 1661 1755 1705
Personal Saving 132 185 173 152 36
Undistributed Corporate
Profits 192 295 376 397 456
Business Consumption
of Fixed Capital 903 894 911 973 982
Household Consumption
of Fixed Capital 172 187 201 233 231
Gross Government Saving 256 –71 –187 –182 –26
Federal (net) 46 –248 –382 –406 –285
State and Local (net) 4 –34 –23 –5 21
Government Consumption 206 211 218 229 238
of Fixed Capital
Gross Investment 1931 1926 2028 2308 2448
Gross Private Domestic 1614 1582 1670 1928 2056
Investment
Gross Government Investment 317 347 358 380 392
Net Lending or Net Borrowings (–) –371 –459 –507 –653
Statistical Discrepancy –89 –21 47 67
Memo:
S-I Private Sector –214 –22 –9 –173 –351
S-I Government –60 –418 –547 –562 –418
* Annualized rate
Anyhow, subject to these imperfections, Table 8.1 reveals that

between 2002 and 2005 (H1), the private sector saving deficit in the US
economy widened by over $300bn, whilst the public sector deficit
widened by $100bn. In looking at the sub-components of the private
sector deficit, what stands out is the decline in personal savings and
rise in private investment. A key component of the increase in private
investment – not shown in the table – was private residential construc-
tion, which increased by around 1.5% of GDP ($170bn) during the
years in question, evidently related to the boom in the residential real
estate market. The advantage of this breakdown is to help shine light
on what forces could bring about a shift in the US savings-investment
balance. In the situation of late 2005 the obvious elements which
could be in transition were construction spending (related to the
cooling of the residential real estate market), personal savings (surely
not to stay so low in the long-run). On the other hand, business invest-
ment as a share of GDP in 2005 was no higher than in 1995 and still
well below the peaks reached in the 1997–2000 information techno-
logy boom.
The speculative investor in currency markets should not become pre-
ocupied with the exact sectoral breakdown of the savings-investment
balance. The division of this between the personal sector (household
savings) and the corporate sector (undistributed corporate profits) is in
large part devoid of economic meaning (see Chapter 7, p. 204) Savings
in the corporate sector should add to underlying equity value – and
capital gains (realized or unrealized) are a form of household sector
saving (albeit not registered as such in the traditional breakdown
which lies behind the compilation of the savings-investment tables).
The equation of corporate savings and rising personal equity value is
most obvious in the case of small and medium-sized corporations. The
owner-manager who utilizes cash flow to repay debt adds to his or her
overall wealth. In general terms we have already seen that the market
value of equity is not always closely related to the accumulation of
profits inside the corporation (see p. 218). Other factors, such as
changed assessment of earnings growth, or shifts in risk premiums,
might be much more important. Everything else the same, however, a
higher rate of profits retention means a higher equity value (for the
given corporation) and thereby higher savings in the economy as a
whole (corporate and household sectors combined).
This equivalence of personal and corporate sector saving is especially
important in the context of the Japanese economy where in the early
years of the 21st century the savings surplus of the corporate sector
ballooned at the same time as the household sector savings surplus (as
recorded by the national income statisticians) dwindled (see Table 8.2).
Quite simply if the Japanese corporate sector had not in these years
been applying its higher earnings to the repayment of debt, Japanese
equity values would have been lower than otherwise. In turn, Japanese
household sector saving would surely have been larger (as measured
in the national income accounts) as there would have been less
capital gain accumulating towards providing an adequate nest egg for
retirement and other purposes.
Analyzing the savings surplus has been a key part of yen currency
analysis through the more than three decades of a floating exchange
rate. In principle, periods of time when the underlying savings surplus
in Japan was increasing (due to a rising propensity to save or a shrink-
ing frontier of investment opportunity) should have been accom-
panied by a downward pressure on yen neutral interest rates and on
the yen itself (assuming that similar developments were not happen-
ing in the global economy – and especially in the US). That was the
case through the early years of the 1980s – and indeed at that time the
US savings deficit was simultaneously ballooning under the influence
of Reaganomics (dramatic widening of budget deficit and buoyant
investment spending).
Many yen analysts became unstuck by the sudden fall in the
Japanese savings surplus in the late 1980s as a boom in investment
spending emerged and household savings fell in part as a reflection of
buoyant equity and real estate markets. (The role of the Japanese
authorities in promoting the boom has been discussed already in
Chapter 6, see pp. 167–8). All of this occurred at a time when the
US savings deficit was contracting (a serious growth recession in the
Table 8.2 Japan Savings and Investments, 2000–8
(¥100 bn) 2000 2003 2008

Non-Financial Corporates –38 99 50
Financial Corporates 182 167 150
Households (& Non-Corporate Business) 313 238 300
General Government –382 –382 –330
Net Capital Exports (to areas –129 –158 –190
(taken as equal to C/A surplus)
Statistical Error +53 +36 +20
(Missed savings surplus = +)

mid-1980s and some early action at reducing the budget deficit).

Correspondingly the yen rose sharply.
The big challenge for analysts of the yen familiar with using a
savings-investment framework in currency economics came during the
early 1990s, after the Tokyo equity market bubble burst. Real estate
markets started their long ascent downwards. All of this would have
been expected normally to translate into a weaker yen (via considerable
downward adjustment in the neutral rate of interest in the Japanese
economy). But instead of falling, the yen rode sky-high (see Chapter 4,
p. 104 and Chapter 6, p. 168, for a discussion of this episode).
In the second half of the 1990s and beyond, the saving-investment
balance framework has become more reliable in application to yen cur-
rency analysts. The fact that the zero rate boundary has prevented
market rates falling to neutral level during much of the time has been
an important point to incorporate (in the analysis) (see Chapter 6,
p. 167–70). The combination of a falling Japanese investment ratio
(business investment as a share of GDP) in the mid-late 1990s and a
business investment boom in the US, coupled with a reversal in mone-
tary stance (Japanese money rates eventually falling to zero whilst in
the US the FOMC moves rates sharply higher), went along with a
weaker yen. That trend, however, was broken by an implosion of the
so-called carry trade in yen (in autumn 1998) followed by a short-lived
equity and capital spending boom (1999–2000). Foreign capital poured
into the Japanese equity market.
The periodic importance of equity flows in Japan’s currency markets
raises the issue – already examined in the context of Chinese capital
flows – as to whether any insight is to be gained from the traditional
concept of the basic balance of payments. In the Chinese context (see
pp. 90–2) we have seen that the concept is of little use. The same
applies, as we shall see below, in the Japanese context, and indeed
more generally. The basic balance of payments should not be in the
main compartment of the currency analyst’s toolbox, even though it
still sometimes receives fleeting attention in market commentaries.
(The basic balance of payments is defined as the current account
balance plus long-term flows in the capital account – meaning direct
investment and portfolio capital). The monthly statistical statements
from Japan or US about portfolio flows (equity and bonds, in and out)
do sometimes provide the market talking point for 24 hours at most.
A main flaw of capital account data in providing insights to underlying
currency flows has already been highlighted (see Chapter 1, pp. 16–18).
An important part of the end-investor or end-borrower flows may be
taking place in the offshore markets, with only the intermediary flows
showing up in the traditional balance of payments, where they would be
registered as short-term capital transactions (largely via the banking
sector) not forming part of the basic balance. A further flaw, related in
particular to our discussion here about equity inflows into Japan, stems
from an emphasis on partial rather than general equilibrium analysis and
a neglect of the time frame over which expectations influence the process
of exchange rate determination. And there is the familiar problem that
actual flows may tell us little about the desired changes in stocks which
are the key element in price action.
On any particular day, or in any particular week or month, a big flow
of foreign buying of Tokyo equities, for example, would mean an extra
source of buyers of yen in the currency markets. But the level of the
yen is not settled by the short-term composition of currency business.
Rather, the dominating factors are long-run expectations regarding
equilibrium values, and divergences from these caused by money inter-
est rates diverging from neutral. A transitory rise in foreign purchases
of Tokyo equities – even if amounting to say a cumulative total of
$45bn over 3 months (as from August to October 2005) – should have
little influence. Much the same as for sterilized foreign exchange inter-
vention, offsetting flows would be triggered (other investors in yen,
including domestic residents, deciding that this was a good opportu-
nity to move into non-yen assets). If, on the other hand, the buying of
equities from abroad is long-run (stretching out over years) and seen as
such, then it might go along with a core surplus in the so-called long-
term capital account. This would have to be matched by a deficit (or
shrunken surplus) in the current account.
A further aspect of the link – or lack of link – between equity flows
and the equilibrium value of the yen (or any other currency example)
is illustrated by the experience of Autumn 2005. Unusually this episode
of massive foreign inflows to the Tokyo equity market was accom-
panied by a big growth of the carry trade in yen (borrowing of the
Japanese currency to match foreign currency assets). The foreign
buyers of Japanese equities were said to have “hedged” almost all their
purchases. The idea behind these hedges was that profit (or loss) from
the carry trade position would be negatively correlated with returns on
Japanese equities (expressed in foreign currency terms). For example if
a fall in the Tokyo market in dollar terms tends to go along with a fall
of the yen against the dollar, then a joint position in the carry trade
(short yen, long dollars) and equity market could appear to be less risky
from the viewpoint of a say US hedge investor than a simple unhedged
position. In practice a substantial correlation as described is only likely

