Asia Society Hong Kong Center
Spring Gala Dinner
with
Professor Robert A. Mundell
1999 Nobel Laureate in Economics
University Professor of Economics, Columbia University

"Reflections on the International Monetary System"

May 3, 2007

PROFESSOR ROBERT MUNDELL: Well, thank you very much Ronnie for that spectacular, spirited introduction. About ten days ago I was about to leave New York. I had to leave my apartment about 2 o'clock and I turned on the television set because I heard that Hank Paulson was being interviewed on Charlie Rose, so I could catch the first half hour of it. I turned it on and the first question he was asked—he was asked something specific but he said "I want to say something general first", and it was that the world economy is in the best shape it's ever been in as far as he can see, that in his lifetime he doesn't know a period when the world the economy was in a better shape than it is at the present time, and I completely agree with that.

I think this is a remarkable period. It is a period when the five big economies—of course we are concerned about all economies, but the very important economies, the big five, the United States, Europe, Japan, China, and India, all five of those economies are moving together rapidly, at different speeds of course, but in a way that hasn't happened for a long time. For a long time Japan was in the doldrums, stagnation after a period when the Japanese yen had tripled in value against the dollar, a period from 1985 to 1995, devastating, terribly bad for the Japanese economy. So now is a very good period.

And then Paulson got on to talk about his favourite subject which is China. When he was made Secretary of the Treasury it was said that he has been 65 times to China. I have only been 40 times, so I feel he is way ahead in that. But then he started to talk about things in China and he went into the usual American position that the exchange rate with China, yes, it's been moving up a little bit but it's not moving rapidly enough, and he talked about those usual things that we have been hearing for several years. He talked about the problems of the U.S. deficit and the global imbalances they caused.

When people talk about global imbalances, it is really a code word for the U.S. trade deficit, $800 billion, 6 or 7% of U.S. GDP in the last year and the year before. But, isn't it interesting the world economy in the best shape it's ever been in, but the problem of big trade deficits is like a fault line in the economy. You could also add a couple of other things that are bad. At the Singapore meetings of the IMF, the annual meetings of the IMF in Singapore last September, one of the big issues was the fact that IMF is making losses. It is not going broke exactly but it is making losses because its earnings have gone way down. So those seem to be bad things for the economy, and yet both those things, the deficit of the United States and the IMF problem (it's not really a problem but it's a pseudoproblem), are connected together.

First, the IMF problem. When the world is going great in the emerging markets, it doesn't need to borrow money. They don't need to come to the Fund for loans so the IMF doesn't get interest on it, and it is because the world is healthy. You know, when the people are healthy the hospitals go broke, and the IMF is a kind of financial doctor, so that is connected to the good happiness of the world economy.

The other thing is—it's a little more obscure, but the U.S. deficit has a particular role in the world economy. The other countries are healthy in large part because a lot of them have big balance of payment surpluses. Not just China, of course it is much bigger than anyone else, but Russia and many of the other countries too, they are all—many of them are in very good shape, better shape than they have ever been in. But they couldn't have those surpluses without the U.S. deficit. The U.S. deficit is a kind of fuel for the world economy. It supplies liquidity. We are also in a world right now of extraordinary liquidity. Maybe the world has never been quite so liquid as it is at that present time. Good parts and bad parts about it because it may pose some kind of inflationary pressure, but the fact is that movement in the U.S. deficit is what creates that, and it is not just any country having a deficit. A lot of countries can have deficits, but it is the U.S. economy having a deficit that creates that extra fuel that drives the world economy.

Why? Well, because ever since 1915, just after the beginning of World War I, the U.S. became a creditor country and the dollar took over from the pound sterling as the dominant currency, and for the rest of the century, the 20th century, the dollar was the dominant currency, and that is what governed in a sense the world economy. I wouldn't go into a long lecture on how that happened, but you think that on the eve of World War I, the United States was already bigger than the next three biggest economies put together. So it was all ready and waiting to take over from the pound sterling as the dominant currency, and it did when the pound became more or less inconvertible during World War I. And as the century went on then we went through what I call "five dollar standards".

The "first dollar standard" was 1915 to 1924 when the dollar was the only major currency and it had become the unit of account. Then the world went back badly to a kind of gold standard and that broke down in 1931 when Britain left it, and 1933 when the United States floated. But then the "second dollar standard" came about when the United States devalued the dollar, raised the price of gold, and that lasted until 1971. And then inflation, everything, had raised this. The price of gold stayed constant, gold got scarce, the U.S. sold off, had to sell off under the system, more than half the gold stocks they had, and at a certain point in 1971 they took the dollar off gold, and that ended "dollar standard two." Well, then four months later in 1971 they went back to a pure dollar standard, not convertible into gold, and that lasted only a year-and-a-half, "dollar standard three." And the world broke into floating exchange rates in 1973, but it didn't end the dollar standard because the dollar was the still dominant unit of account in the world economy, the principal medium payment, and the main abode of international reserves as it is today. So we had "dollar standard four" which went on from 1973 until 1999, and then the Euro came along. The Euro inaugurated "dollar standard five" and we are in that period now. What made this different—the Euro made it different—was that the Euro changed the power configuration of the international system because after the twilight of the pound in World War I there is nothing that could challenge the dollar until the Euro came into being.

