Floating Exchange Rates Essay, Research Paper

Floating Exchange Rates

For some, the collapse of Mexico’s economy proves that floating exchange rates and markets without capital controls are deadly. Others find the crash of the European exchange-rate mechanism (ERM) in 1993 to be proof that targeted rates will always be overturned by the free market. Many see the breakup of Bretton Woods as the failure of fixed rates. Yet others believe monetary unification in Europe is the only way to achieve economic and political stability. Many others hold still different beliefs. There are, however, four main proposals for the management of international currency exchange rates: monetary unification, fixed rates, floating rates maintained within certain “reasonable” limits of variability and freely floating rates. Both fixed exchange rates and rates based on either explicit or unwritten targeting are impossible to maintain, especially in an era of free trade. Complete monetary unification would be impossible to bring about without extensive integration and unification of international governments and economies, a task so vast that it is unlikely ever to be accomplished. Thus, the only option central banks have is to allow exchange rates to float freely.

The European Monetary System, which virtually collapsed in 1993, was an attempt to fix exchange rates within certain tight bands, to coordinate monetary policy between member nations and to have central banks intervene to keep exchange rates within the bands when necessary. The reasons for the collapse were myriad but, simply put, it happened because Germany, dealing with financial problems in part arising from its reunification, refused to lower its high interest rates. This meant other European countries either had to keep their rates equally high and allow themselves to fall into recession as a result, or devalue their currency against the mark, a move viewed by many as a political embarrassment. The possibility of a devaluation caused speculators to bolt from the lira, the pound, the franc and other currencies, sending the markets into chaos and destroying all semblance of stability. In the end, the ERM was adjusted to allow currencies to fluctuate within 15 percent on either side of their assigned level, up from (in most cases) a limitation of 2.25 percent. The bands became too wide to be meaningful or stabilizing, and the system remained alive “in name only” (Hornblower 33).

Many saw this collapse as inevitable and say all attempts at government-imposed stability will fail: Governments both will not and cannot stick to pegged or fixed rates. First, maintaining targeted or fixed rates requires a consistent and fairly uniform monetary policy among nations. There are many reasons that national governments will not consent to this, the foremost being that different countries want different things, different economies have different needs and different governments have different policies. For example, it is thought that Europe and Japan are more willing to tolerate recession than inflation, while the United States prefers to keep interest rates low and the economy growing, even if prices do increase (Hornblower 32). In addition, many nations are in different stages in their overall economic cycles (Eichengreen 89). Many countries thus cannot afford to subscribe to uniform monetary policy. For a country that would otherwise have had low interest rates, for example, raising them could be both economically counterproductive (what good is exchange rate stability if recession is its cost?) and politically disastrous (more people notice high interest rates and unemployment than care about currency stability). Even if the government were willing to bow to international standards, nationalism is strong in the world today and most people do not look fondly upon consolidated global power–witness the problems of the United Nations. People would not widely support what would effectively be international control of their country’s economic policies and money supply. Speculators, unfortunately, know that governments today are likely to put their self-interest ahead of the nebulous common good and to eventually choose the monetary policy that is best for their individual economy (as it could be argued happened in the collapse of the ERM). Speculators will act on this suspicion, dumping uncertain currencies and running to the strongest (in the case of the 1993 debacle, the Deutsche mark).

So, that is why governments will not stick to targeted rates and to what happens as a result. There are also reasons they cannot, first, there is the decline of capital controls and the resulting ease with which speculation occurs. With the growing popularity and reality of free markets and with the advent of the “Information Age,” control over the international money supply is both unwanted and impossible. The slightest hint of a devaluation can be self-fulfilling as uncountable amounts of money change hands at a whim. Some people argue that making realignments less predictable would stalemate destructive speculation (Lewis A27), but most people realize that by the time central banks know to devaluate, the smart speculators, reading the same economic signs as the bankers, will know the same thing, especially if devaluation continues to be seen as a fairly drastic undertaking. Spain, for example, tried in 1993 to catch speculators off guard by realigning in the middle of the trading day, but that can only be done once before speculators catch on (Eichengreen and Wyplosz 89). In the case of a completely fixed system, devaluation is necessarily an extreme measure and thus there is no question: Speculators will have no trouble seeing it coming and will run from the market.

These situations could hypothetically be avoided if central banks could intervene to prevent devaluation from ever becoming necessary. Some currencies, however, probably do not deserve to be propped up even if doing so were possible, because their real value is so far from their nominal value that it would be counterproductive to perpetuate the inaccuracy. Second, it can also be argued that central banks simply do not have the power to control the market, both because they do not have enough money (Germany spent 44 billion marks to prop up the pound and the lira in 1993 with very little success), and because their short-sighted attempts at circumventing the “invisible hand” fail. In the 1980s, governments joined several times to change the value of the dollar relative to the yen (the Plaza and Louvre agreements), an undertaking whose long-term success is dubious. Some people even blame the subsequent volatility in the market and the severe problems in the Japanese economy on the machinations of those governments (Friedman, “Anxiety” 34).

There are also other problems with fixed or targeted rates. Even if the system could be maintained, the economies of the world are probably not integrated enough to deal with a fixed rate system and to correct imbalances of trade. Capital is free to flow from country to country, but labor is not and neither are many businesses. The comparison of the states of the USA to the countries of the world is specious. Not only do the states share a central government and have virtually no economic sovereignty or identity. And not only is everybody certain that the situation will never change and thus there is no speculation, but, most importantly, everything flows freely over every border (”Interview”). The balance of the free market, of supply and demand, is easily maintained. That is not the case in the world at large.

