Read an Excerpt
Approaches to Greater Flexibility of Exchange Rates
The Burgenstock Papers
By C. Fred Bergsten, George N. Halm, Fritz Machlup, Robert V. Roosa
PRINCETON UNIVERSITY PRESSCopyright © 1970 Princeton University Press
All rights reserved.
Toward Limited Flexibility of Exchange Rates
GEORGE N. HALM
In its 1964 report on the balance of payments, the Joint Economic Committee of the United States Congress recommended that "the United States, in consultation with other countries, should give consideration to broadening the limits of permissible exchange rate variations," and in its March 1965 Report it urged once more a study of this idea: "Broadening the limits of exchange rate variations could discourage short-term capital outflows through free market forces, on which we should continue to place our main reliance; permit greater freedom for monetary policy to promote domestic objectives; discourage speculation against currencies by increasing the risk; and to some extent promote equilibrating adjustment in the trade balance...."
Noting again, in August 1965, that it was unaware that any exploration of the advantages and disadvantages of widening the limits of exchange-rate variation had occurred since it had first recommended such study, the Joint Economic Committee expressed the opinion that "to ignore promising proposals for improvement would appear to us a luxury which the free world can ill afford. We do not insist that broader limits for exchange rate variations be adopted, for we have not fully explored their implications nor weighed any possible disadvantages against the benefits we recognize. But we do insist that the expertise of the administration be brought to bear on the idea and that it receive the serious consideration which it merits."
There is no published evidence to the effect that the administration has heeded the urgent appeal of the Joint Economic Committee, which was equally disregarded by other governments, the International Monetary Fund, and the Group of Ten.
Today, three years later, the situation is still unchanged. In September 1968, the Joint Economic Committee repeated its recommendation of a wider band "in view of the persistent international deficits on the part of the United States, the widespread imposition of autarchic restrictions on trade and capital flows in response to reserve losses, and an incipient rise in protectionist sentiment both in this country and the rest of the world." The International Monetary Fund and the Group of Ten, however, continue to insist, at least publicly, that the present system of fixed, though not unalterably fixed, parities has worked well. Nevertheless, it is obvious that the present arrangements have not been working smoothly. They have led to repeated crises of confidence, to political tensions between Europe and the United States, and even to the introduction of quantitative controls that contradict our professed desire for increased freedom in international economic transactions. These difficulties have not been exclusively caused by exogenous forces; they are to a large extent the result of major defects inherent in a system that tries to join together incompatible elements.
One such defect concerns the use of dollar balances as the main source of additional international liquidity reserves. A constant growth of foreign-held dollar balances implies a continuous external deficit of the United States and, considering the gold convertibility of official foreign dollar balances, a deterioration of the United States' net reserve position. The present handling of the liquidity problem, therefore, decreases confidence in the system. The forthcoming creation of Special Drawing Rights may eventually end this dilemma. But the SDR scheme is to come into operation only after a drastic reduction in the deficit of the United States — a dangerous policy that, if adopted, would make the situation worse before it became better. Reforms of the international monetary system must pay careful attention to the problems of transition from old to new arrangements.
Another basic weakness of the present international monetary system comes from the fact that the system is based on fixed, though not unalterably fixed, exchange rates, together with free convertibility of the major currencies into one another — and of dollars into gold — at fixed parities. In spite of all assurances to the contrary, this so-called adjustable-peg system has shown itself to be a poor compromise between fixed and flexible exchange rates. The reason is obvious. A combination of fixed exchange rates, currency convertibility, and imperfect harmonization of the national economic policies of the member countries cannot work well. As soon as national economic policies diverge — as when, for example, different rates of inflation prevail — fixed exchange rates become disaligned rates, even if they had originally been correct or "equilibrium" rates. Disaligned rates give wrong signals to international trade, international capital flows, and domestic production in the various countries. External and internal tensions will then lead to growing insistense that these "fundamental disequilibria" be corrected through devaluations of deficit and upvaluations of surplus currencies; and these discrete peg adjustments, once they have become unavoidable, will cause severe shocks in the market economies in which wrong price signals have been permitted to lead to misallocations.
