results.1.2.3 A Multi-Polar rather than a Bi-Polar Investment WorldThe results we have looked at so far with regard to this model assume a bi-polar world ofmoney/cash or interest-bearing securities. Suppose however that our investment world is muchmore complex than that, involving equities, fixed income securities, money market funds andmoney/cash. As a central bank cuts interest rates, the effect of this should be spread acrossthese asset classes, which in turn react in different ways. If a central bank cuts interest rates, thisshould cause the investor to cut their portfolio weighting in money market funds and increase itin equities. In the short term, it should also cause an increase in the weighting for fixed incomesecurities as the capital gain should offset the lost income. Eventually, however, we shouldassume that it causes a reduction in the weighting for fixed income securities. Finally, a ratecut should also lead to an increase in the weighting of money/cash. The reduction in moneymarket funds and fixed income securities should logically equal the sum of the increase inweighting in equities and money/cash. Since money/cash has to share its gains with equities,one should assume that the effect on money demand and therefore prices is reduced. Pricesshould rise less than they would otherwise do without the influence of equities. Consequently,as prices rise by less, the exchange rate should also depreciate by less than one would otherwiseexpect. In the same way, an interest rate increase should in this multi-polar investment worldlead to less of an exchange rate appreciation than would be expected in a bi-polar investmentworld.1.2.4 Two Legs but not ThreeThe final word on the Monetary Approach and the exchange rate impact from policy combinations concerns the idea from the Mundell–Fleming model that a central bank can in a world
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of high capital mobility target the exchange rate or the interest rate but not both. Another wayof expressing this is that you can have two of the following but not all three:
r A fixed exchange rate regimer Monetary policy independencer High capital mobilityThe first assumes the targeting of the exchange rate, while the second assumes the targeting ofinflation and interest rates. The discovery of this rule was the stuff of brilliance, the monetaryequivalent of the discovery of penicillin, yet history is littered with examples of policymakerswho ignored it to their cost. While the example of Asia and the subsequent Asian currencycrisis may spring to mind, there are also examples within the developed world, notably thatof the ERM crises of 1992–1993. Here, there was indeed a commitment to a type of fixedexchange rate regime under conditions of high capital mobility. At the same time however,ERM members were allowed monetary independence. In practice, some, notably the Beneluxcountries, appeared to all but abandon monetary independence in favour of adopting the harshbenchmark of Bundesbank monetary policy. Others, such as the UK, Italy and Spain, sought agreater degree of monetary independence. Is it any coincidence that these were either forced outof the ERM altogether or forced to devalue within it? While the argument is frequently madethat the UK pound sterling went into the ERM at an overvalued level to the Deutschmark, acontrary argument could be made that sterling would have been forced out of the ERM no matterwhat its entry level because the UK authorities refused to relinquish monetary independenceto the Bundesbank.1.2.5 Implications for New EU Member StatesThis simple rule of being able to maintain two policy focuses but not three has potentiallyimportant implications for the newer EU member states and future Euro accession candidatessuch as Poland, Hungary, the Czech Republic and Slovakia, particularly during their transitionphase between membership of the EU and entry into the Euro. Prior to joining the Euro, itwas commonly assumed that Euro accession candidates would be part of an “ERM II” grid,featuring a narrow exchange rate band, whose limits are defended by the commitment of thecentral bank to intervene.Were a country to do this, it would have to renounce its monetary independence at the sametime. If it did not do that, it would either have to put limits on capital, which would be againstboth the spirit and the letter of the Maastricht and Nice Treaties or eventually be forced torelinquish its exchange rate peg and band. The only way to avoid this would be for ERM II tohave very wide bands. To date, the newer EU member states and Euro accession candidatessuch as Poland, the Czech Republic and Hungary have maintained free-floating exchangerates, while focusing – to varying extents – on achieving “real” economic convergence throughmonetary and fiscal policies. However, one of the stipulations of the Maastricht Criteria is that aEuro candidate must achieve exchange rate stability for at least two years prior to considerationfor accession to the Euro. Normally, this has been understood to mean being kept within tight+/−2.25% bands in an ERM II format. It remains to be seen whether this will be the case, orindeed whether some of these countries will achieve the requisite real economic convergenceto join the Euro any time soon! Either way, the markets of many of these countries are in for awild ride!