When the Euro came into being, it was instantly—it pushed the Japanese into number three place and became the number two currency in the world. And with an area that is destined to grow—it has 13 members now because Slovenia joined this year. The Euro area will have another seven members within a year or two that will be part of that area, and eventually I could imagine there will be 27 members, and all the members of the European Union will be in within a few years. Maybe Britain will be the exception out of it, maybe. Who knows about Sweden? Denmark, I am sure, is going to be in it. But with the one qualification that we are not sure about Britain, all the members of the European Union are going to be in the Euro area in the coming future. Britain might be an exception because Britain, of course, is the biggest of those countries left out, and Britain has its own historic role. The pound is its own historic role and Britain has associated with it. The British people have vanity connected to that historic role that makes it difficult to recognise the reality that the pound is really now the number five currency in the world because in the last two years it was pushed from fourth position into fifth position by the Chinese RMB, even though the Chinese RMB is inconvertible.

So that's the story of this. But what gets that to the dollar standard? Some of you may be old enough to remember the controversies that went on in the 1960s. In the 1960s, there was a fixed exchange rate system based around the dollar which was supposed to be convertible into gold. And the big problem then was the U.S. balance of payments deficit on the one hand, and the risks if the U.S. solved the balance of payments deficit.

There was a Belgian professor teaching at Yale University, a famous monetary economist Robert Triffin, who gave his name to the "Triffin Dilemma." The dilemma was that if the U.S. solved its balance of payments problem, that it stopped letting countries buy up dollar assets and adding to those dollars assets which is part of the U.S. balance of payments problem... If they solved that problem, the world would go short of liquidity and maybe have a deflation like in 1929. If, on the other hand, if the U.S. didn't stop it, there would be a dollar crisis because the U.S. couldn't convert dollars into gold. So that was the dilemma.

Well, today we are repeating that story. Only it is not the deficit. It is not an issue of converting it into gold and so on. It is the issue of what happens to the United States if they don't solve the balance of payments problem, $800 billion a year for the past two or three years. It's going on now. There is no likelihood that is going to be less than that in the future. So can they run an $800 billion deficit? If they do, is the U.S. going to go bankrupt or broke in some way? That's the risk. On the other hand, if they solve the problem, the world is going to have a hard landing because they won't have that liquidity to go forward and generate with that. So that is what seems to be in a way the case.

Now, I present an argument as if I am a dollar pessimist. I am not a dollar pessimist in this. The U.S. position is not nearly as weak as it appears. The U.S. has an $800 billion deficit, that's 6% of GDP today, but that is a small proportion of the total U.S. capital stock. It is really like 1.5% of the U.S. capital stock, which is a tiny amount. Or look at it another way, every time the U.S. runs deficits, it builds up increased indebtedness. So we look at the U.S. indebtedness today and it is about $3 trillion. Maybe the U.S. has liabilities of $13 trillion and assets abroad of $10 trillion, so it's got $3 trillion deficit. Well, that is 25% of GDP, a little less than that. It is growing, it grows with the deficit, but that 25% of GDP really amounts to only about 6 or 7% of the U.S. capital stock, which doesn't sound nearly as bad, and it can on for a long time because as long as U.S. capital stock is growing at the same rate as foreign liabilities, there is no great cause for alarm.

Now, of course, could that deficit be a challenge to the dollar? Of course it would. But ever since we moved to flexible exchange rates in the 1970 the dollar has gone through a very pronounced dollar cycle: It went way down in the late 1970s; up in the early 1980s, the Reagan expansion; down in the last part of the 1980s and to the early part of the 1990s, 1994; and then strongly up in the late 1990s until 2001, the end of 2001; then the global slowdown; and then down; and then it came up; and then it's down again. So that's the way that cycle has gone, and it is not a long run thing. But the fact is the dollar is weak whenever the U.S. economy is weak. If the U.S. goes into a slow down, the dollar is going to go down. If the U.S. charges ahead with continued expansion, the dollar will stay strong. That's the way the system is going.

Well, what is the kind of—why the deficit of $800 billion, and why is it likely to continue? Well, it is a very simple thing. You can take a very incredibly simple model to think about the deficit. You don't have to talk about the U.S. budget deficit. The U.S. has got a very small budget deficit today. It is about now 1.5% of GDP, vastly less than Japan's, and vastly less than Europe's, and less than most countries, so it is not the budget deficit. The U.S. trade deficit, current account deficit, is demand-driven. It is being driven not by the Americans but by the rest of the world and their demand for dollar assets. Now here is the simplest model I can think of. The students back there will probably think it is not complicated enough, but think of this. Think of liabilities, assets that the rest of the world hold in the United States of $9 trillion. I am going to make it easy round numbers. $9 trillion of assets in the United States, and the GDP of the rest of the world is $45 trillion. So the foreign assets in the United States are 9 divided by 45, which is conveniently 1/5 or .2. So that is the basic logic. Let's suppose that goes on and we continue with that going on. And let's suppose that nominal GDP grows by 10%. Nominal, that means includes the growth plus inflation. It may be a little high but let's suppose it does that. China's of course is growing at 14%, but let's suppose the world grows at 10%. What that means is that if you keep the same ratio of assets that the rest of the world holds in the United States, the rest of the world will add 10% to the amount they have now. They will add 10%, to the $9 trillion that they have now they will add, in other words, $900 billion every year to their assets. That will be their demand for their assets and that is exactly what the U.S. deficit is.

And then the other side is how does the U.S. supply those assets? Well, the U.S. is the country in the world that bar none, can produce future income streams to people because of confidence in the U.S., population growth, and the long-run future of the United States is very, very strong and so they supply these assets. The counterpart of it is that this capital inflow keeps interest rates low and keeps spending high and it finances completely the excess of expenditure over income that is the U.S. deficit. The U.S. is spending more than it is earning by the amount of the U.S. deficit. In other words, it is spending about 6% more than it is producing, and so on.