to be found over short holding periods and would depend on Japanese
equities (in yen terms) not bouncing up in response to yen declines
and conversely. (A weaker yen could in principle bolster Japanese equi-
ties by countering pessimism on deflation and improving profits
prospects for the key export sector).
From a longer term standpoint, the so-called hedging strategy looked
more like a passing trade idea rather than a new departure in portfolio
management. Assuming the huge purchases of Japanese equities made
in Autumn 2005 found their way into passive portfolios of global
investors, the key issue would be whether they could gain an improve-
ment in the overall balance of return and risk by maintaining a large
short position in yen. This would be the case if cumulative income
from the carry trade (rolling over positions every say three months)
tended to reduce the overall variability of returns (expressed in the
investor’s base currency or currency mix) measured over a normal
holding period of say several years. There is no empirical research or
theoretical consideration to make the passive investor confident about
any such risk-reduction potential (of currency hedging).
Perhaps some foreigner investors have been lured, nonetheless, into
the strategy of “hedging” yen risk by the resulting apparent access to
zero rate financing. Instead of funding the Japanese equity portion of
their portfolio with dollars, they fund it with zero rate yen (the result
of borrowing yen and lending dollars or an equivalent forward
exchange position). Hence it might appear that the foreign investor
could enjoy the same risk premium (expected returns on Tokyo market
less the real riskless rate of return in Japan) as Japanese investors, rather
than the smaller apparent risk premium calculated as prospective earn-
ings yields in Tokyo less the real riskless rate of return on dollars. (As
we saw at the start of this chapter, real 10-year swap rates on dollars at
end-2005 were more than 200bp higher than on yen). That attempt,
however, to “lock in” a higher risk premium was based on illusion.
Foreigners could expect to earn the same risk premium as Japanese
investors without “hedging” if they correctly took account of the likely
trend real appreciation of the yen. On top of the gains over time on
their holdings of Japanese equities as calculated in yen there would be
an expected translation gain into dollars stemming from the real
appreciation (of the yen against the dollar). That real appreciation was
one element built into the forward structure of exchange rates (either
explicit or as derived implicitly from rate spreads) for the yen against
the dollar and corresponded to the fact that real yen rates were well
below real dollar rates. The real gains on the yen, however, could not
be totally isolated from equity risk by entering the yen carry trade (see
below). Even if the gains could be locked in, it is not clear that the
overall risk-return parameters of the well-diversified global portfolio
measured in a particular currency (or currency mix) would improve.
Rolling over short-maturity forward contracts in the yen/dollar
exchange market (or equivalently borrowing yen and lending dollars
on a short-maturity basis) does not secure the real appreciation (for the
foreign investor) as the nominal rate spread between dollars and yen
(or forward premium on the yen against the dollar) is a joint estimate
also of inflation differences between the US and Japan and might also
include a variable risk premium. As illustration, take 3-month money
market rates in Japan at 0% and in the US at 4.5%. The 4.5% p.a. dif-
ference could consist of an expected inflation spread of 2.5% p.a
(2% p.a. in US, –0.5% in Japan), an expected real appreciation of the
yen vs. the dollar of 1.5% p.a., and a 0.5% p.a. risk-premium in favour
of the dollar. Cumulative error in the form of under-estimating
inflation differences and a dip in the risk premium might mean that
lower-than-expected real exchange rate gains on Tokyo equity values
are not fully offset by profits from the yen carry trade.
Moreover there is a mismatch problem. A big sudden decline in the
Tokyo market would mean that the foreign investor who had fully
“hedged” holdings there would find suddenly that the carry trade
position was well in excess of matched holdings of Japanese stocks. If
the yen were simultaneously strong the investor would realize double
loss (equity fall and emerging excess carry trade position swinging
into the red). Indeed the closing of excess carry trade positions by
foreign investors under these circumstances could give some short-run
upward momentum to the yen.
The future of the so-called “hedging strategy” in the Tokyo equity
market is far from being a trivial question given the amounts
involved. Successive huge waves of foreign buying in the Tokyo equity
market since the Crash of 1990 have seen the share of foreign owner-
ship rising from 5% in 1990 to 25% in 2005. Domestic holders of
Japanese equities have been big cumulative sellers to foreigners.
Included amongst these sales have been the run-down of the vast so-
called interlocking shareholdings (whereby companies have held
shares in each other) and have so contributed to a fall in overall lever-
age (debt to equity ratios), as the cash proceeds have been used to
repay debt. The bolstering of equity values by massive foreign demand
should in principle have meant that domestic spending propensities
(both corporate and household) in the Japanese economy have been

sustained at a higher than otherwise level. Equivalently foreign
demand for equities would have pushed up the neutral rate of interest
in the Japanese economy and the equilibrium level of the yen.
Even so, there is no simple relationship between the size of the
foreign inflow into Tokyo equities, the neutral level of Japanese rates,
and the equilibrium value of the yen. Suppose a given increase in
foreign demand brings a big rise in Tokyo equity prices but little actual
net flow between domestic and foreign holders (perhaps because of
considerable heterogeneity of expectations regarding future returns on
the part of Japanese investors). That is more significant – in terms of
the neutral yen interest rate and equilibrium yen exchange rate – than
the fall-out from a bigger increase in foreign demand which brings a
smaller rise in equity prices but a much larger net flow (as might be the
case if Japanese corporations are quick off the mark to respond to
foreign demand by accelerating their liquidation of interlocking share-
holdings or if Japanese investors hold quite homogeneous views
regarding returns).
And what can we say about the implications (for the equilibrium
value of the yen and yen neutral rates) of a long-turn shift to foreign
selling in the Tokyo equity market. Suppose that markets shift to
expect that over the next decade foreigners would reduce their share of
Tokyo equity wealth from say 25% to 15%? Much depends on the
trigger to that downward adjustment. If the trigger is a reduced aver-
sion to equity risk or an increase in long-run economic optimism by
Japanese investors (relative to the state of mind of foreigners with
respect to Japan which remains unchanged) that would mean a
stronger yen and higher level of neutral rates even though the basic
balance of payments could weaken as equity inflows gave way to
equity outflows. The higher level of neutral rates would mean greater
strength in non-equity inflows – only a small part of which might
show up in the so-called long-term capital account (of the balance of
payments).
Indeed there was a version of this phenomenon in the late 1980s,
when foreign investors did not fully share in the euphoria of domestic
investors concerning the Japanese economic outlook and so they (the
foreigners) became huge sellers of Tokyo equities. Domestic euphoria,
however, went together with eventually rising bond yields and interest
rates. And so the yen was generally strong even though the capital
account data revealed a large long-term deficit fuelled by net foreign
sales of Japanese equities.
Safe haven currencies

We have picked out the yen to illustrate analysis of potential specula-
tive strategies in the currency markets. When it comes to strategies of
using currency positions to provide safe havens against various bad
states of the world, we use the Swiss franc for illustrative purposes. We
describe the Swiss franc as a hedge currency. Through the course of the
20th century, the Swiss franc has demonstrated such hedge properties
in a range of bad scenarios. First, there was the jump in value (albeit
subject to considerable volatility) of the Swiss franc against the bel-
ligerent currencies during the First World War (see Brown, 1987). Then
there was the franc’s sharp appreciation against all other currencies
during the inflation storms of the 1970s. Finally, the franc has dis-
played some hedge properties against global equity market crashes and
wider financial crises.
None of these hedge properties are guaranteed. In the 1930s, the
Swiss franc failed as a hedge against social turmoil in France (the
arrival in power of the Front National) because the French franc and
Swiss franc’s fates were joined as members of the Gold Bloc. As World
War Two approached, the flight of capital from Europe was directed to
the US not to Switzerland, as the latter’s chances of sustaining neutral-
ity was very much in doubt. The franc did rise against the dollar in
the free markets during the late years of World War Two and beyond,
but of course many of those European investors who had sought
refuge in Switzerland found (or their heirs found) that their assets
were subsequently unrecoverable.
In the post-war world, the hedge function of the franc has been cur-
tailed in important respects by the exchange rate policies followed by
the Swiss National Bank. The year 1978 marked the turn, when the
Swiss National Bank (SNB) intervened massively in the foreign
exchange markets to pull the franc down in value and made clear that
monetary policy was subservient to exchange rate policy. The chance
of official action to cut the value of the franc has limited its hedge
appeal. In the wake of the equity market crashes of late 2000, forward
into the ensuing global recession and darkening geo-political climate
(from the September 11 terror attacks through to the build-up of pres-
sure on the Saddam Hussein regime), the franc briefly starred (see
Figure 8.2). In the years since then (2003–6), SNB officials have
repeated declared that they would combat any new substantial rise of
their currency. Some analysts maintain, nonetheless, that the franc
does still possess some hedge properties, even if limited.
3.5 4.0
3.0 3.5
CHF/USD
CHF/EUR (RHS)
2.5 3.0
2.0 2.5
1.5 2.0
1.0 1.5
0.5 1.0
77 79 81 83 85 87 89 91 93 95 97 99 01 03 05
Figure 8.2 Swiss franc exchange rate, 1975–2005
These (hedge) properties stem from two observations. First during

