Do Flexible Exchange Rates Serve the Public Good?

September 3, 2010

While I was a graduate student in economics specializing in international trade and finance, a hot debate at the cusp between the 1960s and 1970s was whether the world and U.S. economies would be better served by the then-existing monetary system framed around fixed dollar parities or one in which market forces of supply and demand would be allowed to determine the value of exchange rates on a day to day, hour to hour, and even moment to moment basis. A considerable body of literature was developed on the issue, but market forces created by widely disparate trends in inflation and current account positions pre-empted the debate.  The old regime simply failed.  Former President Nixon ended the dollar’s gold convertibility in August 1971.  Following dollar devaluations in December 1971 and February 1973, a system of flexible exchange rates was launched in March 1973.

Many people owe their careers to that shift, including myself, so it was hard not to be subjective when considering if currency flexibility is preferable to a rigid but more predictable  international monetary environment.  In the beginning, relatively high inflation in the United States, Italy, and Britain made the fixed rate option look like a non-starter, but having floating exchange rates in fact promoted the very inflation disparities that drove the dollar lower in waves.  Dollar depreciation and internal U.S. inflation reinforced one another in a self-perpetuating vicious cycle that reached a crescendo in 1977-80.

Be that as it may, other developments reinforced the notion that flexible exchange rates indeed promoted general economic welfare.  The new system encouraged the dismantling of capital and foreign exchange controls, providing freer mobility of capital to its most productive uses and a series of multilateral agreements that pared back other barriers to business between countries.  Attempts to limit movements among the currencies of Europe, known as the EC snake and ERM (Exchange Rate Mechanism) proved to be crisis prone.  Government resources were no match for the rapidly growing global foreign exchange market.  The common currency, known as the euro, was supposedly an answer to that problem.  In order to speculate on the declining value of one currency, an investor needs to buy another.  Marry all of Europe’s national monies into one regional currency, and there would be no opportunity to make bets on one denomination of money against another.  This year has exposed the flaw in that logic; speculation simply shifts to long-term sovereign debt.  In the twilight of my career, I find myself revisiting the fixed versus flexible exchange rate debate, nevertheless. 

For one thing, the highly explosive growth of foreign exchange market turnover in the 1970s, those nascent years of flexible exchange rates, did not slow down nearly as much as had been widely anticipated.  The vast bulk of that expanded level of transactions represents a speculative bet in some sense, and volume has become far, far greater than needed to support underlying commerce.  The first U.S. turnover survey in 1969 counted up $17 billion of currency transactions in a single month, or $850 million per day.  The daily rate had grown to $5.3 billion by 1977, when the first of a a dozen triennial surveys was taken, and to $23.4 billion by 1980.  Only once, between 1998 and 2001, did volume shrink between successive surveys, and that was because the euro replaced eleven separately traded national currencies.  Over the 41 years between 1969 and 2010, foreign exchange trading volume in the United States expanded by 18.4% per annum.  And over the past nine years, global FX turnover rose by 13.8% per annum to a daily level of $3.98 trillion.

Also, the period since 2000 has been one of substantially slower real economic growth among the advanced industrialized economies like the United States, Japan, and much of Western Europe.  The succession of multilateral trade liberalization agreements collapsed.  It’s been an era of fantastic revolution in information processing and communication.  Algorithmic computer-driven models represent a huge chunk of the wholesale market these days, and barriers to retail trading have been stripped down, fueling that element of the market with a proliferation of web sites offering platforms for trading and reams of information.  Big money can be won but also lost in jiffy through on-line currency trading.  In an economy where traditional employer/employee jobs are scarce, the lure of forex trading is powerful, and rewards more than ever go to those who can game the system in the shortest of time frames.

Trading activity based on a short-term time frame may still guide markets more or less toward appropriate market-clearing equilibriums, but a considerable amount of volatility is created along the way.  In the past nine months or so, the euro declined 21.6% from $1.5149 around Thanksgiving 2009 to a low of $1.1878 early this past June, but then rebounded over the next two months by some 12% to $1.3333.  The euro had sunk over 5% to $1.2626 earlier this week, but rose 2% subsequently.  In many weeks, high-low spreads on key currency relationships transcends movement in the underlying trend.  The New Zealand and Australian dollars this past week traded within ceiling/floor boundaries that surpassed 3.5%.  Currency moves, even in the long run, do not necessarily reward good fundamentals.  Japan, a prime example, experienced price deflation, scant real economic growth of 0.7% per annum over the last ten years, extremely low long-term interest rates, and government debt that climbed to almost 200% of GDP, yet the yen is at 15-year highs against the dollar.  During the great recession, the yen soared as much as 61% from 170.0 per euro in July 2008 to 105.44 ten days ago. 

The main factor that blew apart the Bretton Woods system of fixed exchange rate, very disparate rates of internal price inflation, is now a non-issue.  The other stress on the old system, a big U.S. external deficit and some large deficits elsewhere, persists.  However, the role of dollar exchange rates in creating those imbalances is suspect.  Dollar declines of 77% against the Swiss franc,  61% against the mark and 76% against the yen since 1969 haven’t eradicated the U.S. deficit or Swiss, German and Japanese surpluses.

A backlash against globalization is one of the most powerful phenomena of the twentieth century.  It is manifested in Islamic terrorism and the crackdowns on undocumented people living in Europe and the United States.  The purpose served by flexible exchange rates for almost four decades was more constructive to the world economy earlier than it seems now.  Greater elements of government interference in currency markets may be an idea whose time is returning.  The political impetus for such would be greater if the growth of GDP and jobs in advanced economies remains unacceptably low as I expect.  And as Asia evolves into an ever-growing share of the world economy, that region’s predisposition for greater currency market micro-management may induce a compromised international financial system between Asia’s comfort level and the U.S.-dictated system that has prevailed since 1973.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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One Response to “Do Flexible Exchange Rates Serve the Public Good?”

  1. Jimbo says:

    The big issue here seems to be the Yuan. The dollar is strengthening and the Euro going down.
    What is China going to do since its biggest trading partner, Europe, has a weaking currency with no immediate end in sight?

    P.S. Keep up the indepth articles. Great!