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1.3 THE INTEREST RATE APPROACHA further approach to trying to determine or predict exchange rates is that involving the analysisof interest rate differentials (the Interest Rate Approach). This involves a number of differentprinciples and we shall go through them briefly and in turn. The first principle involves thebasic interest rate parity theory, which is that:An exchange rate’s forward % premium/discount = its interest rate differentialThus, for instance, the traditional forward discount on the dollar–yen exchange rate shouldequal the interest rate differential between the two currencies. This is seen as the equilibriumreflecting the relationship between the exchange rate and interest rates. Because forwards are atraded instrument and thus subject to supply and demand, the forward premium or discount canvary briefly from this equilibrium, but should always revert to norm. After all, if for argument’ssake the forward premium/discount for some reason did not equal the interest rate differentialbetween the two currencies an arbitrageur could in theory make risk-free profits by borrowingin one currency, investing in the securities of the other currency and simultaneously openinga forward contract in the exchange rate for the same period as the initial loan. This is calledcovered interest rate arbitrage.The theory of interest rate parity is a guiding principle for several economic and financialmodels. Under this theory, it is assumed that the expected (interest rate) returns of a currencyshould be equalized through speculation in another country once converted back to the firstcurrency. This may sound like gibberish, but basically this is an interest rate version of PPP –and like PPP its results are decidedly mixed. Indeed, there can be significant violations of theinterest rate parity theory for substantial periods of time without the immediate reversal thatcovered interest rate arbitrage might suggest. Not too surprisingly, this is a dismal predictor ofexchange rates.Indeed, before we go further into the theory, it is important to point out a practical flawin the theory involving incentive, which is undoubtedly a key contributing factor to its poorpredictive track record – the theory supposes an automatically causal relationship betweeninterest rates and the exchange rate, yet in practice most currency market practitioners tradecurrencies with directional rather than interest rate considerations in mind. Even this statementis a generalization. On a simple numerical basis, the majority of currency market practitionersare made up of interbank dealers, thus it is important and necessary to look at their motivationfor trading. Spot traders for the most part care not one whit about a currency’s interest rate, inpart because they hold positions for too short a time for it to matter, in part because they areseeking to predict direction – and thus make capital gains on their position, not primarily tomake interest income. Forward traders are a different breed entirely and more akin to moneymarket or interest rate traders. Indeed, the way they hedge out their forward exposure frequentlyinvolves an array of interest rate-related instruments. Eventually, interest rate parity violationswill be reversed, but there is little incentive to do so in the immediate term if you don’t careabout the interest rate in the first place.Returning to the theory for now, interest rate parity theory states that the difference betweena spot and forward exchange rate expressed as a percentage should equal the interest ratedifferential between the two currencies. Yet, we know from the PPP principle that exchangerates and inflation rates are linked. Can we not link these also with interest rates? Indeed wecan, thanks to the seminal work of the economist Irving Fisher. Thus, according to what has
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become known as the “Fisher effect:”The difference in interest rates = the difference in expected inflation ratesThus, we have gone from the difference between the spot and the forward exchange rateequating to the interest rate differential through the interest rate parity theory, which in turnequates to the difference in expected inflation rates through the Fisher effect. Yet, PPP tellsus that absolute or relative price growth levels can be used to forecast future exchange rates.Thus, through PPP we can extrapolate this one stage further to suggest that:The difference in expected inflation rates = the expected exchange rate changeBringing all these together, we get:(1) The difference in spot and forward rates = the difference in interest rates(Interest rate parity theory)(2) The difference in interest rates = the difference in expected inflation rates(Fisher effect)(3) The difference in expected inflation rates = the expected change in spot exchange rate(Purchasing Power Parity)Logically