Now, that sounds bad, but as the U.S. gets bigger and bigger, it can handle that. That is not necessarily a big problem. Still we know that at some point it could be a problem, because what will turn out is that if the rest of the world starts to produce income streams that are better than the American income streams, or if the U.S. income streams that they are producing start to become suspect, then there will be a shift away from that and that will cause the beginnings of a crisis. I don't think that is going to come in the next 2 or 3 or 5 years. I think it more like—we are thinking if it is going to come it is more like 10 or 15 years. It is not a big issue, but it could be and some people think it is a much bigger issue than I do.

So, what could that be? Well, you see every company in the world wants to have dollar assets in their portfolio. The dollar, quite apart from what the U.S. is as a country, because the dollar is the global currency, the unit of account, everybody wants dollar denominated assets or something that they can calculate in relation to those, and they will try to get those. It could be insurance companies. It could be foreign central banks. Right now foreign central banks hold about $5-$6 trillion in foreign exchange reserves. That's the liquidity part of it by foreign central banks alone. China owns a quarter of those and Japan holds somewhat less than a quarter of those. So those are the big players in the system.

Well, now when the U.S. goes on and talks about this, they are not talking about this. We have to at first relate that to the Chinese economy. We have to first take one more little look back in history. What is the history of U.S. deficits and what can you say about them?

All through the 19th century, the U.S. had deficits. They were borrowing to build the railways and expand the country, and then by 1915, they were a big debtor. But in 1915, Europe, Britain, and Japan sold off their assets in the United States and the U.S. became a creditor and a surplus nation. It started to have a big surplus. Before 1915 the U.S. was a debtor nation and it was most of the time a deficit nation, but after 1915 it became a creditor nation and a surplus nation. So it was running a current account surplus, and that surplus ran in almost every year from 1915 until about 1975. For 60 years from 1915 the U.S. had surpluses, $4-5 billion every year, and it meant that the U.S. was building up its creditor position. It reached a peak in 1975 and then it started to turn. We moved to flexible exchange rates and then things started to turn, then the U.S. started to run deficits. So that peak position of the U.S. creditor position in 1975 started to go down and it kept going down, deficits continued. By 1990 it had reached the zero line and the U.S. stopped being a creditor nation and became a debtor nation. But then it continued down and it became more and more a debtor nation, and now, as I said before, it is $3 trillion, maybe a little more than $3 trillion is the level of deficit.

Now, in all that whole sequence of events China had no part whatsoever in. China had nothing connected with that. There was a motion for the U.S. of the whole creditor position and deficit position of the United States all through that, that is its own logic, and it is very explainable in terms of theories of the stages of the balance of payments and the role of the dollar which became more and more important with flexible exchange rates, because with flexible exchange rates people needed more reserves than they did with fixed exchange rates. So people who advocated flexible exchange rates in the 1970s said, "Oh, with flexible exchange rates you don't need any reserves." But it was exactly the opposite. You had everybody who wanted more and more reserves with flexible exchange rates. You've got now vastly more in relation to trade and everything, so the whole theory of that was changed.

Well, we come then to the other aspect of the deficits. If the U.S. has $800 billion in deficit, where are the surpluses? Well, by far the biggest counterparts to the surpluses of the United States in the last three years have been the oil exporting countries, and it has come about because of the rise in oil prices which has increased the surpluses of the oil exporting countries, about $400 or $500 billion in surpluses of all the oil exporting countries combined. By far the most important part of it.

Why don't you hear Mr Paulson and Americans and the IMF talking about appreciating the currencies of the oil exporting countries instead of China's? Well, if they did that they couldn't do it with a straight face because it would be absurd. You don't change balance of payments in connection with oil by changing exchange rates. Nobody would be so ridiculous.

So the other part is, counterparts of the surpluses, is China and Japan, and that is together almost $400 billion for the two of them. Last year for the first time China's surplus was greater than Japan's, but Japan's surplus goes all the way back to the early 1980s. Japan had a surplus in their balance of payments and their current account year-in and year-out from 1980 that was $150 billion during the Reagan period of the 1980s, and it was up and down but it is now still $175 billion. Consistently throughout that period Japan has had that surplus. The United States in the 1980s didn't like it and they said Japan had to appreciate. So in 1985 the U.S. organised the Plaza Accord of the G-5 countries, the five biggest countries out of the SGR powers, to depreciate the dollar, which was a code again for appreciating the Japanese yen. And at the time of the Plaza Accord in 1985 the dollar was 240 yen. Ten years later, in April 1995, the dollar had fallen against the yen to 78, or about 80 yen to use round numbers, 80 yen, so it went from 240 to 80 yen. The yen tripled in value against the U.S. in that ten-year-period. Of course all those tremendous things were happening to the Japanese economy at that time. The oil prices and everything was going on to change it, but the bottom line is that that appreciation almost ruined the Japanese economy. It created the non-performing loans of the banking system and it created stagnation for a long time.

I was in Japan a year ago and I talked to Koizumi about it and he said he was very … the papers were talking about for the first time now we have ended deflation. They've had a long period of deflation. And the last time I was in Japan was in March and it happened to coincide with the point when the papers came out and said that the real estate prices for the first time since 1990 have not gone down. The average real estate prices had been in a steady bear market all the way from 1990 until just March, and then they have started to go up again. So this tremendous effect of the ….

