Originally published in Clark, D. (1995), Student Economics Briefs 1995/96. Financial Review Library,

Transcription

1 The Case for and Against Floating Exchange Rates Originally published in Clark, D. (1995), Student Economics Briefs 1995/96. Financial Review Library, This brief overviews 20th century international monetary arrangements, provides a timely re-examination of the arguments for and against floating exchange rates, and concludes with an analysis of the calls for a new set of international monetary arrangements. Economics, like real sciences, has its fads and fashions. However, in the long-term it is the problems of real-world economies which drive serious economic debate and produce useful advances in the discipline. A century ago, most major economies were on more fixed exchange rate regimes, with many tying their currency s value to a given quantity of gold or silver. A century later, after experimentation with more flexible exchange rate systems, there are calls for a return to a less flexible system or series of currency pegs. To understand why requires a little economic history. The Gold Standard era During the Gold Standard era - from the 1870s to the early 1930s - many currencies were tied to a given quantity of a precious metal and notes were redeemable in that metal. The main argument in favour of this approach was that it helped limit inflation by restricting the ability of governments to print more money. If they did so, it had to be backed by an appropriate amount of bullion. However, the Gold Standard gave great power to gold-producing countries, diverted gold from more productive uses, and did not guarantee short-term price stability. There was also the problem of deciding the optimal peg - just how much a currency was actually worth in bullion.

2 The system collapsed in the early 1930s, when key countries such as Britain faced severe trade deficits and were forced to stop bullion export - and governments, faced with massive unemployment rates, wished to print more money, without a necessary bullion backing. A period of severe currency fluctuations and beggar-myneighbour policies followed. The Bretton Woods system At the end of World War II, the Bretton Woods agreement - named after the place in New York State where the agreement was reached - implemented a new regime. Under what was in effect a $US/gold standard, many economies agreed to convert their currencies at a fixed rate in terms of either gold or US dollars, with the US agreeing on a conversion rate of $US 35 = 1 oz. of gold. Like the Gold Standard, this worked best when the US economy - and its currency - dominated the world economy. However, by the late 1960s, the resurgence of Europe and increasing competition from Japan, challenged US hegemony. In addition, the US financed its Vietnam War activities by printing more money, which not only set off inflationary spirals around the world economy, but produced a fall in the ratio of $US/gold and thus the gold value of the $US. The system then collapsed as other countries no longer wished to set their currencies against a peg that was falling in real value Since then, many currencies have been more flexible. We have entered an age of more flexible currencies. The collapse of the Bretton Woods system produced more flexible rates in many economies In this new era, a currency floats to the extent that a country s central bank desists from pegging its price in foreign exchange markets - that is, the currency s value is not tied simply to gold, another precious metal, or the $US. However, not all economies have adopted floating rates. The countries with less flexible exchange rates are largely developing countries and some smaller industrialised ones. The countries with the most flexible rates include most of the more advanced ones plus some smaller, much less developed economies. However, this next set of arrangements did not live up to the promises of the theorists. Advocates of more freely-floating rates argued that they would:

3 Reduce the great trade imbalances between the major world powers. Exchange rate movements would achieve this by encouraging capital and goods to move where they would be most efficiently used, thereby greatly reducing trade surpluses and deficits. Force governments to change other parts of their economic policy mix to enable and stimulate greater trade and capital flows. Reduce the importance of a nation s gold holdings, as previously many currencies were tied, to some degree, to a given quantity of gold. With the former Soviet Union and a then unreformed South Africa being the major gold producers, this argument had more than economic importance. In the 1950s, France s Charles de Gaulle had also disrupted currency markets by stockpiling huge quantities of gold bullion. There is many a slip between the economic theory cup and the real-world economy lip. Criticisms of floating regimes Critics of the floating rate system make five main charges. Each of these deserves close, critical scrutiny. First charge: exchange rate fluctuations have been much greater than expected and adjustment processes have not been as smooth as the advocates of floating rates claimed Critics argue that rates have been so volatile because participants in international foreign exchange markets lack an anchor on which to base their medium-term exchange rate expectations. As a result, short-term events produce large changes in rates. These changes add to general uncertainty which, in turn, increases exchange rate volatility even more. However, this criticism overstates the influence of exchange rate regimes. Shortterm variability of nominal exchange rates for the seven major currencies has been much greater under the floating regime than during the last decade of the previous Bretton Woods one which ended in But we cannot conclude that this greater volatility is due simply to the change in regimes. A lot more changed beside the exchange rate regime over the last twenty five years. In other words, while there is general agreement that exchange rates have certainly been more volatile in the short-term since floating began, there is wide disagreement as to the causes of this volatility and its costs.

