Let me turn now to the main questions that you have raised.

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1 Statement and Testimony In U.S. Congress, Joint Economic Committee, Hearings before Subcommittee on International Economics, How Well are Fluctuating Exchange Rates Working?, pp rd Congress, 1 st Session, June 1973 I am delighted to be here. This subcommittee has had an important influence on U.S. policy and the international financial system. And that influence has been almost wholly for the good. This subcommittee has been a force making for a greater degree of flexibility in international money markets, it has been a force restricting the degree of intervention by our central banks and Treasury in that market. So, I can only compliment you upon the influence which you have had. With respect to the point which Mr. Arriazu has just made, let me say at the beginning, before I go on to my own statement, that while I have long been in favor of a system of floating exchange rates for the major countries, I have never argued that that is necessarily also the best system for the developing countries. Indeed, in April of last year I gave a series of lectures in Israel which are shortly to be published in book form on the problem of monetary policies for developing countries. And in these lectures I recommended as probably the optimum policy under current conditions for a developing country that it peg its exchange rate to its major trading partner rather than have a floating system. So I believe there is no conflict between wholehearted advocacy of floating rates for major countries and the existence of currency blocs of smaller countries attached to the major countries. Let me turn now to the main questions that you have raised. Like the Sherlock Holmes clue of the non-barking dog, the most important development of the past several months in the international monetary area is what did not happen. Despite unprecedented gyrations in the market for gold, despite stories day after day about a crisis in international money markets, there were no headlines reading, German Reichsbank Takes in Billions of Dollars of Hot Money in Single Day, no announcements of hastily called meetings of central bankers to do something about the international crisis, or of emergency trips by Chairman Burns and Secretary Shultz to Paris or Basel, or of carefully worded joint communiqués designed to paper over agreements to disagree all the standard accompaniments of earlier international monetary crises. The market adjusted itself to the new international monetary arrangements far more rapidly and efficiently than the financial journalists, who continued to report as if we were operating under earlier arrangements, in particular, misinterpreting the significance of the fluctuations in the price of gold. Let me illustrate. A Wall Street Journal story early in June began, The U.S. dollar took another tumble on international currency markets Friday. It ended, In London, the pound rose against the dollar to $ at one point but slipped back to close around $2.5735, still well above Thursday s close of $ To translate a change of.0070 in the dollar price of the pound sterling, or of.25 percent, is a tumble! The story went on to blame the alleged weakness of the dollar for a rise in the price of gold in a single day not of.25 percent but of ten times that much, 2.5 percent (three dollars an ounce). 1

2 Before the two-tier system was adopted in 1968, when the United States was committed to peg the price of gold on the London market, a rush into gold was equivalent to a flight from the dollar. It did require the United States to sell gold for dollars and thereby meant in the first instance a reduction in foreign dollar holdings equal dollar for dollar to the value of gold purchased. From the two-tier system to 15 August 1971 the connection was less direct but still extremely important. Persons seeking to buy gold could transfer their dollars to foreign central banks and foreign central banks could legally though in practice they did not demand that the United States convert the dollar into gold. The closing of the gold window on 15 August 1971 snapped this connection and left the United States in the technical position of being unaffected either directly by the gold market or indirectly by associated flows between currencies. However, the Smithsonian agreement involving a United States commitment, at least tacitly, to a new structure of fixed exchange rates replaced the technical link by a political link, as was manifested most dramatically by United States intervention to prop up the exchange price of the dollar in August The adoption of floating exchange rates this past February, together with the explicit refusal of Secretary Shultz and Chairman Burns to commit the United States to large-scale intervention to support the exchange price of the dollar has finally cut the link I trust permanently. Gold is today s soybeans, a highly speculative commodity that has recently experienced a remarkable rise in price. Someone who buys soybeans pays for them in dollars. Similarly, someone who buys gold pays for it in internationally acceptable currency which means mostly dollars. That does not alter in any way the amount of dollars available to be held. It simply transfers them from the purchaser to the seller. If the seller prefers some other currency, he can buy that currency on the open market. He no longer has any guarantee that he can acquire it at a fixed price from the relevant central bank. Far from demonstrating the weakness of the dollar or of the current floating exchange rate system, the recent gyrations in the price of gold have been demonstrating the weakness of gold as a monetary reserve or store of value under current conditions. Who wants to hold his liquid reserve in a form, the purchasing power of which rises or falls by 2 or 3 or 5 percent in a single day, or can double or halve in a few months? Being long on soybeans or gold may seem a good speculation when prices are going up but who would regard that, under current conditions, as a sensible way to salt away a reserve for a rainy day? The long history of the use of gold as a monetary medium and of an officially pegged price of gold has established attitudes that will make my comparison of gold with soybeans appear strained, but as the cultural lag disappears, and particularly after the price of gold takes a tumble or two as it will one of these days from either its present price or an even higher interim price the change in the role of gold will become much more widely recognized. I do not rule out the possibility that gold may at some future time regain an important monetary role. It will do so if, and only if, governments, and the United States government in particular, manage their national moneys in a highly irresponsible fashion. But for the present, gold is simply a speculative commodity with the special feature that governments own large quantities. The past few months are a remarkable demonstration of the virtues of floating exchange rates in insulating international financial markets from speculative markets in both gold and 2