So now nobody is saying—at the G-7 meetings they were talking about for the last several years the Asian countries should appreciate their currencies. But that "Asian countries" now became a code word not for Japan and China, but for China, because nobody was saying that Japan should appreciate its currency after the devastating experience Japan has had with it. And people came to realise Japan's current account surplus was driven by its demography to a large extent. The savings of Japanese for their retirement in that they save and invest abroad and this was a natural way. So the issue turned on China and China is the "Johnny-come-lately" in the surplus category. It is only in the last 3-4 years that China's surplus has become significant and it is now being picked on.

But what happens to China is not going to solve the problem of the United States. It is not going to do anything to help the U.S. deficit. It is not going to have any—it will just mean—Greenspan even said this, if you change the Chinese surplus it is just going to shift it around to some other country. That was his theory. So that is not going to solve the thing.

So what we ended up with is China had this policy, maybe it was a mistake. In 1994 China had a devaluation under IMF auspices. The RMB was—the dollar was raised from 5.5 to 8.7 and then it came down to about 8.3 and 8.28. That was probably a mistake because the next two years combined prices rose about 40%, so it indicated when you devalue too much it creates an inflation spike. By 1997 China had got rid of that spike, but then the Asian crisis came.

The Asian crisis came about largely through the strong appreciation of the dollar and the depreciation of the Japanese yen, because the yen from 1995 to 1998 went from—I gave the figure of 80 yen in April 1995. In 1998 the dollar against the yen was 148, so this tremendous appreciation of the dollar and the tremendous depreciation of the yen, and when the yen depreciates, Japanese FDI, foreign direct investment, which had been the motor for growth into Southeast Asia, just dried up completely. And that was the first thing that stalled the issue, and then combined with their currency fixed to the dollar which was appreciating while the yen was going down, and bearing in mind also the fact that China's currency had undergone a big depreciation before, created the main part of the Asian crisis. But China said when there was a discount on the RMB, it went to about 9.5, then Zhu Rongji, the Prime Minister, came and said there would be no change in the exchange rate of the RMB against the dollar for the foreseeable future. And then immediately FDI came back to China and you got a resumption of growth and it helped stability in Asia, and that was very good. The only thing is that the U.S. economy itself was now going through this Silicon Valley IT revolution and building it on the supply side revolution in the 1980s with the steep tax cuts of the Reagan economy which made the U.S. economy much more efficient. You got the Silicon Valley expansion, the IT revolution, and you got a real appreciation necessary of the U.S. dollar, and what that meant is that when the U.S. dollar has to appreciate in real terms against other currencies, those currencies which are fixed to the dollar have a little bit of deflation. The U.S. price level was going up by 3%, the Chinese currency and the Middle East currencies and the Panamanian currencies, all those currencies tied to the dollar, had a bit of deflation. So you could predict that deflation if you knew about what was happening in the United States and you've got it.

Well, then in 2001 the reverse happened. You got the global slowdown and the dollar went down, and then you got the opposite. All those countries that were tied to the dollar had to have a little bit of inflation, so that eliminated the very mild deflation in China and it moved the inflation rate up in 2004 to almost 4%. Not high, but it was still higher than what it had been. And then after that that was the end of it, and then it came down and ever since it has been well down below that, and that's where we are now.

The important thing for China's economy is the exchange rate is vitally important. The exchange rate fix is very important for two or three different reasons. First of all, with that fixed they don't have to worry. As long as the exchange rate is fixed you don't have to worry about the inflation rate because the inflation rate is going to be essentially the inflation rate of the anchor currency, which is the United States. There might be temporary productivity factors that offset that a little bit but by and large that is what gives us the inflation rate. That determines the inflation rate. So that's the basic policy that China should follow.

Now, people say, "Well, why not target the price level? Why not stabilise the price level in China and let the exchange rate fluctuate, do inflation targeting?" Well, the issue is—after all China's monetary law which first came out in 1985. I was spending a few months at that time and I studied it and we had a conference at the People's Bank of China talking about this. The monetary law required monetary stability. The RMB should be stable. But how do you define monetary stability? It could be stability in terms of foreign currencies. It could be stability in terms of a price level basket. Well, let's say you take a basket of price levels. You want to stabilise it in terms of a basket of commodities. Well, which basket? You could take China's basket which today is 5% of the world economy, or you could stabilise it in terms of a much wider basket, the dollar basket if the dollar is stable, which is 30% of the world economy. So is it better to keep the RMB stable in terms of 5% of the world economy or 30% of the world economy? And the argument for China is that it is better for China to keep it stable in terms of 30% of the world economy, and you don't then have the same problems of dealing with whether you want to look at asset prices or other different anecdotal parts of the thing. So the wide basket is better. It would be better if we had the Bretton Woods system again and it would be the whole world economy, and then every country keeps its currency stable in terms of the world basket. That is a better thing.

Well, what policy for China now? Well, let me make one more argument as to why it is very important for China to have a stable dollar/RMB exchange rate. It is that China's economy is still dominated to a large extent by state-owned enterprises. It is very hard to know what costs are in state-owned enterprises. Do you know what happens when someone comes up and tries to charge China or a country like China with dumping? Dumping means selling below costs, but how do you find out what costs are in China? Well, I think there was a case where they looked at costs in India and they used prices in India or costs in India to measure costs in China because there is no way of looking at costs in China in the dumping case. This is illegal and there are several examples of this which have gone through the courts talking about this example. So what the advantage is that if China fixes its currency to the dollar it imports the scarcity relationships in the United States, the costs relationships in the United States, and that gives China a much more efficient economy because it is utilising the biggest economy and the most efficient economy in the world and importing those scarcity relationships. So this is a plus for keeping it stable.