In failing to solve the adjustment problem, the adjustable-peg system intensifies the weaknesses of the reserve-currency system. A deficit country with an overvalued currency can maintain convertibility only so long as it possesses a sufficient supply of foreign exchange; and a financial crisis caused by peg adjustments leads to an additional emergency demand for liquidity reserves. This explains the present overemphasis on the liquidity problem. The dilemma becomes critical when doubts in the maintenance of the dollar-gold parity lead to attempts to eliminate the external deficit of the United States before a new system has been firmly established. The new system should not only provide for international liquidity reserves independent of a continued deficit of the United States, it should reduce the demand for liquidity reserves through a better adjustment mechanism.
We ought to find out whether greater exchange-rate flexibility can provide the presently lacking adjustment mechanism and, if so, how greater exchange-rate flexibility can be built into the international monetary system.
The Case for Fixed Exchange Rates
Considering the obvious shortcomings of today's international monetary system, it is, at first, surprising that fixed exchange rates meet with the almost unanimous approval of bankers, businessmen, and government officials. If it concerned other prices of strategic importance (such as wages or interest rates), these same persons would oppose a policy of administrative price fixing as inconsistent with the basic principles of a market economy. They know that price fixing tends to lead to quantitative restrictions and eventually to bureaucratic administration of the economy from the center. Why, then, should exchange rates be an exception from this rule?
The main argument is that fixed exchange rates provide a firm and reliable basis for international trade and international financial transactions. If, however, fixed exchange rates can only be maintained by influencing demand and supply conditions on the foreign-exchange market through substantial changes in domestic economic policies or even through quantitative restrictions, the cost of a fixed-rate system can exceed its benefits.
As far as quantitative restrictions are concerned, the case for fixed exchange rates is difficult to uphold. In introducing exchange controls, we abandon the principles of the market economy. If we want currency convertibility and multilateral trade, we cannot argue for fixed exchange rates once they are sustainable only via quantitative restrictions.
Whether and to what extent monetary and fiscal policies ought to be employed to maintain currency convertibility at fixed exchange rates is an open question. The answer will depend on such circumstances as the relative importance of foreign to domestic transactions, the existing price elasticities, and the relative emphasis on domestic or external balance. Where downward price and wage inflexibilities prevail, the maintenance of fixed exchange rates may imply undesirable results in terms of employment and growth. The cost of maintaining convertibility at fixed exchange rates may then exceed the benefits, and it can no longer be taken for granted that fixed rates are better than flexible rates. The fact that the U.S. Government found it advisable to introduce quantitative restrictions in lieu of monetary measures shows that the costs of contractionist policies were considered too high.
The following remarks on arguments for fixed exchange rates are incomplete; they merely try to show that the prevalent wholesale rejection of arguments for exchange-rate flexibility is not justified, particularly when we keep in mind that the present system of international payments permits discrete peg adjustments in the case of fundamental disequilibrium.
The strong attachment of central bankers to fixed exchange rates is easy to understand. Only when the monetary authorities are duty-bound to convert the national currency freely into other currencies at fixed parities, will these authorities be induced to harmonize, as best they can, their national monetary policies with those of the other members of the international payments system. We are told that only the fear of running out of liquidity reserves will assure the necessary monetary discipline and the harmonization of national credit policies. Having received the mandate to defend the exchange value of the national currency and to maintain its free convertibility, the central banker is upheld in his political struggle inside the government (for example, against inflationary deficit spending) and outside (for example, against pressure groups with monopolistic market influence who press for "permissive" money creation).
While much can be said for this argument, it is not correct to assume that discipline is exclusively fostered by the fear of losing liquidity reserves and of endangering convertibility. Maintenance of convertibility can no longer be used as an argument in the defense of fixed exchange rates once exchange controls have been introduced and full convertibility has thereby been abandoned. Furthermore, the size of the liquidity reserves is not the only gauge by which the central bank can judge the international position of the currency. "After all, exchange rate movements are very clear and loud warning signals. They are much more noticeable by the public than are reserve movements. It seems reasonable to expect that, in deficit countries of major importance as well as in surplus countries, clearer signals would gradually increase rather than reduce effective pressure toward responsible behavior."