periods of global financial storm, there is a tendency for international
equity flows to shrink. Investors stop adding to the equity sections of
their portfolios. Hence countries which are typically large net buyers of
foreign equities (measured relative to their economic size) would expe-
rience a sudden curtailment of capital outflow, putting upward pres-
sure on their currency. (There may be some partial offset in the form of
an increased demand for foreign bonds, but there is likely to be some
matching increase in foreign demand for domestic bonds). This is the
case with Switzerland, which has a huge saving surplus (around 13% of
GDP in the 2000s), most of which is exported into foreign bonds and
equities. Second, carry trade activity (the borrowing of low or zero
interest rate currencies to finance assets in higher yielding assets) tends
to shrink at such times. Many of the institutions engaged in the carry
trade find themselves financially weakened by market crisis, and so
they cut back their positions. The Swiss franc, as a prime borrower cur-
rency, should gain in value from the cut-back.
In addition to offering some residual safe-haven role, the franc also
provides some opportunity to speculative investors. Here an essential
long-run question to weigh is if and when the huge Swiss savings

surplus will start to diminish, putting upward pressure on the neutral
real interest rate in Switzerland and on the equilibrium value of the
franc? Related to that question are the projections of a steady growth
in the investment income surplus of Switzerland. There are also some
imponderables. Will productivity growth in the protected sector of the
economy tend to catch up with that in other advanced economies,
meaning downward pressure on the price level and some tendency to
real depreciation of the currency (everything else the same) – the
reverse Balassa effect already discussed (see Chapter 3, p. 82). Or might
any such acceleration of productivity growth go along with a flourish-
ing of investment opportunity in Switzerland putting upward pressure
on the neutral real interest rate and equilibrium value of the franc
which would outweigh the reverse Balassa effect?
On balance, anecdotal evidence suggests that long-run position-
taking by global investors in the franc driven by far distant speculative
considerations such as that just discussed has been small. Long-run
position-taking appears rather to be dominated by safe haven consider-
ations amongst investors and by profit expectations of carry-traders
(who are evidently not scared by the potential scenario where the franc
would appreciate substantially). The investors who select the franc as
one safe haven must still look for protection in those bad states of the
world where the Swiss currency would not perform well. One obvious
bad state of the world is energy shortage.
If indeed cheap conventional sources of energy become growingly
scarce (relative to demand) and a shortfall has to be satisfied (with the
stimulus of high prices) via huge new investment, then this would put
a brake on global economic progress. The capital invested in the
extraction of non-conventional energy supplies, on providing the
infrastructure for new forms of energy to be transported or transformed
(into required products), and on the development and implementation
of new energy-saving technologies, could have been otherwise spent
on productivity enhancing projects.
Investors looking for a hedge against this particular bad state of the
world (in which economic progress would slow overall, albeit not for
the energy producing countries!) can of course turn to a range of
energy equities – in companies that would profit from the bad scenario
described. In addition, so-called petro-currencies would offer some
protection.
In the contemporary world the prime petro currency is the Canadian
dollar. A generation ago it was the British pound (in the late 1970s,
early 1980s). The correlation between the international value of the

Canadian currency and the energy price stems from Canada’s vast non-
conventional energy resources which can be exploited profitably only
when prices are expected to remain at historically high levels over the
long-run (see Chapter 7, pp. 208–9) (see Figure 8.3).
Critical in the link between the energy price and the Canadian dollar
is the responsiveness of investment in Canada’s energy sector. If
energy companies are very conservative in adopting investment pro-
jects, budgeting on the basis of long-run prices far below what is
presently discounted in the market, then the responsiveness would be
that much lower. In principle, markets should force the pace of invest-
ment. Energy companies which are conservative, perhaps because they
are highly levered rather than mainly equity financed, would find their
equity prices languishing compared to their more aggressive rivals.
Their management might face dismissal after a bruising take-over
battle. In practice, however, analysts raise questions about whether
market discipline in the form suggested has worked well in the energy
industry dominated by a few large players with oligopoly power.
The example of the petro-currency (in this case the Canadian dollar)
as a hedge against one particular bad state of the world (from the
1.45 80
1.40 70
1.35 60
1.30 50
1.25 40
1.20 30
CAD/USD
1.15 20
Brent Oil Spot $pb
(RHS)
1.10 10
Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05
Figure 8.3 Canadian dollar vs. oil price, 2003–5
viewpoint of many investors) can be generalized. We suggested above

that a prime motivation for holding such a hedge asset (against con-
ventional energy shortage) is concern about a slower rate of economic
progress due to a squeeze on productivity growth. But there are other
possible motivations which depend on the circumstances of the indi-
vidual investor. For example, there is the risk of windfall loss on the
real value of monetary assets, as would occur if central banks accom-
modated the initial jump in energy prices and if there were no subse-
quent reversal (of energy prices and of monetary accommodation).
This example is generalized in the next section.
Spectre of negative real rates

The association of energy shock with real loss (taking account of inter-
est income) on monetary assets goes back to the traumatic events of
the 1970s, when double-digit inflationary conditions swept over most
of the advanced economies (with the important exceptions of
Germany and Switzerland). Real interest rates on several of the major
currencies (US dollars, yen, and Sterling, for example – but not
Deutsche marks and Swiss francs) lingered at substantially negative
levels for a prolonged period. Investors in fixed-rate bonds reaped large
losses.
It has been a hotly debated topic amongst economists (see, for
example, De Long, 1995) whether the two energy shocks (1973–4 and
1978–9) played a coincidental or catalytic role in the “greatest peace-
time inflation”. It is indisputable that the core rate of inflation in the
US had already reached (in Spring 1973) double digits before the first
energy shock erupted (October 1973). It is also clear from the German
example that inflation was not an inevitable consequence of energy
shock. A tight monetary policy as pursued by the Bundesbank in 1973
could act as an antidote to any impulse towards inflation from energy
prices shooting up towards the sky.
In principle, energy shock might bring a short-run fall in the neutral
rate of interest, measured in real terms, across all the main currencies
(but not in financially feeble developing countries – see Chapter 4,
pp. 98–102). That would be the case if savings in the oil importing
world fall (under the influence of households seeking to maintain their
living standards despite the squeeze on their real disposable incomes
from higher energy prices) by less than the rise in savings in the oil
exporting world (where governments, corporations, and households
might indeed be slow to raise their spending in line wealth gains).
In the longer term there can be no presumption about a sustained