Whereas if China did what say the European Union does, the European Monetary Union does, the ECB, they do inflation targeting, and they have been very successful at inflation targeting. They have kept the inflation rate in terms of the big European basket about 2% and without too much variation, but they have done it with huge swings in the dollar/Euro exchange rate. If China did this it would undermine the role of the RMB and create devastating problems in the interior parts of China because you cannot treat the Chinese economy as a unitary economy. It is at least a dual economy. It's the coastal regions and then the interior regions and they obey different laws. And whatever happens if you apply a policy that works for the costal regions, and that's where the models that people use in saying that China should have a big appreciation and can afford to. People were saying before China should let the dollar go down to 5 RMB and so on. It's ridiculous because it would create devastating deflation in the interior regions because the opposite is the relationships that exist there.

So, anyway, China does have to do something though because China has a balance of payments disequilibrium. China has had almost a $200 billion surplus in the balance of payments for the past four or five years. So the rest of the world has an argument against China, and they are using the argument to try to force China into appreciation. Appreciation is the worse thing that you could have to the Chinese economy. All kinds of terrible things would happen, not just things like the non-performing loans, of aggravating those things, and deflation of the rural sectors, the cutting back of exports, the increase in unemployment, all those things that associated with appreciation of the currency. Just remember what happened to Japan, those are the things.

What China has to do is bring its balance of payments into equilibrium at close to the current exchange rate and phase out the problem, I think, of appreciation. It has got to do this because once you change—you had a fixed rate and there was an argument for keeping that fixed rate. I believe that China should have kept that fixed rate back then, but China changed that policy in June 2005, and you can't now go back again because you no longer have that tradition of a fixed rate for ten years to say you are not manipulating things this time, so you have to make a new policy, and the way to is you have to move to a new equilibrium but do it with credibility. I think the way to do it is by bringing the balance of payments into equilibrium.

Don't think for a moment that—don't believe for a moment the argument that a flexible exchange rate is a free market idea. It is not a free market idea. It is a mistaken analogy from commodity markets where you have costs of production are related to prices, but money is a different thing from that. Money is a central bank monopoly, a government monopoly, and the idea of a free market between two or more government monopolies is a ridiculous idea. And the idea that you should say you should move towards changing the exchange rate rather than eliminating foreign exchange controls or reducing foreign exchange controls is a very anti-liberal idea. You shouldn't move in that direction.

Now, the last point I want to make is the point about the famous impossible trinity, and we are not talking about the Father, the Son, and the Holy Ghost. We are talking about the fact that somebody said you can't have more than two of the following three things. You can't have more than two of these three things: One is free capital movement; second is an independent monetary policy; and the third is a fixed exchange rate. You can't have more than two of those three things.

Well, this is created—it sounds plausible. Some people even attributed it to me. I don't know who said it first. Milton Friedman wrote an article about it and he attributed it to Keynes, but Keynes never said it. Keynes never said it, so it's still a mystery. But it is wrong. It is a basic mistake because the fact is it has nothing to do with capital movements. You cannot have a fixed exchange rate over the long run and an independent monetary policy. You can only have a fixed exchange rate if you have a passive monetary policy that will guarantee that that exchange rate is an equilibrium exchange rate. Now, capital movements, if there are no capital movements in the system, it's irrelevant. Capital flows don't make a difference. But it's had a pernicious effect in China in the interpretation because what people have said in China, "Oh, well we can have that. We can do this. We have a fixed exchange (let's say almost fixed, it's not really fixed). We have a fixed exchange rate and we have an independent monetary policy. Those are the two things we can have because we have controlled capital movements." People in China sometimes think that because they control capital movements they can have an independent monetary policy and a fixed exchange rate. So it is a very pernicious idea. That's what the problem is and that is what needs to be corrected, and I hope that it will be corrected in the coming months.

Thank you.

QUESTIONER: There has been a lot of… we keep reading about a Chinese Temasek being formed. In view of the problems that Temasek Little Singapore has had in Thailand, what do you think of a Chinese Temasek and would it be politically radioactive?

PROFESSOR ROBERT MUNDELL: What's that?

MODERATOR: Temasek, it's a Singapore government company that controls a lot of business in Singapore. So I suppose this professor's question is what do you think about China forming a single company that controls a lot of the major industries in the country?

QUESTIONER: Yes, in the country and around the world. How is this going to work if Singapore has had so many problems in Thailand?

PROFESSOR ROBERT MUNDELL: I think this would create major difficulties with other countries around the world because you have mores let's say worked out between the United States and Europe and China about companies and their relations to governments. You are not allowed—airlines, for instance, or airplane producers Boeing or Airbus aren't allowed to have subsidies hidden or otherwise from governments. This is sort of treated as illegal and it's a conventional wisdom. Now, if you have a kind of monopoly produced by, well, a big fund that started to do something, I think this would create, especially if it is a government fund, this would create major problems. You know, in the post war period, after 1945, one of the big issues was how do you deal with relations—this largely concerned the Soviet Union and the rest of the world—with state-trading companies and how do you treat them, how do you arrange trade with them. You can't apply the same laws that you apply to private trading companies and yet you obviously create a monopolistic force that is not fair to the other countries. So I think you would end up with the creation of these, especially if it was a big country, that would create opposition and retaliation and eventually there would be some way of dealing with it.

QUESTIONER: Michael Kurtz with Bear Sterns. Professor Mundell, I hope you will indulge me in a two-part question. The first is, if we can return for a moment to your assertion that China should stop sterilising its reserve accumulation, aren't you concerned that if you ceased sterilisation there would be an expansion, a much more rapid expansion of bank credit in China than what we have already seen, and given the inefficiencies in the banking system, that could result in an explosion of bad assets in the financial system? The second part concerns inflation in China, and that is—of course China is still burdened by a number of controlled prices—it's a very straight forward question, what do you think CPI inflation would be in China were it not for a number of controlled prices like municipal utilities, gasoline, and so on? Thanks.

