Exchange rates and international capital flows have played only a minor role in the saga of the global financial crisis so far. For the United States and the United Kingdom, the essence was an old-fashioned domestic financial crisis. But as the financial sector is restored to health over time, the international aspects will come to the fore. The aftermath will require the adjustment of international imbalances in a world characterized by large differences in the growth rates between the seriously affected countries (Europe, Japan, the United Kingdom, and the United States) and those which dodged the bullet—Asia (including Australia) and Latin America. Adjustment to international imbalances and the carry-trade that will result from a two-speed world will put exchange rates center stage.

All this will play out through a creaky and volatile international exchange rate mechanism, where international private capital flows are frequently destabilizing. If international imbalances are to be shifted to a more sustainable position, a number of countries need to achieve both internal adjustments (involving domestic savings and investment balances) and external (involving exports, imports and the current account). If these internal and external adjustments are not made in lockstep, the outcome will be unacceptable unemployment and distorted exchange rates. Superimposed on this, requiring a further layer of adjustment, are volatile private capital flows.

The woes in the United States illustrate how narrow a path policy makers must tread to achieve a smooth adjustment. The budget deficit needs to be substantially reduced as soon as possible, but not while the economy is lethargic. A weaker exchange rate would boost net exports and help to close the current account deficit, allowing the budget deficit to be wound back. But while this is happening, the current account deficit still needs to be funded, mainly by Chinese capital inflow, and the existing foreign debt needs to be kept bedded down. Thus the exchange rate can’t be so limp as to discourage inflows. A combination of low domestic interest rates and a weak exchange rate will foster carry-trade outflows.

There are different paths of adjustment and multiple equilibria, some of which are better than others. The imbalances could be narrowed through a big rise in the renminbi (RMB) exchange rate (as some advocate), sharply trimming China’s exports and retarding the principal engine of world growth. The better answer is for China to build domestic demand, not just through continued expansionary fiscal policy (which may not be sustainable in the medium term) but also by rejiggering the split between profits and wages and strengthening the social safety net. China’s surplus would shrink through expanded imports, not through contracting international trade.

The free market may clear demand and supply efficiently enough but has no great capacity to differentiate between good, less-good, and bad equilibria. A better approach is international policy coordination. The newly empowered G-20 forums are the obvious mechanisms for this. Discussions there would create the opportunity to cobble together give-and-take policy packages that could include some sweeteners to make China more willing to maintain its US dollar holdings. The G-20 discussions could set the broad parameters and bring some peer pressure to bear, with the details to be hammered out bilaterally.

At the same time, the global financial crisis has forced some countries to take actions that would have seemed infeasible beforehand, including governments acting as market-maker of last resort. If the bumpy path of the pending adjustment process involves excessive exchange rate volatility, countries may be readier than before the global financial crisis to intervene and to examine capital flow controls (Brazil’s 2 percent tax on portfolio inflows is an example of such intervention). This widening of policy options is a step in the right direction.

The G-20 provides a forum, also, for pondering some longer-term problems, including the role of the dollar as reserve currency. There is no obvious alternative in sight (although progressive diversification of holdings seems to make sense). But compared with the task of negotiating the adjustment of international imbalances, the reserve currency issue seems minor. We are not in the situation of the post–WWII world when the growth of international trade was being held back by shortage of international liquidity. The threat to expanding international trade comes not from reserve currencies (unsatisfactory though these may be), but from the political difficulties that will arise from the necessary domestic adjustments. Reserve currency holdings tend to be fairly stable, as central banks try to avoid large disruptive currency shifts. The same cannot be said for the often lemming-like behavior of private capital managers.

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