from this, one may conclude that the difference between the spot and forward ratesexpressed as a percentage should equal the expected change in the spot exchange rate. This isknown as the expectations theory of exchange rates.Finally, there is the theory that:(4) The difference in interest rates = the expected change in the spot exchange rate(International Fisher effect)On the face of it, the ideas presented above seem logical and follow a clear and persuasivetrain of thought. There is only one small problem – this clear train of thought rarely worksin practice. More specifically, the difference in interest rates or expected inflation rates maybe equal to the theoretical construct of the “expected change in the spot exchange rate”, butin practice it is of the future exchange rate. In line with this, the forward rate is also a verypoor predictor of the future exchange rate, a fact that economists have labeled “forward ratebias” or the “forward premium puzzle”. As Bansal and Dahlquist (2000)2 confirmed in theirexhaustive study, in contrast to the theory, empirical evidence suggests that in fact currentinterest rate differentials and future spot exchange rates are frequently negatively correlated.This is particularly the case within the developed economies, though the picture is somewhatmore mixed within emerging market economies.Over the long term, the interest rate parity theory is seen to work as enough market participants can be found to “discover” the opportunities available for covered interest rate arbitragebetween currencies and interest rates, thus in the process eliminating such disparities. However,there are much longer lags than the theory might suggest is possible. Here again, the issue ofincentive must be a focus. As noted earlier, it should behoove the theorists to know that themajority of currency market practitioners are currency interbank dealers and moreover thatthe main incentive for these to trade is directional gain rather than interest income. Currency2Ravi Bansal and Magnus Dahlquist, The forward premium puzzle: different tales from developed and emerging economies,Journal of International Economics 51 (2000) 115–144.
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markets do focus on interest rate differentials for extended periods of time, but equally theyfocus on other factors, in many cases completely disregarding interest rates.1.3.1 Real Interest Rate Differentials and Exchange RatesCurrency strategists do however use models comparing the real interest rate differential witheither the nominal or the real exchange rate between two countries. The logic behind this relatesto both the international Fisher effect and to PPP, where on the one hand the difference in interestrates should, if not be exactly equal to an expected change in the spot exchange rate, at leastbe an important driver of it, and on the other hand where nominal interest rate differentials areadjusted for inflation (i.e. domestic price growth) and thus relate to the exchange rate throughthe law of one price.The link or correlation between real interest rate differentials and the exchange rate appearsto have grown exactly in line with the gradual move since the end of the Bretton Woodsexchange rate system to liberalize capital flows globally. As barriers to capital movement havefallen, so the overall importance of capital flow has grown exponentially relative to that oftrade flow. Exchange rate models that focused solely on the current account no longer seemedappropriate in such a world, those that focused on capital flows seemed increasingly so. Ascapital flows have gained in importance, so their importance within overall currency marketflows has grown and thus the correlation between the two increased. Thus, currency strategistsacross the market continue to track this relationship between real interest rate differentials andnominal exchange rates as one of many useful and important indicators of currency over- orundervaluation. Figure 1.1 compares the Euro–dollar exchange rate against the 10-year bondyield differential from 1996 through to the end of January 2002.
1.4 THE BALANCE OF PAYMENTS APPROACHThe core idea behind the Balance of Payments Approach is that changes in national incomeaffect both the current and the capital account and through this cause a predictable reaction inthe exchange rate in order to restore balance of payments equilibrium. The best way of lookingat this is to examine the transmission mechanism from the change in national income through tothe exchange rate reaction. When considering the Balance of Payments Approach to exchangerates, it is good to keep in mind the classic accounting identity for economic adjustment:S−I =Y −E = X−Mwhere:S = SavingsI = InvestmentY = IncomeE = ExpenditureX = ExportsM = ImportsWithin economics, this is an unequivocal law, which governs how economies adjust to changesin economic dynamics.