Finally, the last problem with fixed or targeted exchange rates is that confidence in the system has to be absolute or else pessimistic, self-fulfilling speculation will cause the collapse of the system. Unfortunately, the system isn’t perfect. Again and again people write that as soon as this or that crisis passes over (Germany’s reunification, for example), we will have economic and political peace and be able to fix exchange rates. But crises in Europe and elsewhere haven’t ceased just because Hitler is no longer alive and the Berlin Wall has fallen. Overwhelming problems will at some point strike the system–we haven’t advanced beyond war, mayhem and natural disasters–and there will be no solution but to leave the monetary regime, as has happened before (notably in World War II). People with money in the currency market know this, and knowing this, help to make it inevitable.

One misconception about fixed exchange rates ought to be noted here: the difference between real and nominal values of money. With fixed rates, nominal exchange rates may be stable but real exchange rates vary. Prices of imports and exports still change relative to each other; this is how the system balances itself. As a country’s money supply contracts and expands by the actions of foreigners, the price level within the country changes. (Theoretically, it would go both up and down, but the tendency of prices to “stick” high hinders the balancing mechanism by making deflation rare.) As one author put it, the attractiveness of fixed rates depends partially on the answer to the question, “How stupid is your labor force?” (”Currency Reform” 21). And how stupid are all the business people? Is not the fluctuation in the nominal and real values of the currency under a floating system similar to the fluctuation in the real value of fixed currency? The changes in floating exchange rates have proved to be much more volatile than the (real) changes in fixed rates, but it ought to be noted that real values still change under both systems, in both cases to remedy balance of payments problems. Since we would have to sacrifice in order to maintain nominal stability through fixed rates, we ought to remember to ask exactly how much real stability we would be getting in return.

The third major proposal for a monetary system is that of monetary unification. This poses some of the same problems as a fixed or targeted rate system. Most people do not support it because, essentially, it unifies too much. It takes too much power out of the hands of nations and puts it somewhere else. It would, like a free market, increase harmonization (competition) in taxation, another trend that threatens the autonomy of nations (Hornblower 41). Governments would, as in the other two systems, give up a great deal of control over their domestic economies and the problems of individual country’s business cycles would be ignored and unregulated. Even if monetary unification was wanted–and it would remove the problems currency volatility poses for international trade–its institution would be virtually impossible in the current political climate. “Jealousies, allegiances, the bases of political support remain firmly national; that fact cannot be wished away by a coin” (”Currency Reform” 22). The governments of countries and their populations are further from integration than the economies themselves; it would be impossible to achieve the amount of political coordination–one could even call it union–that would be necessary to create and sustain complete monetary unification.

So, what is the answer? Obviously, currency volatility is a problem. Unfortunately, all other alternatives seem worse. There are, at least, some advantages to freely floating rates aside from their existence as the only viable system. First, they can act as “shock absorbers” and moderate the exportation of one country’s problems (inflation, for example) to its neighbors (”Fixed and Floating Voters” 64; Friedman, “Introduction” xxiii). Second, the free market punishes incompetent governments for bad fiscal policies. Mexico’s monetary policy was woefully irresponsible; thus, it’s hardly a surprise its entire economy collapsed. Competition in the currency market, as in all other things, drives people and governments to be responsible (Becker 34).

The system is also in some ways fair. As Paul Magnusson posts it “arguably reflects the fair value of nations’ legal tender based on the fundamentals of growth, inflation, and interest rates.” He goes on to add that “currency volatility is the price of a free market, not a condition to be cured” (108). Just as, for example, it’s widely believed that price and rent controls hurt more than they help, so too do government interventions in the currency market. As mentioned above, many even blame government intervention for volatility in the first place, as in the case of the Plaza and Louvre agreements. Some people also argue that volatility may be temporary until the system settles down (Friedman, “Introduction” xxiii). But this bears some of the marks of the unrealistic optimism of people who seem to believe Europe and the world will be (after we resolve just one more crisis) forever peaceful and ready for unification.

The biggest advantage of floating exchange rates is that they give each country control over its domestic affairs. Presumably, it knows best how to handle them, and it is to be hoped that knowledge of the workings of the free market will keep it from doing so irresponsibly. Speculation can be a stabilizing force that demands responsible fiscal policy and money management. The cost of economic stability and prosperity may in fact be exchange rate instability. $6.5 billion to $39 billion was estimated to have been spent on hedging in 1989 (Becker 34). But how much money would be lost each year by sacrificing individual economies to the international “good” (as in the case of the European nations that fell into recession during the ERM crisis)? Besides, as the president of the New York Federal Reserve Bank said, “low inflation is the best assurance of exchange rate stability” (Lewis A24). Theoretically, intelligent domestic control of national economies will dampen currency volatility as well as improving the health of the economy itself.

For all these reasons, floating exchange rates are the best system available to central banks at this time. The mechanism is certainly not without flaws, but it is the only truly feasible choice

Governments will always desert a fixed or targeted rate system, either when their reserves run out or when domestic inflation or recession becomes too severe. T he real values of currencies do

fluctuate–that is the problem. Sooner or later a gross imbalance will arise and it will be fixed either by the nation voluntarily leaving the system or by speculators foreseeing its demise and forcing it out. The solution to that problem, monetary union–fixed rates with no devaluation or “leaving the system” allowed–would be impossible to institute and maintain even if it were economically advantageous to all involved. The only realistic and economically sound solution, problematic though it may be, is to have exchange rates float freely and without restriction.

Bibliography

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