The argument that fixed exchange rates foster monetary discipline rests on the assumption of limited, reserves. However, some advocates of fixed exchange rates want to soften the impact of an external imbalance on domestic policies through the supply of very large liquidity reserves. This, for example, is the attitude of Sir Roy Harrod, who considers fixed exchange rates advisable because a depreciation of the national currency would imply increasing import prices and interfere with an "incomes policy" that tries to keep wages and prices in line by moral suasion rather than by the use of monetary instruments. But, if an incomes policy is to be substituted for monetary and fiscal measures, we have to doubt the ability of the country to maintain a given fixed exchange rate in the long run. Peg adjustments will then become unavoidable and may prove more damaging than flexible exchange rates to the success of an incomes policy.
Most of the reasoning in favor of fixed exchange rates can be applied only to permanently fixed rates. In the adjustable-peg system the monetary authority can count on the International Monetary Fund's permission to alter the gold parity of the national currency in the case of "fundamental" disequilibrium. Once parity adjustments are permissible, most of the arguments for fixed exchange rates collapse: the long-run transactions no longer rest on the safe foundation of a stable international value of the currency unit; monetary and fiscal policies are no longer forced to defend international liquidity reserves through inconvenient domestic policies; and harmonization of national credit policies can no longer be counted on, with the result that needed adjustments are brought about belatedly and abruptly through devaluations and upvaluations. Emphasis in recent years on liquidity rather than adjustment indicates the increasing erosion of the very discipline and harmonization on which the advocates of fixed exchange rates try to rest their case.
The Case for Freely Flexible Exchange Rates
Consistent application of the principles of a market economy argues for exchange rates that would be free to adjust automatically to changing conditions of demand and supply in the foreign-exchange market. Automatic exchange-rate variations would bring about external equilibrium by changing directly and instantly the prices of all commodities in terms of other countries' monetary units. In a system with fixed exchange rates, on the other hand, balance-of-payments adjustments are the result of a long-delayed, roundabout, and painful process through alterations of aggregate spending that exert deflationary and inflationary pressures, often with undesirable consequences for the national economies.
It is easy to ridicule a system with freely fluctuating exchange rates by exaggerating the claims of the advocates of greater flexibility. It can be doubted that the latter really expect that exchange-rate variations would "automatically offset the impact of disparate national policies upon the international pattern of prices and costs ... without any interference with each country's freedom to pursue whatever internal monetary and credit policy is chosen." Overstatements like these prevent serious discussion. A system with freely fluctuating exchange rates could not work satisfactorily in a country with endemic inflation, but neither could other payments systems with free convertibility be successful under similar conditions. The very mention of exchange-rate flexibility seems somehow to convey the idea that one would have to expect either self-aggravating depreciations or extremely wide fluctuations or, finally, an irresistible urge to practice competitive exchange depreciation. It is evidently taken for granted that to stray from the virtuous path of exchange-rate rigidity would mean the end of both national monetary discipline and international cooperation.
This view is overly pessimistic. Easing constraints on domestic economic policies may, on the contrary, improve the internal equilibrium of an economy, with beneficial results for the other members of the international payments system. How widely the exchange rates fluctuate will depend on the degree of international economic harmonization that can be achieved under the realistic assumption that each member of the system tries to reach high employment and income levels. The exchange-rate variations needed for the achievement of both external and internal equilibrium may be modest A system with flexible exchange rates does not postpone the adjustment process and is likely, therefore, to avoid the development of discrepancies that, under a system of fixed exchange rates, may eventually lead to adjustments of parities or the introduction of quantitative restrictions.
Excerpted from Approaches to Greater Flexibility of Exchange Rates by C. Fred Bergsten, George N. Halm, Fritz Machlup, Robert V. Roosa. Copyright © 1970 Princeton University Press. Excerpted by permission of PRINCETON UNIVERSITY PRESS.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.