high level of energy prices lowering the neutral level of real interest
rates. In principle that might happen if the long-run growth rate of
productivity (and productive potential) in the global economy slows –
and we apply the logic of simple economic growth models in which
the rate of return to capital equals the growth rate. However that is a
very distant and unreliable anchor to real interest rate forecasting!
Taking a more pragmatic approach, the analyst perceives that a big
new source of demand for capital is created – the exploitation of new
energy sources, development of new energy distribution networks, and
investment in energy-saving technologies. On the other hand, a slower
growth of productivity (due to scarcer energy) might mean a higher
savings rate (in that households cannot look forward to the same
growth of income) and less investment opportunity in the non-energy
sectors. The medium-term influence of energy shock on the neutral
level of real interest rates is not unambiguously in one direction or
another.
Indexed government bonds are a hedge against an unexpected
transitory (or longer lived) fall in real interest rates in a situation of
raised inflation risks, such as might occur in the immediate aftermath
of energy shock. In this scenario, though, petro-currencies or energy
sector equities are the star hedges. There are other scenarios featuring
the same phenomenon – a transitory or longer-lasting fall in real inter-
est rates amidst raised monetary risk – including natural disaster or
war, where petro-currency offers no protection.
A benign cause of a short-run fall in real interest rates, induced by
monetary sources, would be a sudden acceleration of productivity
growth under a monetary regime in which the central bank stabilizes
inflation at a low level and strenuously avoids any episode of deflation
(even if not accompanied by recession or worse). The holding of
foreign currency (assets denominated in currencies other than that of
the political jurisdiction where the given investor resides) is a hedge
against a transitory or long-term dip in real rates that occurs just in one
country or regional group of countries. (The assumption is that some
combination of exchange risk and expectation of exchange rate change
allows real rate spreads across currencies to persist). Where the decline
in the neutral level of real rates is global, then currencies are not a
hedge vehicle, unless there are considerable monetary divergences
(with respect to how actual rates are related to neutral level).
In the case of the first and second oil shocks, a dip in market real
rates was not general, even though neutral real rates likely fell every-
where for some time. In particular, the monetary response (to the
shock) diverged between Germany and Switzerland on the one hand,
and the rest of the world. So in that case the Swiss franc and Deutsche
mark were in fact hedges. But that divergence could not be counted on
in the future. Indeed in the 2004–5 oil shock there was a divergence in
terms of monetary rhetoric. The Federal Reserve was fully ready to
tolerate a temporary rise in inflation so long as the core rate remained
unchanged and low. In the euro-area the ECB proclaimed that its aim
was to hold down overall inflation and that core inflation was a
lagging indicator. In Japan the BoJ proclaimed that deflation was
coming to an end and this would justify an early end to extraordinary
monetary ease, even though some price level measures excluding
energy still hinted at mild deflation. Looking beyond the rhetoric,
however, the monetary response of the major central banks was largely
the same – to accept some short-term acceleration of inflation, so long
as core inflation (excluding oil) and inflation expectations remained
subdued. The rationale for this response was that an attempt to
prevent or reverse any oil-induced transitory acceleration of overall
inflation would most probably inflict considerable economic costs.
Towards understanding the possible divergences in monetary
response (to oil shock) and its consequences for the market real interest
rate, consider a strict monetarist regime, in which the central bank
targets monetary base and aims for long-run price stability. A sudden
jump in energy prices would mean that the demand for money (in
nominal terms) would increase relative to supply (monetary base
remaining on an unchanged trajectory). A rise in nominal interest rates
in the money markets would be essential towards short-run balancing
of supply and demand in the market for monetary reserves (base
money). The rise in nominal money market rates would be one of the
transmission mechanisms forcing non-oil prices down, so that the
overall price level rise would be curtailed. There is no guarantee,
though, that the price level would fall back to its long run previous
stable level – as the demand for money in real terms may have fallen
somewhat in view of shrunken real disposable incomes.
During a period of transition market interest rates could be some-
what above the neutral level, which may indeed be temporarily
depressed. By the same token, once adjustment has occurred (non-
energy prices falling), there may be a period of sub-neutral market rates
as the economy bounces back from its situation of some overall slack.
It is possible, but far from certain, that the total cumulative real inter-
est income from monetary assets over the whole period of price level
adjustment to the oil shock will have been depressed compared to

what it otherwise would have been. There should be no overall denting
of market confidence in long-run conditions approaching price level
stability and bond market values should remain well sustained.
Compare the path of adjustment that occurs under modern mone-
tary management. A first point is that aiming for an unchanged core
rate of inflation is itself not a fully accommodative policy. The so-
called core price index includes many items which have high energy
content – for example, transportation services (including transporta-
tion fares) and chemicals. So consistent with an unchanged core rate
of inflation there has to be some bearing down on non-energy
prices, but almost certainly less than in the yardstick case of an
unchanged path for monetary base growth. It may be that the
bearing down can come without nominal money market rates rising
at all or at least by considerably less than the full extent of overall
inflation (including oil prices). That would be consistent with real
interest rates dipping in line with neutral real rates (reflecting the
transitory tendency towards excess savings in the global economy,
referred to above).
Uncertainty as regards the price level in the long run is greater (in
the case of core inflation stabilization) than under the previous
example (monetary base remains on an unchanged trajectory). There
may be no basis for predicting that the present jump in oil prices will
subsequently be reversed. Even in the case of reversal, the central
bank might not allow a fall in the overall price level or even a serious
fall in the inflation rate to take place (to below say, 1% p.a.) and so a
permanent increase in the price level or cumulative inflation rate
(beyond what would have occurred without the energy price shock)
might occur. Long-run inflation expectations might climb. There is
the danger in such circumstances of nominal interest rates falling
behind the neutral level in real terms (owing to inflation expectations
being underestimated by the monetary authorities) triggering thereby
a further acceleration of inflation. In any case a period of above
neutral interest rates might be required to lower inflation expectations
back to their previous level.
It is not self-evident that at the end of the monetary process
described investors will find that their real income accumulation on
money and debt instruments has fallen below normal expectations
before the energy shock. Much depends on whether in fact the end
result is indeed a higher inflation environment – in which case losses
will surely have been realized on fixed-rate assets. There may also have
been a period in which real income on floating rate assets (these

include bank deposits or other money market instruments rolled over
repeatedly at maturity) was very low or negative. Also critical is
whether the oil price in fact falls back.
A period of higher-than-expected inflation brought on by a sudden
apparent shortage of resources and resulting in real interest income
loss for investors can be seen in most dramatic form in the case of
natural disaster or war. Consider first the case of natural disaster (earth-
quake, hurricane, tsunami, or pandemic, for example). Suppose this is
restricted to country A but is on a large enough scale to dislocate a
large share of the economy (a historical example is the 1923 earth-
quake in Tokyo). The savings balance (in country A) would plunge into
large deficit, as stricken households now earning little or nothing
would try to maintain consumption out of capital, and businesses
sought to replace destroyed capital (whether inventory, machinery, or
plant). The government deficit would explode. Some particular items
in short supply (for example materials required for reconstructions)
would jump in price. It is very likely that the neutral interest rate in
real terms for country A would rise far – at least over the short and
medium-term.
If the central bank in such circumstances were to run a strict “mone-
tarist” policy – maintaining the high-powered money stock on its pre-
ordained growth path – then almost certainly there would be a huge
jump in short-term interest rates, and this would add to overall dis-
tress. More plausibly, the central bank would take the view that the
jump in prices would subsequently be reversed, and that some consid-
erable immediate rise in the price level should be tolerated. Indeed the
subsequent fall-back in the price level once the resource shortage was
relieved would mean that a low level of nominal interest rates for
medium or long maturities (with respect to money and bond market
instruments as viewed during the period of shortage) would in fact
translate into a high real interest rate.
The test for the central bank would be to stand firm during the sub-
sequent “deflationary” period, when the price level fell, and not
engage then in stimulatory policies which resulted in prices remaining
far above their pre-natural disaster level. The fall in the price level
might mean that real interest rates rise considerably at this stage, to
well above the hypothetical neutral level, and induce economic slump.
The monetary pilots at the central bank, in attempting to avoid the
hazard of depression, might in error steer the economy into an
inflationary episode.
We can visualize a particular variant of the deflationary danger stage

in the hypothetical case of country A operating under a gold standard
regime under which international capital flows are highly elastic.
Capital would flow in during the period of resource shortage and the
price level would rise, whilst nominal rates remained at the interna-
tional level. Subsequently, as resources again became available, the
price level would fall back and capital would flow out. Whether the
price level ended up lower or higher than at the start would depend on
whether the natural disaster had permanently affected country A’s
international competitiveness or international balance sheet (and the
related investment income account in the current account of the
balance of payments) in some major respect.
Under the gold standard – or absolutely fixed exchange rate system
– there is no option of slowing down the process of price decline
once the resource shortage is overcome. And so the danger of depres-
sion (induced by market real rates far above neutral) might become
acute. There is the option under such circumstances of a temporary
break from the gold standard, during which the central bank pushes
rates down towards zero. Suspension, however exceptional the cir-
cumstances, carries a credibility problem for the future.
In the case of a floating exchange rate regime with independent
paper currencies, the central bank could ease the process of price
deflation by engaging in stimulatory monetary policy. This may be
constrained, however, by the zero rate boundary to nominal rates,
meaning that only non-conventional monetary policy could be effec-
tive. Tools would include explicit devaluation of the currency, aggres-
sive monetary base expansion, and negative interest rates (see
Chapter 4, pp. 114–5). These tools are all cumbersome and their
application may lead to a price level (or cumulative inflation) higher
than what would have been the case if natural disaster had not struck.
A permanent loss of real interest income (cumulatively) and losses on
fixed-rate bonds might be suffered by investors. Foreign currency
assets (bought before disaster strikes) offer investors protection
against this eventuality, so long as it is confined geographically. In
the case of worldwide natural disaster, there is no such protection
possible from foreign currency assets. It is not clear that any other
asset could offer protection. Even indexed government bonds might
be tampered with – as emergency decrees could restrict the extent of
their compensation for price rises due to natural disaster.
Equities or real estate do not offer infallible protection against world-
wide natural disaster Profits earned by corporations or rental income
received from physical properties in the wake of these disasters are