4 Defenders of the present system argue that the increased volatility has not been caused by the system itself but by other factors outside the system. They argue that exchange rates are jumpy, forward-looking auction prices that anticipate future events- rather than prices which lead change. Certainly most forex dealers believe that they are anticipating change rather than leading it. Similarly, the huge current account imbalances between such countries as the US and Japan have been caused by a whole host of factors besides current international monetary arrangements. These include: the important changes in the structure of international trade over the past decade, particularly those resulting from the two oil price hikes; unsuitable domestic policy responses to exchange rate movements; and trade barriers, which hindered smooth adjustment of trade flows to exchange rate fluctuations. A more fixed exchange rate regime would not have automatically countered these de-stabilising forces. The fact that a country runs a large current account deficit or surplus is not simple proof of maladjustment to external pressure. If net private capital flows move in the opposite direction, thereby financing the deficit or surplus, then such movements can result in an efficient allocation of international resources, reflected in the fact that such capital is moving to countries with the highest rate of return. This enables countries with a low saving ratio, but with attractive domestic investment opportunities, to run large current account deficits financed by foreign saving. Clearly, the capital account should not be neglected when considering the pros and cons of various exchange rate regimes. Furthermore, the impression is often given that the pre-floating era was one of great harmony and international balance. In fact, the Bretton Woods arrangements broke down because of the lack of such harmony and balance. Misalignments and "overshooting" of currencies also occurred under these previous arrangements. Second charge: floating rates are more inflationary than other regimes. Here, critics suggest that floating rates boost inflationary pressures in two main ways- through a "vicious circle" and "ratchet" effects. The first of these suggests that depreciation of a currency is rapidly translated into higher domestic costs and prices, which, in turn, lead to further depreciation of that currency. The second suggests that in a situation where prices are much more flexible in an upwards direction than a downwards one, prices in an appreciating economy do not fall as fast or as much as prices in a depreciating one- hence the use of the term ratchet. The net effect is greater world inflation than would exist under more fixed exchange rates. Certainly, exchange rate movements tend to reinforce the price effects of monetary policy and can shorten the time lag between changes in the money stock and

5 changes in the price level but this does not mean that exchange rate movements are the prime cause of inflation. Inflationary pressures are products of many forces besides currency depreciations. What is crucial is how an economy reacts to exchange rate fluctuations. Various empirical studies - which Australian policy-makers were far too loath to acknowledge in the 1980s - have shown that appropriately accommodating monetary and wage policy can dampen greatly the impact of these fluctuations. Third charge: by creating exchange rate instabilities, floating rates reduce the growth of international trade Studies show that there is no simple relationship between nominal exchange rate volatility and the volume of international trade. Moreover, a more fixed exchange rate does not automatically eliminate such volatilities. Fourth charge: a floating currency system allows a high degree of substitution between different currencies which, in turn, makes the control of the money supply of individual economies much more difficult. This charge is best explained by an example. If markets expect a currency to appreciate, there may be a massive conversion of foreign currency holdings into that currency. This will produce an appreciation of that currency and a faster growth in the money stock. Critics argue that such substitutions of currencies not only exacerbate exchange rate fluctuations but make monetary policy much more difficult. However, studies show that there is not a high degree of elasticity of substitution among currencies, although no-one could deny that it does exist. Yet, as our immediate pre-float experience in late 1983 showed, the fact that a country is on a more fixed regime does not prevent such substitutions and highly de-stabilising movements in and out of a particular currency. Fifth charge: floating rates are unsuitable for a small economy like Australia. The final criticism, that floating rate regimes penalise smaller, less industrialised economies, is the most difficult one. Certainly, the claim that flexible rates would shelter economies from developments abroad, by providing a kind of automatic adjustment mechanism, has been refuted by the experiences of the past decade. Moreover, critics of floating rates argue that the burden of adjustment falls much harder on the developing rather than the industrialised economies and that external adjustment has been least effective in the very countries with the most substantial spillover effects.