PROFESSOR ROBERT MUNDELL: Yes, I don't—I wouldn't know the answer to the second question. It's easy to answer that question because I just don't know what it would be if you decontrolled prices. Maybe if controls currently are important and you decontrol them prices would go up. So what you might be saying is that there is implicit inflation or hidden inflation in China that has been so far repressed, and by eliminating this you would move in this direction of un-repressing it and so prices would go up. China had that experience of course. In 1985 they decontrolled prices and prices went way up, but it wasn't clear if they went up largely because of that decontrol or through the expansionary monetary policy that was involved. Whatever is the case, we know that clamping on them after that led to the tightness and the restrictions and the big drop in growth that occurred in 1989 and 1990, the Tiananmen Square years that were very dangerous for China.

Now, about the sterilisation. You know, you have a history of countries that have not done, have not sterilised. You look at the actions of the countries that are in the position now most similar to China's. Japan in the period of their hey day of economic growth, the sudden economic rise from 1955 to 1971, and Germany over more-or-less the same period, and those countries were doing just what China is doing now. They were fixing the exchange rate and they were using those surpluses that came from those economies that they had, those balance of payment surpluses, to provide for the expansion of domestic money. And there is not—of course it wasn't a perfect level of prices, there was some degree of inflation and so on, but those countries roared ahead at those super growth rates and didn't experience a problem with that, and they did not sterilise the economies. That was the way—they didn't have the tools really to sterilise the economy. Those post-war economies didn't have the bonds to sell and so they didn't sterilise and that worked very, very well, superbly well, for those two economies.

Now in China you have a tremendous demand for money in China. The demand for money comes first because nominal GDP is rising maybe 13 or 14%. Real GDP is 10 or 11% and some inflation, 14%, so you have a 14% demand for money just on those grounds alone. And then you've got still some elements of further monetisation in the economy. I don't know how large that is, probably not so large now, but you have a big element due to the expectation of the appreciation of the RMB. So everybody who holds RMB now can start to think if the trend of the RMB continues to go upwards 5% that they are getting a yield on their cash, which is the most liquid thing that you could have, like a bond. You are getting a yield on the bond that is like what you get in the United States, so this creates a tremendous excess demand for money. And the symptom of that excess demand for money is the surplus. It is the balance of payment surplus.

You know, in balance of payments accounting we used to think of three approaches to the balance of payments, but actually there are 16 counterparts to the balance of payments, the way they fit together in a general equilibrium system, and when you look at that one of those important approaches is the monetary approach which looks at the balance of payments as the excess demand for money, and it has to be equal to that, and that is why the elimination of the sterilisation operations is not in my opinion going to be inflationary.

QUESTIONER: Okay. Professor Mundell, you mentioned earlier that the United States deficit is a problem but it won't become a serious trouble in the next 5 to 10 years. Can you elaborate on that?

PROFESSOR ROBERT MUNDELL: Well, the way I look at it, if we look ahead at the U.S. economy continuing with the great enormous success of that economy since 1982, a period over almost more than 25 years, only two recessions. That is unique in American history. Now, we are going to have some recessions, but if this continued growth and continued increasing productivity that is going on, all these big innovations of the 1990s, the IT revolutions and so on, are so with it they are going be expanding and there is a whole flood of new innovations coming about with that productivity growth. The U.S. economy, I see it as continuing to grow and grow strongly over that period, and not just per capita GDP but also gross GDP because the U.S. is one of the economies with a strong high population growth. Apart from a cyclical downturn that is going to happen, I don't think that there is any reason for any big dislocation that is going to cause a major collapse. You know, you don't have a big downturn unless there is a distortion that has to be corrected. You had a distortion in the 2001 recession which was the overshooting of the IT investments, and you had a distortion in the 1991 recession where you had, because of the computer, you had one or two if not three whole tiers of middle management that could be displaced by the new technologies, so you had that and that took some adjustment. Apart from those adjustments that are going to cause it, I don't see any reason why the U.S. economy can't continue to grow strongly.

QUESTIONER: Professor Mundell, I was going to ask you a very intellectual question but the best ones have already been asked, so I will just ask you a short question. What is the U.S. dollar versus Euro going to be, the U.S. dollar versus yen, and commodity prices over the next two years?

PROFESSOR ROBERT MUNDELL: So it's the dollar?

MODERATOR: Euro, dollar, yen, and then commodity prices.

PROFESSOR ROBERT MUNDELL: I wouldn't be able to say anything about the others, I can guess at those others. I would say that the dollar/Euro rate is going to be between 130 and 140, and I don't think it is going to shoot up above the 140 level. I think this will create so much tension in Europe if that occurs. You have Mr Sarkozy who thinks that the European Central Bank should have an exchange objective. I believe that too. I've said—I've told Mr Trichet this. I've said before that I thought the European Central Bank should put a ceiling on the Euro at $1.30, just as I thought they should put a floor on the Euro at 90 cents back in the year 2000. Of course it didn't happen and it's not the way people are thinking of going, but it's politically sensitive—the exchange rate on the dollar/Euro rate—and that is going to be the thing that keeps it up.

About the yen, my guess is that the shift from deflation, mild deflation, to stability, if not even mild inflation, it's not going to move to inflation, but that involves a definite adjustment, and I think it means the shift is going to mean that the yen is going to stay in the territory 115 to 120.

MODERATOR: Commodity prices?