likely to fall far short of expectations held by investors prior to their
occurrence. It is a matter of conjecture whether the cumulative loss on
the real assets is more or less than on the monetary assets. Much
depends on just how far the monetary authorities fail to reverse the
initial jump in prices and what longer-term inflationary problem might
thereby set in. Monetary diversification (across currencies) should still
pay off. Some monetary authorities will be more successful – or better
placed (in terms of the socio-political context) – than others to steer a
course that does not substantially erode monetary values.
An extreme example of a bad state of the world characterized by
resource shortage and induced inflation is war. Resources are diverted
from the production of butter to guns. The output of consumer goods
and services falls. Yet real incomes and wealth fall only partly in step.
(There is rapid growth in incomes from production of guns offset only
in part by increased tax deductions, on the assumption of a big widen-
ing of the government budget deficit). Prices of goods and service in
short-supply (in the absence of price-rationing, discussed further
below) come under upward pressure. In the illustrative case of the
central bank pursuing an unchanged rate of expansion for money
supply, it is likely that there would be some upward pressure on money
market rates. That would reflect demand for money (swollen by the
higher prices) exceeding supply (of money). Money rates at above the
neutral level (which in real terms would surely have risen, reflecting a
shift of the savings balance into deep deficit – see below) would bear
down on prices.
In the new equilibrium, prices would settle at a higher level than
during the preceding peace, but lower than in the first stage when
prices shot up under the influence of scarcity, in line with the fall in
demand for real money balances (in line with the decline in aggregate
real incomes). Long-maturity rates, even in nominal terms, might
remain low, reflecting anticipations of an eventual decline in the price
level once peace is restored. (Expectations of an eventual price decline
means that low nominal long-maturity rates could indeed be abnor-
mally high in real terms).
Massive budget deficits would be an important factor in the swing of
the overall savings-investment balance into large deficit. High real rates
would rein back private spending (whether by households or busi-
nesses outside the military sector) making way for the transfer of
resources to military use. In a global context, the high real rates would
also induce capital inflows, most likely from neutral countries.
When peace returned, a reverse set of dynamics to the above would

come into effect. The neutral level of real interest rates would fall, and
so would the general price level (fall) as resources were transferred back
to production of butter. If the price decline were violent (as might
happen if rampant wartime commodity speculation came to an abrupt
end and moved into reverse) then in principle interest rates might
have to fall well below neutral level to prevent an economic depression
and limit the overshoot (in the downward direction) of the overall
price level. Indeed, in the context of overall deflation, the zero rate
boundary might become effective, meaning that equilibrium cannot be
reached under conventional monetary policy. As in our illustration
above, a period of unconventional policy would be optimal.
In practice, the examples of the US in the First and Second World
Wars shed some light on the theoretical discussion. In both cases there
was substantial price rationing (more in the second than in the first).
Price controls (meaning that spending is limited by rationing) mean
that interest rates during wartime can stay at a much lower level than
otherwise without recorded inflation soaring. (Long-maturity rates,
however, might reflect expectations of very high real interest rates in
the post-war situation once rationing is abandoned). At the end of the
war the private sector has large pent-up demand (held in the form of
above-normal holdings of money and government bonds relative to
income). Interest rates then would have to rise sharply – and stay high
over a sustained period – so as to bring savings and investment into
equilibrium. It may prove politically unacceptable to rein back in this
way reconstruction spending to allow space for households to spend
revenues saved during wartime. Calls would grow for some windfall
taxation of the wealth overhang – some of which had accumulated in
the black economy. A bout of inflation, during which the central bank
deliberately pegs interest rates at a very negative level in real terms,
could satisfy the calls.
In the example of the First World War, the US price level rose by
13% in 1916, 24% in 1917, and 15% in 1918. In the first year of peace,
1919, the price level stabilized, then jumped by 14% in 1920, before
falling back by 15% in 1921 and 5% in 1922. Elements of the story
above can be intertwined with this data. Evidently the Federal Reserve
did not aim to hold down inflation induced by resource shortage
during the war, and in fact gave it a helping hand by holding rates
below the neutral real level. The fall-back of inflation to virtually zero
in 1919 reflected the resumption of peacetime production and relief of
scarcities. The Federal Reserve did not realize the temporary nature of
the calm climate on prices and failed to push rates up into line with
the then neutral real rate level reflecting peacetime prosperity amidst a
high propensity to spend in the post-war environment. (It is possible,
nonetheless that the new neutral level was lower than during the war
itself, but of course market rates had been far behind).
Contemporary critics realized the inadequacy of Federal Reserve
policy at this time (1919), as evident from Joint Congressional
Commission of Inquiry (see Friedman and Schwartz, 1963, p. 229).
Critics cite the boom which got underway in 1920, largely speculative
in nature. This then gave way to the bust of 1921. The Federal Reserve
(created in 1913 and with little peacetime experience) reacted severely
to the boom and associated speculative price rises. But it then failed to
prevent a short episode of severe deflation.
Friedman criticizes sharply the Federal Reserve for overkill in early
1920 (when large rate hikes occurred). In one sense, however, that line
of attack (by Friedman) misses a wider issue – as to whether the Federal
Reserve should have been seeking to induce, albeit belatedly, some roll-
back of the price level rises related to resource scarcity during World
War One. It stood in the way of that roll-back during 1919–20 by at
first following an over-easy monetary policy. It then sought to correct
its error – but in a way that had abrupt and painful economic conse-
quences. If the aim had been to foster a smooth roll-back of the
wartime price level, then policy should have been tight throughout
1919–20. Strategy rather than fine-tuning is the issue to debate.
Following the Second World War, the Federal Reserve took no
chances on abetting a process of price level decline, at least part way
back to pre-war levels, once resource shortages eased. Nominal money
market rates and Treasury bond yields were maintained at around the
same low level (1% for bills, 2.5% for long-maturity bonds) that had
prevailed during wartime, when aggregate demand had been restrained
by a much more powerful system of physical rationing than had been
in force during the First World War. The lesson learnt from the previ-
ous post-war recession (1920–1) was that deflation and recession
should be enemy number one. The price level had risen by 8% in 1941,
13% in 1942, 13% in 1943, 7% in 1944 (restrained in that year by
greater rationing), and 4% in 1945 (lowered by a relief of resource
shortages following the end of war). In 1946 and 1947 the price level
bounded ahead by 18% and 10%.
There were then two years’ calm – in 1948–9 – during which the
price level was stationary (up 1% in 48 and down 2% in 49). In 1950–1
there was a new inflation surge associated with resource shortages
during the Korean War – prices rising by 8% and 5% in each year

respectively. In the peace that followed the Federal Reserve did not
allow the overall price level to fall back. It was only in March 1951 that
the Federal Reserve and Treasury entered into an accord which effec-
tively brought a formal end to the former’s price-fixing operations in
the government bond market and so made possible again an indepen-
dent monetary policy (see Hess, 1969). The Federal and Reserve and US
Treasury had been working partners in an almost 50% increase in the
price level (1945–52) under conditions certain to impose huge real loss
on all holders of dollar assets (whose principal was fixed in nominal
terms). By contrast in the seven years following the end of World War
One, the price level had fallen by a cumulative 5%.
Where could investors in 1945 have found refuge from the coming
direct attack on monetary wealth organized jointly by the government
and Federal Reserve? Foreign currencies provided no hedge at all, in
that the dollar was generally strong and the rest of the world struggled
with dollar shortage (huge payments deficits in the midst of post-war
reconstruction). Back in 1934 the Roosevelt Administration had raised
the official price of gold in terms of dollars by around 70%. And so the
yellow metal now offered no hedge protection to investors who could
obtain stocks (either on a legal or illegal basis according to the political
jurisdiction in which they lived). (Arguably gold did provide protection
to those few farseeing investors back in 1930–2 who saw the possibility
that depression could be followed by a long bout of inflation. The
insurance pay-out occurred upfront).
In fact this was a period (1945–52) when real estate and equities first
gained their reputation as hedges against inflation. But that was an ill-
defined concept. More precisely they were hedges against a deliberate
but controlled exercise in the partial destruction of real monetary
wealth by government via the holding of all interest rates at substan-
tially sub-zero real levels, far below the neutral level. Moreover it was
essential (to the hedge-asset performing well) that this was a time of
growing economic prosperity.
The example of post-war destruction of real monetary wealth has a
very tame parallel in the situation of peacetime productivity or positive
terms of trade surprise where the monetary authority is seeking to
prevent a fall in the actual price level (or to maintain inflation at a low
positive level rather than allowing it to dip to zero or even into nega-
tive territory). Take as yardstick again the case of the central bank
aiming to maintain money supply growth on a target path or at a
target level. An acceleration of productivity growth (or a new trend
improvement in the terms of trade) as might occur in advanced