6 Smaller industrial countries have experienced larger current account swings and more year-to-year persistence in current account imbalances but the reasons for this are still in dispute. Even European countries continue to feel the effects of US monetary policies and are complaining as loudly as ever about them. Yet, defenders of the system argue that it has shown remarkable resilience in the face of the problems plaguing the international economy and that a more fixed regime would have harmed both capital movements and trade. Certainly Australia s dependence on imports makes us especially vulnerable to inflationary effects of depreciations and to short-term movements in capital. Are exchange rates optimal - can they ever be? Such charges have encouraged a growing overseas debate about whether the real exchange rates of at least the major industrial countries have been out of line with what has been termed the "fundamental equilibrium exchange rate". In other words, has the floating system produced actual rates which are anywhere near the equilibrium rate which would have generated a current account surplus or deficit equal to the underlying capital flow over time- in the absence of abnormal internal demand conditions or trade restrictions- or have they been persistently and significantly out of line with such a yardstick? Available research suggests that they have diverged markedly from such an "equilibrium" rate. Such divergences are of particular interest to small, open economies like ours which are more vulnerable to external shocks from trade policy changes and capital movements. This fact raises interesting questions about the efficacy of floating rates but does not provide a simple rationale for a return to much more fixed rates. For example, how could one determine an "equilibrium rate"? How could we have confidence in the monetary authorities to correctly determine what that rate is and thus what steps should be taken, or not taken, in aiming the actual rate to that rate? The post-war era of fixed rates certainly produced erroneous judgements by central bankers and politicians. Given that some degree of intervention is required under even floating systems, there has to be some criteria by which to decide whether and/or when to intervene. Unfortunately, most of the available literature on this question rests on such heroic assumptions as the actual choice of intervention is made by authorities possessed of perfect knowledge of all the possibilities and their consequences. Of course, if they

7 were possessed of such knowledge then intervention decisions would be much easier to make. Clearly, there is a great deal of learning by doing still to be done. However, much of the criticism of the $A floating rate regime is misguided and illinformed. While some of the expectations that were held for the regime have had to be modified, it has enabled a large range of capital controls to be dismantled and, in general, improved the microeconomic efficiency of international trade and investment. Why there has not been a return to much more fixed rates? Why don t the major economies return to more fixed rates, as is often advocated by those on the far Right and far Left of the political spectrum? Opponents of such a return make four main points: Those who advocate such a return tend to forget that exchange rates fluctuated before the adoption of more freely-floating regimes, albeit fluctuations have generally been greater under the latter. Such a return would thus not guarantee stability. The setting of fixed rates is far from a simple exercise. Different interest groups prefer different currency levels and the level agreed upon usually reflects the relative power of such groups, rather than economic rationality. Assuming interest group pressure could be overcome, there is no simple theory in the economist s tool-box which enables an optimal rate to be set - see accompanying box. A return to fixed rates would also necessitate the re-introduction of greater barriers to the movement of capital. Such barriers as exchange controls are also likely to be determined by interest group pressure, rather than economic rationality. Moreover, the removal of many such barriers in the 1980s enabled a dramatic increase in the mobility of capital, which in turn fuelled economic growth, albeit it also made national economic management more difficult. A recreation of such barriers would thus remove this stimulus to the international economy. Volatility exists under both fixed and less-fixed exchange rate regimes. However, in the latter risk management is much easier. It is usually easier to predict what