3 commodities, in enabling adjustments to be gradual and orderly. The exchange rate of the dollar has on the average declined, but it has declined in an orderly fashion and by moderate amounts. There has been no sudden crisis, no closing of exchange markets, no changes of rates by 10 percent overnight. Business has been able to proceed in a far more orderly fashion than under the earlier regime. There has been none of the pressure for ever more extensive restrictions on the movement of capital and goods that opponents of floating rates so feared. On the contrary, the pressure for such restrictions has lifted now that the market can provide a sensitive adjustment to changes in circumstances. The most dramatic example, of course, is the liberalization by Japan of its restrictions on the movement of both capital and goods. Thus in answer to the first question being investigated in these hearings, the evidence to date suggests that the introduction of a floating exchange mechanism has facilitated rather than impeded international trade and investment transactions. Since I have long argued that floating rates would have this effect, I find the actual outcome reassuring but not surprising. I turn to the second question, What sort of guidelines should be established to regulate central bank intervention in exchange markets? This question has two very different parts: What guidelines, if any, should be part of an international monetary agreement? Pending such an agreement, what policy should the United States follow? I shall restrict myself to the second question, partly because that is directly under United States control and in the legislative domain of this committee, partly because I believe that the answer I shall give to it is also the right answer to the first question for the United States. In brief, I believe that the best interests of both the United States and the world financial system would be served by a United States policy of complete abstention from any intervention in exchange markets for the purpose of affecting exchange rates. A legislative proscription of such intervention, including the repeal of the authority under which the Federal Reserve enters into swap arrangements with foreign central banks, would be extremely desirable, both to protect the policy from the accident of changes in the particular persons in charge at the Federal Reserve or the Treasury and to give the world financial markets a firm assurance that nonintervention is the considered policy of the United States. Otherwise, there will be recurrent speculation that the United States proposes to intervene. In testimony before this subcommittee in September 1972 and I quote from your report of last November Both Under-Secretary Volcker and Chairman Burns assured the committee that, to the best of the capabilities of their respective institutions, the swap mechanism would never again be used to prop up an overvalued dollar exchange rate or delay a necessary exchange rate adjustment. I have the greatest respect and admiration for both Undersecretary Volcker and Chairman Burns; I have every confidence in their integrity and sincerity in giving these assurances. Yet the policy that is embodied in their assurances guarantees beyond a shadow of a doubt the occurrence of precisely the opposite. The only uncertainty is the date. 3