economies as the pace of globalization accelerates would, under this
monetary regime, put downward pressure on the steady-state inflation
rate or on the overall price level – both towards a new lower long-run
equilibrium level as the case may be (dependent on the exact monetary
rule followed).
That adjustment downwards might carry economic costs. As money
demand accelerates (under influence of faster economic growth) rel-
ative to money supply, money rates would rise above the neutral rate
in real terms (and that latter variable might well have risen). Some
prices could be rigid downwards. And so the economy could be in a
recessionary disequilibrium for some time. A fall in the inflation rate to
near zero might mean that anti-recessionary monetary policy could
not in future be accomplished with the use of conventional tools.
Rather than accept these costs, the monetary authority may bolster
the pace of monetary growth in pursuing its aim for stable prices (rather
than falling) or an unchanged moderate rate of inflation (rather than a
lower one). In that situation the nominal money market rate might dip
below the neutral rate during a transitory period (in which the central
bank presses on the monetary accelerator until the new higher rate of
money supply growth is achieved. Real market rates of interest might
well fall during this interim period to below previous levels. A corollary
of the fall in the real rate would be a transitory decline in the real
exchange rate of the currency (issued by the economy whose productiv-
ity growth has increased). Hence foreign currency assets would offer
some protection against the real income loss during the process of mon-
etary acceleration. Where productivity growth gains and matching tran-
sitory monetary acceleration are a global phenomenon the real estate or
equities may be the only protection against real income loss (on mone-
tary assets), but they are subject to considerable risk on their own
account. Moreover the phenomenon of monetary acceleration linked to
stabilizing the price level or inflation may very well go together with a
bout of asset price inflation (in real estate or equity markets or both)
culminating in a bubble and bust.
Indeed, the Austrian school’s diagnosis of the US asset price inflation
(real estate and equities) in the 1920s is based on just such a sequence
(see Oppers, 2002 and Hayek, 1931). The rapid productivity growth of
that period coupled with low or stationary money supply growth
would have meant a significant trend decline in the price level.
Instead, the Federal Reserve (according to the Austrians) held the
market rate of money rates below the neutral rate in order to shore up
the price level. The below neutral level of real rates played a crucial role
in generating the asset price bubbles, which subsequently burst as rates
in the late 1920s (1928–9) rose to neutral level and eventually well
above.
It is too early to tell whether history has been repeating itself in the
early 2000s (2002–6) with the Federal Reserve offsetting the downward
influence of rapid productivity growth and terms of trade improve-
ment (fuelled in part by a heightened pace of globalization) on the US
price level by holding money rates at below neutral level. During the
same period (2002–4) the US dollar fell sharply. Many commentators
suggest that the residential real estate market in consequence entered a
bubble. Then in 2005 the Federal Reserve sought to drive short-term
market rates back up to neutral level, now convinced that inflation
expectations and underlying monetary growth had risen to levels con-
sistent with the optimum path of low and stable inflation (rather than
actual deflation, which had surfaced as a risk in early 2003). The energy
price shock of 2004–5 undoubtedly played a role in overcoming the
perceived danger of inflation falling too low (or of actual deflation
emerging).
Perhaps the red-hot residential real estate market which character-
ized the growth-cycle upturn in the US economy during 2004–5 will
prove to be the latest example of the bubble-and-burst phenome-
non. As rates move to neutral and above a process of asset deflation
could set in. From the viewpoint of a US investor at end-2005,
foreign currency assets were widely touted as the best hedge against
the scenario of real estate market crash. The problem was that the
dollar had already fallen steeply (in 2003–4) (with only a modest
overall recovery – measured in real effective exchange rate terms –
during 2005), and the main alternative international currency, the
euro, could also be influenced by the bursting of hot real estate
markets in Spain, France, Italy and the Netherlands. Moreover many
global investors had concerns that the failure of progress towards
monetary union in Europe would eventually doom the euro. Gold
was sparkling again but was widely seen as in speculative frenzy. The
Swiss franc seemed to be totally drained of any protective strength.
The search of the rational investor for safe haven was not leading in
a clear direction.
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Index
aggregate global gap, 18, 19, 20, 23 Bank for International Settlements,
its clue to grey and black capital Canadian influence in, 152
flows, 49–55 Banking system rarely an important
Alberta tar sands, their influence on conduit (as distinct from
Canadian dollar exchange rate intermediary) for capital flows,
and interest rates, 207–9 131
arithmetic of external debt growth, 123 bank secrecy, defenders and
Asian dollar bloc opponents of, 39–41
electoral considerations in why banknote exports, as form of hidden
Bush Administration launched capital flow, 47, 58–64
attack on, 172 banknote markets, 58–60
Washington assault on, 171 scandal in, 62
why ECB’s Trichet joined in unholy banknotes, 1:1 convertibility
alliance with Washington suspended under negative
against, 176–8 interest rate regime, 115
why Greenspan and Bernanke Bernanke monetary shock, 2003, 109
supported the attack on, 173 impact on currency markets, 170
Asian savings surpluses big neighbour next door
their influence on neutral rate examples of Japan vs. China and
spread between dollars and Germany vs. Eastern Europe,
euros, 71 85–6
their recycling to the US via the influence on trade and capital
euro-area in part, 15 flows, 86–7
Australia, its large savings deficit, 21 black money
Austrian school of economics, its defined, 38–9
diagnosis of asset price inflation methods of detecting flows, 42–4
and causes, 249 role in financing US deficits, 55–6
bond markets, their failure to predict
bad states of the world, for example deflation, 102, 108
natural disaster, war, and how to Brazil, a growing savings surplus in
hedge against, 243–5 the long-run?, 128
balance of payments Bretton Woods
accounting errors in, 3 its breakdown, 150, 153
identities, 3 revived in Asia, 77–8
see also command-type model of bubble aftermath, the fall of neutral
balance of payments interest rates to negative level, 110
adjustment; world balance of bubble economy, in Japan, 103
payments bubble markets, in yen, 107
Balassa effect in US residential real estate market,
reverse Balassa, 80 250
speculation on, 79–81 Burns, Arthur, responsible for the
Swiss franc and Japanese yen as greatest US peacetime inflation,
examples of reverse Balassa, 80 163
256
Index 257
Canada concentration risk, as factor in

exchange rates, 207–10 sustainability of US current
its “French” position in account deficit, 129
international currency corporate sector savings, how to
diplomacy, 152 integrate with household savings
the energy bonanza in Alberta and analysis, 228
its influence on relative prices crash
and of Japan bubble economy, 103
Canadian dollar, as prime of Tokyo equity market, 105
petro-currency, 238 currency diplomacy
capital account data China becomes active in, 152
problem with traditional concepts, definition of three main types of,
16 146
see also currency flow of funds France’s role in, 150, 153–8
analysis its focus on China, 142
capital export restrictions in China, 142 role of UN security council seat in,
capital flight 151
and its use of turntables, 11 use of US trade threats in, 147:
banknotes as vehicle of, 58 trade-offs with other forms of
historical examples, 78 diplomacy, 149, 175
its relevance to neutral rate spreads, see also China-US-France currency
73–5, 78 diplomacy; outlook for
within monetary union, 195 currency diplomacy;
capital outflows, weakened by Tokyo-Washington dialogues
deflation in Japan, 104 on currency policy; US
carry trade currency diplomacy
contraction during global financial currency flow of funds analysis
crisis, 236 advantages of compared to
in yen, 28, 233 capital account analysis,
Cayman Islands, 47 26–7
China problems of, 37
as example of round-tripping in currency flows, how to measure,
global flow of capital, 13 16–17, 26–37
as example of turntable in global currency preference
flow of capital, 14 its influence on interest rate
its currency diplomats skilled, 152 differences between countries,
its emerging savings surplus, 90–1 71–2
China-US-France currency diplomacy, possible influence on neutral rate
174–8 spread between dollars and
Chinese diaspora, as source of capital, euros, 71
14 currency risk, as determinant of
Chinese savings surplus, set to grow savings balance, 7
much larger?, 128, 142
Chinese yuan, external flow of funds De Gaulle, Charles
in, 32 his promoting of France’s voice in
command-type model of balance of currency diplomacy, 153
payments adjustment, use of by his rejection of a trade-off between
euro-negotiators in currency US nuclear help and
diplomacy, 2003–5, 177 renouncing gold, 153
258 Index
deflation energy bonanza