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2.50
1.35
1.50
1.25
0.50
1.15
−0.50
1.05
−1.50
0.95
−2.50
Real Gov’t Bond Yield Differential(EU-US)
0.85
EUR/USD (RHS)
Source: Bloomberg−3.50Jan-96
0.75Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Figure 1.1 Euro–dollar exchange rate vs. 10-year bond yield differential
1.4.1 A Fixed Exchange Rate RegimeUnder a fixed exchange rate regime where capital mobility is extremely limited, the focus is onthe current account rather than the capital account. Assume for the purpose of this exercise thatnational income is rising. As national income rises, so stronger demand sucks in an increasingamount of imports, which in turn causes current account balance deterioration. The exchangerate cannot be the transmission mechanism for restoring balance of payments equilibrium sincethe exchange rate is fixed. Hence, the monetary authority has the choice of either selling itsforeign exchange reserves in the market to alleviate pressure on the exchange rate or morepractically tightening monetary policy in order to dampen domestic demand, thus reducingimport demand and restoring the balance of payments equilibrium.Equally, within that same fixed exchange rate regime, say national income was falling. Thiswould imply that weaker domestic demand would cause a decline in import demand, whichwould paradoxically cause an improvement in the current account balance. Because the capitalaccount would not be a consideration given our premise that capital mobility is highly restrictedand the exchange rate is fixed, equilibrium in the balance of payments can only be restoredthrough a reversal of that current account balance improvement. Such an improvement wouldpressure the fixed exchange rate to appreciate. The monetary authority could either absorbthis pressure by increasing its foreign exchange reserves and selling the domestic currency inthe market to do so, or by loosening monetary policy. Either way, this would cause marketinterest rates to fall, spurring domestic demand and thus import demand, which in turn wouldcause the current account balance to move back to a position such that the balance of paymentsequilibrium would be restored.
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The dynamic whereby a change in national income is transmitted within a fixed exchangerate regime through the current account balance is expressed in the following diagram:Change in national income → Change in current account balance → Monetary reaction →Reversal of current account balance change → Balance of payments equilibrium restoredIn theory, a fixed exchange rate regime should automatically be in balance as left to its owndevices it should be self-correcting through changes in capital flows and interest rates. Animbalance of one kind or the other should automatically be corrected, albeit after a lag. Yet, inreality, fixed or pegged exchange rate regimes have faced an increasingly turbulent time duringthe 1990s to the extent that many of them have collapsed in the face of seemingly irresistiblespeculative pressure. Why has this been the case? Many of the reasons for this are case-specific.However, the underlying theme is that frequently countries simply have not been prepared tomaintain the degree of economic discipline that is required to maintain the fixed exchangerate regime. In addition, many appeared to forget the core rule established by the Mundell–Fleming example that you can have only two but not all three outcomes with a fixed exchangerate regime, high capital mobility and an independent monetary policy. Under the misguidedinfluence of the official community in Washington, many emerging market countries, whichhad fixed or pegged exchange rate regimes, opened up their economies to high capital mobilityat the same time they sought to maintain some degree of monetary independence. Looked atfrom this perspective, the result was inevitable.Maintaining a fixed or pegged exchange rate regime within a world of high capital mobilityrequires a considerable degree of economic discipline given that the transmission mechanismfor restoring imbalances to the equilibrium of the balance of payments cannot be the exchangerate but instead must be the real economy. Furthermore, global financial markets must beconvinced that the monetary authority of this fixed exchange rate regime will hold the line comewhat may. In the case of Asia, countries like Thailand, Indonesia and Korea were ultimatelyeither unwilling or unable to maintain that discipline. Interestingly, China, Hong Kong andTaiwan were all able to weather the storm, not least because they upheld the principles of theMundell–Fleming rule. In the case