Dear Sir,

Jeffrey Frankel makes the intriguing proposal that Iraq should define the value of the dinar as one third of a dollar plus one third of a euro plus one hundredth of the price of a barrel of oil. (A Crude Peg for the Iraqi dinar). The basic weakness of this proposal is that it amounts to only a mildly watered down variant of a fixed exchange rate system. Professor Frankel’s own analysis correctly suggests that the vicissitudes of international oil prices makes the adoption of a fixed exchange rate regime for a highly oil dependent country like Iraq a very risky proposition.

A basic point that Professor Frankel’s analysis overlooks is that the volatility of Iraq’s future oil export earnings is as much, if not more, a function of the level of its oil production than of the international oil price. Having the second largest proven oil reserves in the world, Iraq is theoretically capable of producing almost as much oil as Saudi Arabia. However, recent events in Iraq’s chaotic oil sector would suggest that there is great uncertainty as to where Iraqi oil production might be in the next three to five years. Will it be closer to the pre-Iraq war production level of 2 million barrels a day or closer to the potential 8 million barrels a day that Iraq can produce? The compounded uncertainty of Iraq’s future oil production level and of the future path for international oil prices would seem to leave Iraq little realistic option but to choose a flexible exchange rate regime.

The notion that emerging market economies need fixed exchange rate anchors and are incapable of managing a floating exchange rate would seem to be belied by the recent successful experiences of Brazil and Mexico with floating exchange rate regimes. After bitter experience with fixed exchange rate type regimes, both of these countries have found that managing a floating exchange rate in the context of an inflation-targeting regime with a more independent central bank offers a more viable anchor than did the fixed exchange rate regime.

Desmond Lachman is a resident fellow at the American Enterprise Institute.