as obstacle to international illustrated for Canada, 207–9
equilibrium, 103 its influence on capital flows inside
in Japan, 103 and outside monetary union,
Delors, Jacques, his view about 207–10
feasibility of Socialism in France equilibrium path for exchange rate,
or Europe, 196 69, 122
demographics, its influence on global equity capital flows
capital flows and relative price analysis of in yen analysis, 230
change, 204–7 as force behind and relation to
descent into deflationary neutral rate spreads, 84–7
disequilibrium, 103 errors and omissions in balance of
direct investment flows payments, 44–9
how related to neutral rate spreads, EU, exchange of information by tax
84–7 authorities, 40–1
into China, 92–3 EU Commission, its false diagnosis of
disequilibrium US current account deficits and
affecting the savings-investment the role of EU in global
balance and its relation to adjustment, 142
balance of payments, 4, 6 Euro
caused by export surplus banknotes popular in grey areas of
outstripping savings surplus, 88 world economy, 59–60
Chinese balance of payments in, 89 external flow of funds in, 33–4
disequilibrium scenarios and euro-area
divergences between market as turntable in flow of funds from
and neutral interest rates, 87–8 Asia to the US, 14–15
why observed savings balances may enters arena of currency diplomacy
be out of line with equilibrium, at Dubai, 171–2
20 problems of measurement, 24
diversification away from the US savings surpluses and deficits
dollar, by Asian investors, 15 diverge largely between
divorce of monetary union, principles member countries, 20
of how this would occur Euro-Group, its participation in
illustrated for European Monetary currency diplomacy, 171
Union, 210–14 Euro-nationalists, 176
Dubai G-7 summit, 112, 148, 174–6 see also Trichet, Claude
see also G-7 diplomacy European Central Bank
its contribution to international
earnings yields, how to use in equity disequilibrium, 2001–4, 157
market valuation, 219 its refusal to focus on German price
East Asian countries, move into level only despite large relative
savings deficit from surplus price level adjustment within
following debt crisis, 23 EMU, 189–91
East European economies, their European Monetary Union, see
aggregate savings deficit, 20 divorce of monetary union;
elasticity pessimism German problem in EMU;
as expressed by Laurence Summers, German savings surplus; national
137 socio-economic choice within
with respect to trade, 135 monetary union; real interest
Index 259
rate spreads within a monetary opposition to German monetary

union; relative price level nationalism, 155
adjustment within monetary response to Nixon shock, 148
union; Rhenish capitalist model why so active in currency
exchange rate trends in real terms, 79 diplomacy, 150, 152–7
relevance to neutral rate spreads Friedman, Milton, his criticism of
and savings surpluses and Federal Reserve policy after First
deficits, 79–80 world war, 247
speculation on, 79–83
see also equilibrium path for G-7 diplomacy, as front for
exchange rate US-Japanese bilateral deals?, 148
exchange restrictions, their influence general equilibrium
in China, 89–90 and interest rate neutrality, 68–70
related to savings balance and
Federal Reserve, its failures in balance of payments, 3
monetary policy during 2000–1, German economic miracle, 1925–8,
108 capital flows during, 78–9
Federal Reserve Bank of New York, its German problem in EMU, 187–93
ECI program for foreign dollar German reparations problem
banknote holdings, 61–2 revisited, 94–6
Financial Action Task Force (FATF), as example of transfer problem, 95
39–40 currency losses made in connection
five wars of globalization, 39 with, 220
floating vs. fixed exchange rates, false analysis of by Keynes, 95
benefits and costs in reparations key issue was inability of private
problem, 98 capital markets to function, 97–8
foreign appetite for US dollar assets, German savings surplus, its bulge in
satiation of, 126–35 2003–5 and issues raised for
foreign exchange intervention European Monetary Union, 187
by Japan 2003–4, 111, 170 Germany
justified by zero rate boundary, 111 impact of its unification boom, 23
foreign exchange reserve its huge savings surplus, 2005–6, 21
accumulation, see sterilized role in currency speculation,
foreign exchange intervention 2004–5, 224
freely floating exchange rates, why Global financial storms, what are the
not possible under deflation safe-havens against these?, 236
conditions, 115–18 see also carry trade
France Gold
a potential alliance with Japan in its failures as a safe-haven
1971 to maintain international investment, 248
monetary the raising of the official price in
blossoming of French currency 1934, 153
diplomacy under Trichet’s Gold standard system, the transfer or
presidency of ECB, 156, 174–6 reparations problem under, 98
its attitude and importance in Greenspan, Alan
currency diplomacy vis-à-vis his brief participation in Clinton
China, 152 Administration’s currency
its vision of a multi-polar world, diplomacy vis-à-vis Japan, 164,
153 169
260 Index
Greenspan, Alan – continued pursuit of by Greenspan Fed, 67

his involvement in Bush why most of time neutrality does
Administration’s currency not hold, 67–70
diplomacy with respect to investment income, missing amounts
China, 163, 173 received into tax havens and
his general distaste for currency offshore centres, 18, 31, 50, 54
diplomacy, 163–4 investment opportunity, changes in
his one-day visit to Beijing in 2005, and influence on capital flows,
164 84–5
his opposition to and undermining
of Louvre Accord on eve of Japan
Wall Street Crash, 163 as big round-trip in global flow of
his view on sustainability of US funds, 25
current account deficit, 126 as small turntable in global flow of
why he favored break-up of Asian funds, 25
dollar bloc, 173 Japan savings surplus
see also Wanniski, Jude below equilibrium level in 2005, 22
grey and black areas of the world, forecasts of as integral part of
on dollar standard?, 131 currency analysis, 229
grey capital, black and grey Japanese yen
distinguished, 38–9 assessment of exchange rate trends
in, 81–3
hidden capital exports, 45–7 flow of funds in, 27–9
hidden capital inflows, 46–7 use of savings-investment analysis
into residential real estate markets, in predicting exchange rate
47 trends, 231
Houthakker-Magee effect and
pessimism on US trade, 137 Keynes, John Maynard
his view that Germans should cut
immigration, its influence on capital back beer consumption, 137:
flows, 206 his losses as currency
indexed government bonds, as speculator, 220
safe-haven against spectre of see also transfer problem
negative real rates, 240 Koizumi government, its excellent
India relations with Bush
a growing savings surplus in the Administration, 111
future?, 128: a big appetite for
dollar assets?, 131 limits to size of US current account
inflation deficit, 122, 132
driven by real scarcity, 240 lost Decade, of Japanese economy, 103
how to hedge against, 240–5 Louvre Accord, 1987, 156
the special case of war-time initially supported by Treasury
inflation, 246–8 Secretary Baker and then
interest rate neutrality undermined by same, 162
2-dimensional definition of, 66–7 Luxembourg
how capital flight affects, 74–6 cooperation with EU on tax, 41
how long-term rates can diverge its defence of bank secrecy, 40
from, 68
partial concept in one country Middle East oil exporters, their
only, 70 savings surplus, 22
Index 261
Mieno, Yasushi oil shock

faulty concept of role of Japan’s analogy with reparations, 100
savings surplus in currency and the transfer problem, 98–103
market equilibrium, 168 its effect on global capital flows,
his contribution to Japan’s 22
deflation, 105 OPEC cartel, and the transfer
miracle economy, savings deficit not problem, 94–5, 99–102
characteristic of, 128 outlook for currency diplomacy,
monetary base policy, why better 178–81
suited than rate-targeting to
international equilibrium, 112–15 passive investment strategy, 215
monetary authorities, as source of defined, 217
disequilibrium in global petro-currencies, speculative
economy, 140 calculation in, 237–8
multi-polar world, France’s and euro Plaza Accord, 146
diplomats’ ambition for, 181 the most over-sold accomplishment
in the history of currency
narcotics trade, its influence on diplomacy, 161
currency flows, 45, 56 population ageing
national socio-economic choice its influence on interest rates and
within monetary union, 193–7 price levels inside and outside
natural interest rate, definition of, 66 monetary union, 204–7
negative interest rate regime, its see also demographics
possible introduction in Japan or pre-retirement generation, their role
elsewhere, 114–15 in bolstering savings rate, 128
negative interest rates, neutral level private bankers, in Switzerland and
negative in Japan, 110 Luxembourg, 31
Netherlands, its experience of productivity growth
adjustment to rising energy as source of deflation, 250
revenues, 210 influence on exchange rate trends,
neutrality, see interest rate neutrality 80–2
Nixon shock, 147–8, 164 see also Austrian school of
non-sustainability of current account economics; Balassa effect
deficits
economic concept of, 125–6 radio-frequency tags, for detecting
failures of Japanese monetary policy black capital flows, 64
and currency diplomacy in real estate market speculation
response to, 165–6 in China, 92
North Korea, nuclear crisis there plays its influence on capital flows, 92
a role in currency diplomacy its influence on capital flows
between Japan, US and China, within monetary union,
149 197–204
Norway, public sector foreign asset real estate, when is it a hedge against
accumulation in, 74 inflation?, 249
real interest rate spreads within a
OECD monetary union, 183
role in promoting exchange of perverse movements possible,
information in tax matters, 184
40–1: its pessimism on US trade regime change as an aim of currency
deficit, 139 diplomacy, 146
262 Index
relative price level adjustment within in case of yen, 210