of China and Taiwan, both had monetary independence anda fixed or pegged exchange rate regime (Taiwan’s cannot be called a freely floating exchangerate regime by any stretch of the imagination), but maintained significant restrictions on capitalmobility. In the case of Hong Kong, on the other hand, it had very high capital mobility anda fixed exchange rate regime in the form of a self-balancing currency board, but its monetaryauthority, at least in theory, abandoned monetary independence in favour of following themonetary policy of its peg currency, namely that of the Federal Reserve. Granted, Hong Kong,China and Taiwan perhaps had both greater resolve and ability to resist speculative pressures,but the structure of their exchange rate regimes was crucially more secure. As the example ofArgentina shows in 2002, following this two-but-not-three model is not a guarantee of success.However, one could well say that not following it is more or less a guarantee of failure.1.4.2 A Floating Exchange Rate RegimeUnder a floating exchange rate regime, we have to consider the capital account as well as thecurrent account. Here, as national income rises, so import demand rises, in turn causing the
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current account balance to deteriorate. So far, this is just like the fixed exchange rate regime.However, in the case of the floating exchange rate regime, the exchange rate is able to be thetransmission mechanism for restoring the balance of payments to equilibrium. On the capitalaccount side, a rise in national income, causing the current account balance to deteriorate,must be accompanied by a rise in real interest rates. The higher real interest rate will dampenimport demand, which will in turn cause the current account balance deterioration to reverse.As that happens, national income will fall back, causing real interest rates also to fall back.If we start off with national income falling, we achieve the same transmission mechanism,only in reverse, with real interest rates falling, causing capital account outflows and currentaccount balance improvement to the extent that these developments cause on the one handa revival in domestic demand and on the other a loss in export competitiveness. Thus, thecurrent account improvement reverses and real interest rates rebound. We can express thistransmission mechanism from a change in national income through the balance of paymentswithin a floating exchange rate regime with the following diagram:Change in national income → Change in current account balance → Change in realinterest rates → Change in capital flows → National income change reversed → Currentaccount reversed → Capital flows reversed → Real interest rates reversed → Balance ofpayments equilibrium restored
1.4.3 The External Balance and the Real Exchange RateSimilar to the Balance of Payments Approach to exchange rates is that which focuses onthe relationship between a long-term equilibrium value for the real exchange rate and theexternal balance. Under this, the long-term equilibrium exchange rate is that which generatesboth internal and external balance, where internal balance is defined as full employment andexternal balance as the current account. Since the creation of this model, the emphasis hasshifted away from focusing on full employment to concentrating on achieving a sustainablecurrent account balance – not necessarily zero – which will achieve a perceived economic andexchange rate equilibrium.As with the Balance of Payments Approach, the current account is seen as the transmissionmechanism for the exchange rate, albeit this time under both fixed and floating exchange rateregimes. If the current account balance is showing an unsustainably high deficit relative tohistoric deficit levels, this will require a real exchange rate depreciation to restore equilibrium.Conversely, if it is showing a very high current account surplus, this will require a real exchangerate appreciation to restore equilibrium.The example that is often used with regard to this is Japan, which has had a structurally highcurrent account surplus. Using the external balance approach, if that current account surplusis seen as unsustainably high relative to historical norms, it requires a rise in the yen’s realexchange rate to restore equilibrium. Barring periodic reversals, this is what we saw from 1971to 1995. Since then, the yen has reversed course, not least because the strengthening of thenominal yen exchange rate to a record dollar–yen low of 79.85 caused such a real shock to thecurrent account balance that it in turn required a significant real exchange rate depreciation torestore equilibrium once more.