4 They do not forswear intervention. They rather assert implicitly or explicitly that they will intervene but solely to prevent disorderly markets, to avoid an undervalued dollar, to prevent unnecessary exchange rate changes, not to prop up an overvalued dollar exchange rate or delay a necessary exchange rate adjustment. But whether a currency is overvalued or undervalued, whether an exchange rate change is necessary or unnecessary, is a matter of judgment not of objective, easily determined fact. If the situation happens to be so clear as to remove any reasonable doubt, government intervention is clearly unnecessary. In that case, private speculators will have a strong incentive to step in and correct the obviously wrong exchange rate. If the situation is not that clear, a mistake is possible. Perhaps the Federal Reserve and the Treasury will be right nine times out of ten, or for that matter, ninety-nine times out of one hundred. In those cases, they will do a bit of good. But, surely, they will make some mistakes. And there s the rub. Having made a mistake, there will be a strong resistance to recognizing it, a strong tendency to hang on and hope that circumstances will change and show that it was not a mistake, a strong tendency to convert what might have been a minor exchange rate movement into a major disequilibrium and crisis. This tendency is particularly strong and particularly hard to resist when the financial risk is borne by someone else, namely the public at large, not by the officials engaged in the official speculation. That is a point which I have developed further in a Newsweek column which I have asked to be included in the record ("Speculation and Speculation," Newsweek, 23 April 1973). The recent experience of Germany is a dramatic illustration a cost of half a billion to a billion dollars imposed on the German people because of the economic minister s unwillingness to admit to error. Chairman Burn s description to this subcommittee of the events preceding 15 August 1971, is another only slightly less striking example. And similar examples can be multiplied manyfold, not only in the area of exchange rate intervention, but also in other areas of policy, including in particular domestic monetary policy. Almost without exception, the major mistakes in Federal Reserve policy in the nearly six decades of its existence reflect the unwillingness to admit to mistakes and the persistence in an erroneous policy until great harm has been done. With the best will in the world, that experience is likely to be repeated in the future. The only way to prevent intervention to prop up an overvalued dollar or delay a necessary exchange rate adjustment is to prevent intervention, period. That will sacrifice minor advantages from slightly smoothing exchange rate movements most of the time, but it will gain the major advantage of avoiding occasional catastrophic mistakes. The case against official intervention is strong, in my opinion, for every country the market will do a far better job of speculation in exchange than the government. But the case is particularly strong for the country that provides the major international currency. Whether we like it or not, the world is on a dollar standard. It will remain on a dollar standard as long as United States monetary policy is not more unstable and more inflationary than the monetary policy of other leading countries. As you know, I have been a strong critic of United States monetary policy, precisely on the ground that it has been too erratic, shifting from unduly rapid monetary growth to unduly slow growth. I have welcomed and applauded the actions of the Joint Economic Committee in recommending a steady rate of monetary growth. Yet, defective as our policy has been, it has been less erratic, more moderate, than the policy of most other leading 4

5 countries. That, plus, of course, the immense economic strength of the United States, is why the world is still on a dollar standard. If the United States is, as in fact it is, issuing an international currency, it belies that role completely for us to intervene in the market for the currency. I believe that we should not try to force the dollar on the world. Indeed, all things considered, I believe we would be better off if some other currency had happened to become the international currency. Yet, given the situation as it is, I believe that we should not deliberately set out to destroy the usefulness of the dollar as an international currency. Central bank intervention in the market would do precisely that. The minor improvements when the Federal Reserve guesses right would be far outweighed by the harm when the Fed guesses wrong, by the controls that would be imposed to try to salvage the Fed s mistake, and even more by the widespread knowledge of the possibility of such an outcome. A firm commitment to nonintervention would reassure every holder of dollars that he could base his decisions on his judgment about objective economic circumstances and did not have to allow for the possibility of major political misjudgments. Our own past experience shows how easily measures intended to strengthen the dollar can backfire. The interest equalization tax, the restraint on foreign lending by United States banks, the restrictions on foreign investment by United States corporations, Regulation Q ceilings on time deposit rates all of these were undertaken to strengthen the dollar, not weaken it. Yet their combined effect was to drive the international financial market from New York to London, to encourage the rapid growth of the Eurodollar market, to make the dollar a less attractive currency to hold and to add to our balance-of-payments problems. A policy of occasional intervention into foreign exchange markets would have a similar effect. We are a great nation. We should act the part. We should, as soon as possible, remove all restrictions on the use of the dollar by United States citizens and foreigners, whether for capital transactions or for trade. We should, so far as possible, assure all that the United States will take no measures to prevent anyone from holding dollars, borrowing dollars, lending dollars, spending dollars on goods and services, acquiring dollars by selling goods and services and giving dollars or receiving dollars as gifts, provided only that the terms are mutually agreeable to the parties to the transaction. That is the way and ultimately the only way to assure that the dollar is correctly valued in the market. If that policy is accompanied by a steady and moderate monetary policy at home, the dollar will remain the major international currency for the indefinite future. A dollar crisis will become an historical curiosity. Reprinted as How Well Are Fluctuating Exchange Rates Working? AEI Reprint, no. 18. Washington, D. C.: American Enterprise Institute, /12/12 5