8 exchange rate markets might do than what governments might suddenly decree. Moreover, risk managers have sophisticated programs and techniques to deal with market movements. This does not mean, however, that we should abandon efforts aimed at improving the existing international system. Suggestions for international currency regime reform Three main suggestions for reform have been made: The adoption of target zones for the exchange rates of the major currencies. These could be both "hard" and "soft" - that is, narrow and infrequently revised or wide and frequently revised. Advocates of such zones usually use the European Monetary System (EMS) as an example. Under it most Western European countries to limit fluctuations of their currencies tried to tie their currencies against the German mark - hence the term The snake. But in the early 1990s this broke down. Even the relative stability achieved in exchange rates between its members was not just a simple product of the EMS. These countries also harmonise capital movements and other policy decisions. Such zones are easy to advocate; harder to operate. For example, which currency should be the base one? How shall the targeted zone be policed and kept within? How should an economy react if its currency is about to move outside the zone limits? The adoption of objective indicators or formal targets for macroeconomic policies in the major economies. Policy indicators could include the rate of growth of money supply, the Budget deficit, and changes in foreign reserves. Performance ones could include growth in GDP and domestic demand, the current account and unit labour costs. Intermediate ones could include real interest and exchange rates, and investment and savings ratios. The adoption of policy adjustments and new forms of co-operation between countries under the aegis of the IMF and other international bodies. As government policy decisions can indirectly affect exchange rates, there has to be more consultation and co-ordination of the policies of the major economies. Steps in the right direction of these last two options were made in the 1985 Plaza Accord and the 1987 Louvre Accords, which saw the major powers agree to implement sharp and symmetrical interventions, when necessary, try and reduce fluctuations.

9 However, they have not been as effective as hoped. Indeed, as the sharp fall of the US in 1995 reminds us, governments talked big about such co-ordination but did not follow it up with real action. As an international authority on these issues, Mr John Williamson of the Washington-based Institute for International Economics, has remarked: There is really nothing called co-ordination any more, in any sense. Indeed, international co-ordination in the 1990s has been made much more difficult by three factors: A tendency for foreign exchange markets to simply ignore such communiques and pleas, in the wake of an explosion of footloose money thundering around the world economy, taking advantage of interest rate and other such differentials. The failure of the US to do what the communiques suggest. For example, the 1995 G7 communique calls on the US to cut its Federal Budget deficit drastically and raise interest rates to help push up the $US - higher such rates encourage funds to flow to the US and thus push up the demand for the $US and its price. However, the Clinton Administration has domestic concerns to worry about. Higher rates and drastic deficit cuts could harm its short-term political position. An increased emphasis in individual countries on fine-tuning their own economies, rather than worrying about international co-ordination. The emphasis is now on sustaining non-inflationary growth and using fiscal policy to increase domestic saving. In other words, the feeling is that even when exchange rates overshoot, the best way to stabilise currency markets is for each economy to stick to improving its own economic fundamentals, rather than worry too much about the international monetary system. Would a return to the Gold Standard or the formulation of a New Bretton Woods be superior? While a return to the Gold Standard appears attractive, it would give great power to the world s major gold producers - Russia, South Africa and Australia - and would greatly restrict the ability of governments to use the printing press to finance their activities. For both reasons, a return to gold is unlikely. Similarly, a New Bretton Woods remains a hope rather than a likely reality. In 1994, a non-official Bretton Woods Commission was set up to offer guidance for the next 50 years of international monetary co-operation. It called for the setting up of a formal international agency to co-ordinate the economic policy making of the