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Within the emerging markets, another good example is that of Russia. Before the Russianrouble crisis of August 1998, Russia continued to record significant current account deficits.The external balance approach suggested that at some point a real exchange depreciation wouldbe required to restore equilibrium. However, the Russian rouble was pegged to the US dollarand in order to maintain that peg real interest rates were kept high. Eventually, the costs ofdefending the Russian rouble peg – yet another case of trying to have all three of monetaryindependence, reasonably high capital mobility and a fixed exchange rate regime – proved toomuch and the rouble was de-pegged and devalued, and for good value Russia defaulted on itsdomestic debt.1.4.4 REER and FEERIn line with the external balance approach, the Real Effective Exchange Rate (REER) is thetrade-weighted exchange rate (NEER) adjusted for inflation. As with PPP, the purpose of usingREER is to try to gauge an exchange rate’s over- or undervaluation relative to a given norm. Aswith PPP, using REER is far from an exact science and in fact PPP and REER run into similarproblems. For instance, a major problem with PPP is which base year to choose. REER hasthe same problem and for similar reasons. Using a particular base year with which to beginone’s analysis can significantly distort the results. On the face of it, it would seem logical tostart both PPP and REER analyses in the 1971–1973 period when the Bretton Woods exchangerate system broke up, yet this was a highly inflationary and therefore distorting period as faras such analyses are concerned.The transmission mechanism is again the current account balance. Significant REER overvaluation relative to a given norm of 100 tends to produce a widening current account deficitor “external imbalance” in the jargon of economists. In order to restore balance or equilibrium,there has logically to be a REER depreciation. This can be achieved either by a depreciationof the trade-weighted exchange rate – that is to say by a depreciation of the nominal exchangerate – or by a sharp decline in inflation.So far, this seems relatively logical and deceptively predictable. However, significant REERovervaluations can last for substantial periods of time. In some cases it can take several yearsbefore an adjustment process takes place to eliminate such overvaluation. A good exampleagain is that of the Russian rouble, whose REER value was overvalued by around 60% forthree years – depending on the base year used – before it finally succumbed to gravity. TheREER values of both the Mexican peso and the Venezuelan bolivar have indicated significantovervaluation for several years now, and in the case of the Mexican peso to a greater degreethan before the 1994–1995 “Tequila” crisis. The lesson of REER is that it can be a useful toolfor diagnosing over- or undervaluation and a consequent need for an adjustment to restoreequilibrium – but what it cannot do is tell you when that will happen.Another way to estimate a real exchange rate’s equilibrium is FEER, or Fundamental Equilibrium Exchange Rate, pioneered by the writer and economic scholar John Williamson in1985. Recognizing the imperfections of the PPP concept, FEER reflects the exchange ratevalue that is the result of a current account surplus or deficit that is in turn appropriate tothe long-term structural capital inflow or outflow in the economy, assuming that the countrydoes not have barriers to free trade and is also trying to pursue internal balance. Assessingthe appropriate level of long-term structural capital inflow or outflow requires a considerable degree of value judgement. Even if it did not, it assumes that such capital inflows oroutflows should persist simply because they have occurred in the past. Given this construction,
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it is not surprising that estimates of an exchange rate’s FEER value vary widely. This is notto say that it is not a useful model. Indeed, models based on the FEER concept have beenwidely used within the private sector for some time. However, it is to say that using sucha type of exchange rate model puts a considerable degree of emphasis on the value judgement of the analyst concerned, thereby undermining the point of using a model in the firstplace.Looking at exchange rate models in general that use some variation of the external balanceapproach, we see that considerable “misalignments” in the external balance – and thereforepresumably in the exchange rate – can persist over significant periods of time. The fact thatthis can happen suggests equally that for substantial periods of time the importance of theexternal balance to the exchange rate can be more than offset by capital flows. Eventually, itappears that the misalignment in the external balance reaches a level, which produces a lossof market confidence and capital outflows. As capital outflows occur, this by necessity mustreduce the current account deficit. The problem of course is that this level, this trigger pointthat causes a loss of market confidence, is not static but changes. Thus, as with all exchangerate models, those which focus on the external balance should be used for long-term exchangerate considerations rather than for the short term.1.4.5 Terms of TradeAnother important aspect of the external balance