Floating Exchange Rates: The Only Viable Solution
Elizabeth M. Boschee
Edina High School
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
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" (Whitney 19).
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 (Whitt 11).
In addition, many nations are in different stages of their overall economic
cycles ("Gold Standard" 79). 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 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 ("The Way Ahead" 22), 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 don't 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; Wood 8).
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 labour force?"
("Currency Reform" 18) 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
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 don't 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 which 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 were 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" ("To Phrase a Coin" 14). 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 posits, 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 (Rolnick and Weber 33), 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. The 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.
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