10 major economies and greater policy convergence between them, so that exchange rate movements could be reduced. However, with no economy - and currency - dominant and the international economy dividing into great regional trading blocs, the world is very different to the Bretton Woods era, when the US economy and the $US reigned supreme. What we are more likely to see is the development of regional monetary systems but even these face great obstacles. Take the suggestion of a yen-based system in the Asia- Pacific region. It would face many obstacles, including the following: Countries which had suffered at the hands of the Japanese during World War II would oppose tying their currencies to the yen. It would impose too great a discipline on weaker economies. Governments of these would find it easier and more politically expedient to let their currency depreciate, rather than cut government spending sharply or push up interest rates to prevent capital outflow. While Japan remains a very strong economy its dominance in Asia is being increasingly challenged by later Asian industrialisers. Indeed, the very strength of the yen is harming the competitiveness of its exports, compared with those of its dynamic neighbours. What we have learnt What conclusions and lessons can be drawn from this heroic overview of a complex topic? The following stand out: Under the floating rate regime, exchange rate volatilities have been greater than expected. Currencies have "overshot" relative to textbook "fundamentals" and floating rates have not prevented the development of large - in some cases such as the US huge - current account imbalances. Economic life has become a lot more uncertain and volatile over the past 15 years and this has been reflected in exchange rate instabilities. As a result, forces which influence the value of one currency - such as changes in government policy - have a much greater and more immediate effect on exchange rates. However, there is now a greater realisation that external pressures on economies like ours are not the simple product of floating exchange rates. The openness of national economies and dramatic increases in economic and financial links between economies are more important. As capital markets have become much more international and volatile, the effects of capital movements have become harder to control, irrespective of what exchange rate regime a country follows.

11 In short, exchange rate movements are no quick-fix solution to the problems of an economy like Australia s. They cannot solve deep-seated balance of payments problems overnight. Australia s experience of the mid 1980s showed that only too clearly. The hope then was that a mere depreciation would stimulate exports and encourage import replacement, producing a J Curve effect on our balance of trade and current account deficits. A similar false hope was raised in the early 1990s, when the $A also depreciated for a period. These false dawns have forced us to accept that a depreciation is more a warning that the rest of the world is judging us poorly, rather than a simple salvation. Having hopped on a more flexible exchange rate tiger in late 1983 Australia has no choice but to keep riding it. Further suggested reading: Blundell-Wignall, A. (ed.), (1993), The Exchange Rate, International Trade and the Balance of Payments, Reserve Bank, Sydney, pp. 1-5; especially Clark, D. (1995), Economic Update 1995, Chapter 1 and graphs 18 & 19 IMF World Outlooks MacFarlane, I., (1993) "The Exchange Rate, Monetary Policy and Intervention", Reserve Bank Bulletin, December OECD Economic Outlooks, published in December and June each year The Financial Times surveys of the world economy - usually published in September each year. Appendix: Watching the $A There is no simple theory which explains movements in the $A - or any other currency. Generally though, the better our export prices, particularly the price we receive for key metals such as copper and aluminium the higher the $A. The converse also usually applies. Copper and aluminium prices are the ones to watch closest.

12 However, short-term fluctuations in the $A do not simply follow commodity price movements. There is also a fairly close relationship between the $A s value and the difference between our 10-year bond rate and similar rates overseas. For example, lower Australian rates relative to the rest of the world can produce a capital outflow and thus a fall in demand for the $A, followed by a depreciation in its relative value. A bad run of balance of payments figures can also send the $A sliding downwards. Forecasting movements in the $A is thus a real tea-leaf reading exercise. Often even the highest paid forecasters fail to get even the sign right in front of their forecasts - whether it will appreciate or depreciate - let alone the magnitude of the change. Nevertheless, the following description of how the Aussie generally has moved since the float in December 1983 is worth remembering: It climbs up the staircase and falls down the elevator shaft.