Exchange Rates under the East Asian Dollar Standard: Living with Conflicted Virtue (review)

Exchange Rates under the East Asian Dollar Standard: Living with Conflicted Virtue is a compilation of several articles on exchange rate policies and related issues in East Asia published by Ronald I. McKinnon (with various co-authors) between 1999 and 2004. The works have been modified and are tied together nicely to fit the major theme of the book; chapters 5 and 8 are brand new. According to the author, the analytical framework of this book differs from McKinnon and Ohno (1997) in three aspects: (1) the new idea that "mutual exchange rate stability is the quintessential public good" (p. 10); (2) a focus on cross-border financial claims rather than trade flows; and (3) an extension of how monetary and exchange rate policies work within a natural trading region to include the key trading currency from outside the region.

The book highlights the financial fragility of East Asian "miracle economies"-China, Hong Kong, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand-and their dependence on the dollar standard. These economies were all formally or informally pegged to the dollar before the financial crisis of 1997-1998-and appear to have returned to dollar pegging since then (although the yen has been given more weight in some currency baskets, as in the cases of Indonesia, Korea, Thailand, and Singapore). McKinnon takes the controversial position that the East Asian dollar pegs are perfectly rational, despite the relative decline of trade between East Asia and the United States, since almost all the intraregional trade and capital flows are invoiced in U.S. dollars. In addition, the dollar is the anchor that provides these economies with mutual exchange rate stability that is regarded as a public good. The dollar standard has given these economies both exchange rate stability and price stability for tradable goods. Thus, in sharp contrast to conventional wisdom, buttressed by the International Monetary Fund's position in favor of greater exchange rate flexibility, McKinnon argues convincingly in support of a fixed exchange rate system, namely a unilateral peg to the U.S. dollar. Adopting the dollar standard, for lack of a better alternative-such as an "Asian Euro" -appears to be the best strategy for the East Asian economies to reduce short-term domestic payments risk. But is that sustainable? Will that policy not lead to another financial crisis? McKinnon addresses these issues in chapter . and throughout the book. The author revisits the Asian crisis and blames it not on the exchange rate policies per se, but rather on the buildup of short-term foreign denominated (mostly dollar) debt over 1994-1996 followed by the "extraneous" sharp devaluation of the yen in 1997-1998.

The impact of large fluctuations in the yen/dollar exchange rate on the East Asian economies is fully investigated in chapter 2. Given Japan's predominant economic role in the region, fluctuations in the yen/dollar exchange rate affect the East Asian economies via trade and foreign direct investment. The rise of intra-Asian trade is closely related to the synchronization of the business cycles. As a result, any yen devaluation is bound to have a strong negative effect on the regional economy, either directly (as in the case of Korea, Taiwan, Hong Kong, and Singapore) or indirectly (as in the case of the core ASEAN countries)-although its impact on China is notably smaller than on other East Asian economies. This effect tends to be exacerbated by a decline is the Japanese economy. Consequently, the author vehemently argues against the wisdom of the yen depreciation (or the U.S. pressure for Japan to depreciate) as a way to stimulate Japan's economy and calls for the indefinite stabilization of the yen/dollar nominal exchange rate.

Japan's economic problems are addressed and carefully examined in chapters 3 and 4. The author regards the appreciation of the yen up to the mid...