approach to exchange rate determinationis the so-called “terms of trade”, which is the relationship between a country’s export andimport prices. A country’s terms of trade can be an important determinant of its long-termequilibrium real exchange rate. We find this particularly the case for countries that are majorcommodity exporters and therefore whose economies are particularly sensitive to swings incommodity prices. An improvement in a country’s terms of trade, that is a rise in its exportprices relative to import prices, should lead to a rise in the real exchange rate equilibriumvalue. Rising export prices should be reflective of rising global demand for that country’sexports, both on an absolute basis and relative to domestic demand levels. Consequently, oneshould assume that an improvement in the terms of trade should lead to an improvementin the current account balance, which in turn requires a real exchange rate appreciation torestore equilibrium. Equally, a deterioration in the terms of trade leads to a current accountdeterioration, which requires a real exchange rate depreciation to restore equilibrium. Forthe sake of clarity, we can express this transmission mechanism using the following simplediagram:Change in terms of trade → Change in current account balance → Real exchange ratechange to restore equilibrium
Taking oil as an example, the terms of trade concept is an important determinant of thelong-term real exchange rate equilibrium value for the countries of the Gulf, Mexico,Venezuela, Colombia, Nigeria, Indonesia, Russia, the UK and Norway. Note that these arejust the exporters. The terms of trade concept also works for the importers as well, whichis why when the international price of oil experiences a significant uptrend, this causes aterms of trade deterioration for the major oil importers, leading to current account balance
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deterioration. All else being equal, this should require a real exchange rate depreciation torestore equilibrium.1.4.6 ProductivityLast but not least, we look at how productivity growth can affect the equilibrium real exchangerate. What is productivity? We have a vague concept of this in our work place, but it has aprecise definition – output per man hour. Rising productivity growth causes increased supplyof a good. Supply/demand dynamics require that increased supply relative to demand leads toa fall in price. The principle of Purchasing Power Parity requires however that falling prices inone country relative to another lead to an offsetting exchange rate appreciation under the lawof one price. Thus higher productivity growth in tradable goods should lead to exchange rateappreciation to restore equilibrium to the current account.The issue of productivity growth was much in debate in 2001 as economists sought toexplain the US dollar’s inexorable rise against the Euro. Indeed, both the Federal ReserveBank of New York and the Bank of England produced reports on the issue of whether higherUS productivity growth explained the US dollar’s strength and indeed whether or not the US didin fact produce higher productivity growth. Despite the presence of such eminent scholarship,the jury is still out. There does however seem to be greater clarity at least as regards the broaderissue of whether or not productivity growth should produce exchange rate appreciation. Justas PPP is not a good short-term predictor of exchange rates, so productivity growth shouldnot be used as a short-term trading model. However, both are profoundly useful in predictingmedium- to long-term exchange rate trends. Here, the fact that the US has had consistentlyhigher productivity growth in the wake of the “re-engineering” drive within the US economy in1994–1995, and the fact that the US dollar has been on a long-term uptrend ever since, shouldnot be seen as coincidence. Similarly, Japan during the 1970s and 1980s had consistentlyhigher productivity levels than either the US or Europe, and this should be seen as at least oneof the major reasons why we saw trend appreciation of the Japanese yen during that period.Yet, at some point productivity growth becomes unsustainable. After all, it deals with theissue of increased supply, presuming that there is always demand for that increased supply. Atsome point, the levels of supply will exceed demand. When that happens a hitherto unforeseen“inventory overhang”, as per the economists’ jargon, appears. The natural dynamics of supplyand demand suggest that the excess supply should instantly be eliminated to restore “equilibrium” supply levels relative to demand. Yet, we know from painful experience that this is notwhat happens. If we view productivity as supply and wages as demand, the standard economicmodel suggests that higher productivity growth automatically results in higher wages. Yet,during periods of major technological change, which tend to produce the strongest levels ofproductivity growth, the fact that competition is greatly increased produces such downwardpressure to prices to the extent that the only way some can compete is to cut wage growth. Atthe very least, wage growth does not keep up with productivity growth. In other words, demanddoes not keep up with supply – which brings us back to the idea that this excess supply willrather quickly have to correct automatically to match the level of demand.However, this is not what