monetary union, 184 in case of dollar, 208–10
potential barriers to and possible in global capital flows, 2000–4,
overall size, 184–7 106–12
small and large countries Singapore
distinguished, 186 political risk in its financial centre,
residential real estate market price 41
formation, an analysis of, 197–202 public sector foreign asset
Rhenish capitalist model, how the accumulation in, 74
costs are divided in a monetary small advanced Asian economies,
union, 188, 193–5 their external flow of funds, 30
risk premiums, estimation of for smuggling, impact on reported
different asset classes, 218 balance of payments, 45–6, 54
round-trips in the global flow of see also narcotics trade
capital, 11–15 socialism, is it possible within
examples of, 12–13, 25 monetary union?, 196
Rueff, Jacques, his role in French speculation, defined, 215
currency diplomacy under de speculative talent, how to assess, 219
Gaulle, 153 speculators against the dollar
Russia, its huge savings surplus in a basis for calculation, 221–6
2005, 20 how they miscalculated in 2004,
221
safe-haven currencies sources of power behind capital flows,
definition of, 235 66
role of in portfolios, 235–9 Spain, as real estate bubble economy
see also Swiss franc in monetary union, 183
Sakakibara, Eisuke, role in US-Japan spectre of negative real interest rates,
currency diplomacy, 169 239–50
savings deficit countries, where investors can look for
characteristics of, 7 safe-havens against, 239–48
savings surplus countries sterilized foreign exchange
characteristics of, 7 intervention, 74
small countries with huge surpluses disadvantages of, 79
in East Asia and Western fictional use of in Europe of 1960s,
Europe, 20–1 75
savings surpluses and deficits rare successes of, 74–5
currency risk as determinant of, 7 use of in East Asia, 76–8
equilibrium path for, 6 Sterling, external flow of funds, 33
how estimation of is a key Strategic Impediment Talks between
component of speculative Japan and US, 167
currency analysis, 224–6 Summers Laurence, his pessimism
their relationship to balance of about US current account deficits,
payments, 3, 9 137
shipping companies, their unreported sustainability, of huge current
trade and capital transactions, 51 account deficits or surpluses
short circuits Greenspan’s view of, 124
how monetary base policy might problem defined and arithmetic of,
prevent, 112 123
how they interfere with freely see also non-sustainability of
floating currencies, 118–21 current account deficits
Index 263
Swiss Federal Banking Commission, example of, 2003–4, with respect to

action against UBS, 63 Europe between Asia and US, 9
Swiss franc how to measure and identify, 24–6
and reverse Balassa effect, 237 illustrated in Latin American capital
as safe-haven currency, 235–7 flight, 11
assessment of exchange rate trends,
80–3 UK as a centre of round-tripping in
Switzerland global flow of capital, 25
as centre of banknote market, 59–60 UK savings deficit, 20
cooperation with EU on tax, 39–41 UN Security Council
its defence of bank secrecy, 40 currency diplomacy, 151, 175
its huge savings surplus, 236 its action against Iran and related
diplomatic trade-offs between
tax havens and offshore financial Beijing and Washington, 149
centres, 31 lack of a seat there for Germany or
two forms of black capital flow to, Japan has influence on their
55–6 role in
Tokyo equity market Union Bank of Switzerland, forced to
build-up of foreign holdings in withdraw from US dollar
since Crash, 1990, 233 banknote program, 62
illusory currency hedging of, 233 US currency diplomacy
Tokyo-Washington dialogues on in the 1960s, 159
currency policy, 164–71 in the 1970s and 80s, 160–1
trade invoice tampering see also Nixon shock; Plaza Accord
as means of exporting hidden US dollar
capital, 48, 52 final reconciliation of global flow
two types distinguished according with black capital analysis, 55–7
to their impact on recorded foreign holdings of banknotes in,
trade balances, 47, 51–4 60–3
transfer problem global flow of funds in, 35–7
as defined by Machlup, 95 US Internal Revenue Service, pursuit
false analysis of by Keynes, 95 of offshore credit card
general definition of, 95–6 transactions, 52
how US deficits fit in to analysis of, US mega current account deficit
96–7 benchmarks of sustainability, 22
in context of oil shock, 100–3 its origins, 72–3
see also zero rate boundary its financing related to transfer
Trichet, Claude problem?, 95
an old-hand French currency its sustainability, 18
diplomat, 152 growth arithmetic of, 122–5
his blindness to the global see also limits to size of US current
dimension of interest rate account deficit; sustainability
neutrality and his embracing of US trade law, its use in currency
euro nationalism, 157 diplomacy, 147
his position on Chinese currency
issue at G-7 summits, 153, Volcker, Paul
174–5 his active role in US currency
turntables in the global flow of diplomacy, 161–2
capital, 8–11 reasons for supporting Louvre
defined, 8 Accord, 162
264 Index
Wanniski, Jude, his criticism of world balance of payments

Greenspan’s conduct on eve of concept described, 19
Wall Street Crash and in history of, 19
particular his undermining of the
Louvre Accord, 163 zero rate boundary
war, its influence on global capital as barrier to Japan’s international
flows and asset prices, 245–6 equilibrium, 104
Washington as obstacle to solving transfer
its periodic efforts to devalue the problem, 100–3
dollar, 146 as potential barrier to US
its traditional positions and use of equilibrium, 106–7
trade weapons in currency Zurich airport, as one-time hub for
diplomacy, 157–64 global currency trade, 63
withholding tax, in Switzerland,
Luxembourg and Austria as part
of EU agreement, 40

(Brendan Brown) What Drives Global Capital Flows

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(Brendan Brown) What Drives Global Capital Flows

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What Drives Global Capital

List of Tables viii

1.1 World Current Account Balance, 1975–90 4

1.1 Foreign holdings in Japanese equity markets 27

The unprecedented force of capital inﬂows to the USA which built

Arithmetic and geography of net capital ﬂow

account of the balance of payments. (More exactly, the surplus of

Table 1.1 World Current Account Balance, 1975–90

(US$ bn) 1975 1980 1985 1990

* Germany, France, Italy, Spain, Netherlands, Belgium

retained proﬁts less intended capital expenditure including planned

Table 1.2 World Current Account Balance, 1995–2005

(US$ bn) 1995 2000 2005

appears whilst aggregate demand growth continues unabated). Real

reﬂects unanticipated ﬂuctuations in sales volumes or the hitting of

The point here is that in the equating of savings surpluses and

Some illustrations help demonstrate these points.

Table 1.3 Euro-area Capital Account, 2001–5

(€ bn) 2001 2002 2003 2004 2005H1*

Table 1.4 UK Capital Flows, 2002–4

(£ bn) 2002 2003 2004

Third, in the early and mid-1990s, investment opportunity in the

the Asian developing countries to replace Japanese production,

Table 1.5 UK International Investment Position, 1993–2003

(£ bn) 1993 1998 2003

hold more equities in these countries than residents there hold

funds into Japanese equities far exceed outﬂows of Japanese funds

Table 1.6 Yen External Flow of Funds, 2005–6 (¥ 100 bn p.a.)

Inﬂows to Yen Outﬂows from Yen

portfolio and government investment in foreign currency assets

If by contrast Europeans have very small appetite for US assets, (or

All of this data is produced by national statistics ofﬁces. Some con-

porate assets (direct investment) and also foreign countries running up

across the US coastline (in a transaction between resident and non-

Net capital ﬂow – present and past

inﬂuenced by the surge in oil imports). There are some common

deﬁcits match a shortfall of domestic saving below investment –

emergence of mega capital exports and savings surplus matched by

How to identify currency turn-tables and round-trips

direct investment outﬂows to the US). It might well be that much of

How to map currency ﬂows

The currency ﬂow of fund tables are either historic (relating to a

prospective 1-year forward earnings yields being no longer far below

Typically the conventional data on Japanese capital ﬂows show large

balance of payments. Only the Swiss franc amongst the various

Table 1.8 Small Advanced Asian Economies* – External Flow of Funds,

* South Korea, Taiwan, Hong Kong and Singapore

Table 1.9 Non-EU Savings Surplus Countries* – External Flow of Funds,

* Norway, Sweden and Switzerland

current account surplus in 2005–6 is estimated at around $240bn p.a.

Hidden Investment 50 International Money 40

example) we could guesstimate that around $40bn p.a. of the re-

Table 1.12 Sterling Flow of Funds, 2005–6 (US$ bn p.a.)

* includes borrowing in foreign currency by UK residents to ﬁnance £-assets

Finally before we come to the euro and US dollar ﬂow of funds

Table 1.13 Euro Flow of Funds, 2005–6 (€ bn p.a.)

* Includes borrowing in foreign currency by Euro-area residents to ﬁnance €-assets

Table 1.14 US Dollar Flow of Funds, 2005–6 (US$ bn p.a.)

* less US borrowing of foreign currency to ﬁnance acquisition of US dollar assets (ﬁnancial

would include for example a UK real estate company ﬁnancing its UK

of dollar paper issued by non-US residents or dollar deposits in banks

ment outside the US less US resident borrowing of foreign currencies

It is impossible to give a comprehensive picture of international money