PROFESSOR ROBERT MUNDELL: Well, where do we start now? The price of gold, we could guess at that? What is the price of gold today, 687 or something?

MODERATOR: What is it? Come on, there must be a lot of bankers here?

PROFESSOR ROBERT MUNDELL: What is the price of gold today?

MODERATOR: Ah, come on, Alan, roughly? 670? Okay, fine.

PROFESSOR ROBERT MUNDELL: What?

MODERATOR: You're right.

PROFESSOR ROBERT MUNDELL: Yeah. Well, I think the price of gold is going to be between 600 and 700.

QUESTIONER: Professor Mundell, it's a quick two-part question. First one, do you think in the near future it is possible for Asia to adopt a common currency with all its political problems, and if it does how do you think it will affect the mutual business relationship between China and America? Yes, thanks.

PROFESSOR ROBERT MUNDELL: A common currency, it depends upon what you mean by it, but if you mean a single currency like Europe then I think it is impossible in Asia to have that in the next 20 years because countries to have a single currency, big economies, world powers like Japan and China have to give up their own currency, and I don't think there is any possibility of either Japan or China giving up their national currency. So if you have—the idea of a stable monetary area in Asia is very important and I think it is—I would applaud it very much, but it would have to be not a single currency area but a multiple currency monetary union. You could have a fixed exchange rate zone. It could be a very high—it could even a kind of currency board system operation. But I think it can't be initially—it can't start initially by using either the Japanese yen or the Chinese yuan as the anchor, and it wouldn't work to have a basket of those two currencies. I've seen all kinds of plans. We were talking about these in Korea just yesterday, about different alternative types of things, and I don't think any of them would work at the beginning. If you have a currency, if you have a common monetary area, a common zone of stable exchange rates you always have to have it fixed initially to the dollar and you just see how close it would be if when China had a fixed rate and then if Japan just decided to fix the yen dollar rate at 120 while the Chinese currency was fixed at 8.28, then you would automatically have the two big areas and I think it would just be a matter of time before Korea and Indonesia and other countries would want to join in to that big area, and that would start off, that would use an external anchor, not an internal anchor, the U.S. dollar, and that would work very, very well as long as the dollar is not unstable, but I think we don't need to worry about the dollar being unstable. The dollar has got all the attributes in the long run for being and remaining stable. And Americans keep learning things too. They see the mistakes from the past and sometimes correct them in the process. But this would be a very good step to work toward. Now, what you have though in the discussions going on with the ADB and others, you have talk about the monetary single money and gradually getting to a common money, a single currency, and I think they are doing that because they don't want to talk about a fixed exchange rate zone because it is unfashionable. But the whole purpose of the IMF was to develop a fixed exchange rate area. The IMF was the organisation that would back a fixed exchange rate area in the world and administer it, effectively administer the dollar area. As somebody said, as Joan Robinson said prophetically in 1945. Joan Robinson is the best, maybe the best economist who never won but should have won a Nobel prize, but she was a woman of course. She said that the IMF is an episode in the history of the dollar. She said that in 1945, so it was absolutely correct. It was a way of managing a dollar standard, because the problem in 1945 was how do you arrange a global monetary system when one country is so much bigger than all the others, particularly when the other countries after World War II were way down. How do you manage that system? And that was a way of including the world into a global system that was a de facto dollar standard then.

QUESTIONER: Hi, Professor Mundell, how are you? My name is Christian Toeno. Thank you very much for your speech today. You said that the U.S. deficit was caused by excessive overseas demand of U.S. assets which increased capital inflow into the States, depressed interest rates, and led to a consumption demand. But could you identify, or is it right to say that actually the root cause of the deficit is the excessive consumption habit of U.S. citizens, which gives excess profits to U.S. trading partners which choose U.S. as an investment destination because of the political stability and also a strong consumption-led economy? Which is the horse and which is the cart? Please.

PROFESSOR ROBERT MUNDELL: Yes. I don't think that that is really true. I don't think it is. That's a way you can blame the Americans because they have an excess of—they are spending more than their income collectively. You could do that, but what would you do about the Americans in the 1960s when they were spending less than their income? They had a surplus over that period but the U.S. still had the deficit. You see that's the characteristic, the common thread throughout this has been the accumulation of dollar assets. And even though in the 1960s the U.S. had a trade surplus they still had a balance of payments deficit because the rest of the world then needed dollar assets. Now, I don't think it—I think the fact is it is a little bit like this question: If you need money and you go to the bank and the bank lends you money then you are going into debt and you are going to spend more than you earn by the amount you are borrowing. That is the bank financing your lending. That initiative comes from you because you are asking the bank to lend. But let's suppose that you've got the U.S. as a supermarket of financial assets and anybody around the world can come and buy those financial assets, whatever is the case, whenever they buy financial assets, on balance more Americans are buying abroad there has to be a deficit in the United States. This is an accounting necessity, they have to be, so the Americans are forced to do this.

Now, look at the way this is governed. What happened in 19 …, we had the debt crisis in 1982. Mexico defaulted on its debt in 1982 for first time. There was never a big global debt default under the stable previous monetary systems we had, but under flexible rates we had a debt default. Countries like Brazil had deficits. They were borrowing, importing capital, they were borrowing and spending and developing. What happened when the debt crisis came? Nobody would lend to Brazil and Mexico and those countries. They all ran big surpluses, not because they wanted to but they were forced to because nobody would lend to them. The U.S. has deficits because other countries lend to them or they buy and invest in them, those assets, and that imposes this situation on the United States.

