Published in: American Affairs, Fall 2025 / Volume IX, Number 3
John Maynard Keynes recognized that countries with persistent current account surpluses posed a threat to the world economy, but no agreement was reached at Bretton Woods, nor in any subsequent discussions, on how countries might be dissuaded from running them. The burden of accommodating or altering these imbalances thus falls on the deficit countries, and what has for many years been a chronic problem has now become acute. Demand matches supply worldwide but not necessarily for individual economies. Countries that seek to save more than they invest have inadequate internal demand and, if they invest abroad, this depresses their exchange rates, allowing those with weak domestic demand to avoid unemployment by exporting more than they import.
Countries run trade deficits because investing in such countries appears more attractive than elsewhere, in terms of the expected returns and risks. The exchange rate that results produces the trade surpluses and deficits that match investors’ preferences. As with all market prices, exchange rates reflect the short-term equilibrium, because buyers and sellers must match, but exchange rates are unstable as both trade flows and investor preferences are constantly changing. It is, however, easier to change the prices of currencies than the flows of goods and services. So trade responds more to exchange rates, which move with changes in international investment preferences, than exchange rates do to trade.
Exchange rates fluctuate, and their changes are often ephemeral, so the experience of traders encourages feedback loops which introduce considerable short-term instability in currencies. Accurate forecasting seems impossible, because, without the benefit of hindsight, we cannot distinguish ephemeral wobbles from fundamental alterations in investors’ preferences. The theory that exchange rates must in the long-term adjust so that currencies have similar purchasing power is reasonable, but it provides little help to forecasters for two reasons: mispriced currencies can adjust through variations in comparative inflation rates as well as exchange rates, and the equilibrium rates vary with relative rates of productivity.
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