Of course there are always two sides to it. I make it appear as if it's all driven by demand, but both demand and supply are in it. You have an equilibrium that comes. There is the demand for dollar assets and there is this supply of dollar assets, and the price works out so that there will be exactly that equilibrium at the rate of the capital imports into the United States.

QUESTIONER: I just have a question about the sterilisation again. You have only two possibilities if you don't sterilise, prices go up or economic growth goes up. Both are taboo in China. You can't have faster growth and you can't have higher inflation. So how do you sell this to the Chinese government if both outcomes are undesirables, and would you rather change interest rates if the excess demand for money is too high?

PROFESSOR ROBERT MUNDELL: Well, you start off with a fallacy, so I have to start off by correcting the fallacy. You say there are only two possibilities and one of them is that prices go up, but the fact is that prices don't have to go up. Let's suppose that I am running a surplus. Because I am doing something I have a surplus and excess demand for money, or let's say there's an excess demand for the products of any country and they get a surplus and the Central Bank has to buy up foreign exchange. It doesn't mean that prices have to rise. It may just mean that they increase output or they supply those products. It may be that prices are all determined in the global world. If you take a small country and a big country, all the price levels and the fixed exchange rate, all the prices are determined in the big country, and you have a surplus in a little country maybe like Bermuda, or the Bahamas, or some tiny place like that, you don't get adjustment through price changes, you get adjustment typically through increased spending. That's the adjustment mechanism. And if I have an excess supply of money it doesn't mean that my prices rise, it just means I spend it. You get rid of money by spending by more, and you acquire money by spending less.

QUESTIONER: Robert, just a question in the long term, unlike all the short-term speculators in the room here tonight. The pound, 2015 the U.S. dollar, what next? So is it 2050, and is it Japan, China and Korea trading on a fixed exchange rate or a common currency, and is that the new paradigm of the world economy? Maybe it's 2040, 2050, but where do you see the future and what next after the U.S. dollar?

PROFESSOR ROBERT MUNDELL: I'm sorry. I missed something you were saying at the beginning. Just tell me again.

QUESTIONER: So, the pound, then the U.S. dollar, and then what next?

QUESTIONER: As a world currency?

PROFESSOR ROBERT MUNDELL: What do you mean, the pound and the dollar?

QUESTIONER: So you gave us a history of the pound until 2015, and then the U.S. dollar operating in surplus thereafter, and the U.S. dollar dominating.

PROFESSOR ROBERT MUNDELL: Right.

QUESTIONER: What next? Is it Japan, China, and Korea as a dominant unified economy which will dominate currencies and take a leading position in front of the U.S. dollar by either 2040 or 2050?

PROFESSOR ROBERT MUNDELL: Um huh. Well, this is a very good question. It's like—put it a different way, how long will the dollar era last?

QUESTIONER: Yes, right.

PROFESSOR ROBERT MUNDELL: We are in the dollar era.

QUESTIONER: Thank you. Thank you.

PROFESSOR ROBERT MUNDELL: How long will the dollar era last? Yes. And that's a great question.

QUESTIONER: Thank you. And I know it won't be the Australian dollar.

PROFESSOR ROBERT MUNDELL: You see the pound was a global currency in a different way than the dollar was. The pound was largely of course the role of the City of London and sterling bill that was widely used in this, and the pound had great prestige and the Bank of England was the price leader because it was the information centre of the world and it made the moves before other countries made the move, but it wasn't dominant—it wasn't much bigger than Germany and it was smaller than the United States after say 1890, but it still was the leader in a sense. But the United States is something unlike anything that has ever existed before. We have never had in the world economy—not even the world of Genghis Khan had a position like the U.S. where there is so much power, and economic power as well, concentrated in one country, and now it is also a period of innovative power and it is a resurgent economy. Now, of course at some point the law of nations is that nations decline, and you've had a lot of British historians who have been—there is sort of a school of British historians that are declinists and they have been talking about on every downturn whenever the U.S. looks bad then they talk about the decline of the United States. You had that about 40 years ago, and you had it with Paul Kennedy in the 1980s, the declinists, and that became a word and so on. It's not that the dollar—there is so many wrong things about the United States that you are puzzled why it keeps going, but it's because when you compare it to other countries they are even worse or they have other defects. I mean you could say Europe could take over as the successor to the dollar, but Europe has moved to unity as a kind of grasp to hold it together to prevent it from going down, to stop it on its way down. Europe has been on the way down, the decline of the West so to speak, and the demography is showing that in a big way. So it doesn't look as if Europe can possibly be there. And remember, it's something I wrote anyway, that every great currency has to have a strong government. It has to have a strong country. All the great currencies in history have been backed by a strong central state. Now Europe doesn't have a strong central state but the Euro can still survive as long as NATO stays there, because as long as NATO exists then the military security of Europe is assured because NATO is there, that's the thing. But there again, it depends upon the United States, so it is a dependent economy in part even if Europeans don't like to think on those terms. To an extent the long run future of the Euro depends very much on the United States. It's a little bit like—you asked the question in the 1960s, or 1970s, or 1980s, the strongest economy in Europe was Germany by far, but why was there never any 30-year bond in Germany? And it was clearly because they were too close to the Iron Curtain, the risk of, you know, too long you can't think. So you have to think in terms of military security and economic security.

It's a romantic and nice idea to think well the next big country on the line up is China, but China is a long way behind in order to take over the reigns of global power. It's got a long way to go and per capita income is 20 times lower than the United States and Japan. It's got a long way of catching up, but its got, of course, great power. So what I am really saying is that I think the dollar era is going to last a long time. I think we are talking maybe if it is going to decline it's maybe, barring some action that we are not predicting of course, another 100 years.