I favor a regime of currency flexibility as a practical way to deal with the need for differing monetary policies and different national economies. While in theory, either fixed or flexible exchange rates can work, in practice, fixed exchange rates or exchange rate targets have been counterproductive. This is because fixed exchange rate regimes tend to impose the same monetary policy on different economies whose differing needs may require different monetary policies. Some specific examples of difficulties over the last thirty years serve to reinforce the point.
The struggle to preserve the Bretton Woods system of fixed exchange rates in the late 1960s until August of 1971 illustrated the problems with pegged currencies for advanced industrial countries. During the late 1960s, when the United States pursued more inflationary policies than Europe and Japan, the dollar became overvalued. In an attempt to peg the U.S. dollar exchange rate, counterproductive restrictions on U.S. capital flows were put in place. The final, disruptive collapse of the Bretton Woods system in August of 1971 ushered in a period of flexibility among the exchange rates of most G-7 countries. The attempt to re-peg currencies in December of 1971, under the Smithsonian Agreement, was unsuccessful. The pegged exchange rate regime ended with the abandonment of currency pegs in February of 1973, just in time to avoid the currency chaos that would have ensued in financial markets if fixed rates had been in place when the oil crisis hit in the fall of 1973.
In 1992 it proved unworkable to maintain fixed exchange rates within the European currency system. The British pound, the Italian lira, and the Spanish peseta were allowed to float down after Germany was forced to follow tighter monetary policies to avoid the inflation associated with currency union between East and West Germany. Despite dire predictions of inflation that would follow, the trio of European countries that devalued their currencies prospered without inflation. Spain and Italy were able to join the European currency union on schedule while Britain’s economic performance was enhanced by the freedom to pursue its own monetary policy separate from that of Europe.
Today in Europe, excluding the United Kingdom, the European Monetary Union is imposing a single monetary policy on all of Europe. The stresses are beginning to show as Spain’s economy heats up while the economies of Italy and Germany are weaker. These economies require different monetary policies and yet none are available under the single currency arrangement that is an extreme form of exchange rate fixity. Time will tell how durable the exchange rate mechanism in Europe will be.
One of the most dramatic illustrations of the danger of pegged exchange rates came with the Asian crisis that emerged in the spring of 1997. Pegging the currencies of emerging Asian markets like Thailand, South Korea, and Indonesia to the U.S. dollar created the illusion of fixed exchange rates and tempted business to borrow heavily in dollar-denominated loans. Too much borrowing and too much investment led to excess capacity and an inability to service debts. When the links to the dollar collapsed, as they did in most of emerging Asia, the excess capacity and heavy dollar borrowing proved a lethal combination for emerging markets. As a result, the Asian crisis was far more intense and prolonged than many had expected.
Pegging currencies in an environment of excess capacity and deflationary pressure adds to that deflationary pressure. The IMF’s initial approach to the currency crises in emerging Asia (tighter monetary and fiscal policy) proved disastrous since it exacerbated the conditions of excess capacity. In fact, the tighter monetary and fiscal policies left a weaker currency as the only way to stimulate demand in those economies.
The lessons from the Asian crisis, as Secretary Rubin has acknowledged in an April 1999 statement, are that IMF efforts to peg currencies of emerging economies by enforcing tighter monetary and fiscal policies are counterproductive. In Secretary Rubin’s view, currencies should either be allowed to float freely or irrevocably pegged through the use of a currency board. In my view the currency board solution is a dangerous one for emerging economies, especially in a world of excess capacity, as it tends to force deflationary policies on countries trying to satisfy the conditions necessary to maintain a currency peg to the dollar. Those policies will be deflationary if the dollar is strong, as it has been over the past several years. Argentina, with its currency board, is currently suffering from the deflationary policies necessary to maintain its rigid currency peg to the dollar. Wages and prices in Hong Kong—and in China—are falling sharply due to currency pegging.
One by one the currency pegs in emerging markets, Asia, Russia, and Latin America have given way. In fact, the experience of countries like Mexico that have maintained a flexible currency policy since 1995 and Australia, with its floating currency, have suffered less from the problems of excess capacity that have plagued emerging market economies since 1997.
I do not mean to suggest that allowing currencies to depreciate is a costless panacea to all the problems that can confront emerging markets. But, in a deflationary global environment where problems of excess capacity are widespread, avoiding devaluation essentially means following deflationary policies that are dangerously destabilizing. Since the policies ultimately fail and create disruptive market conditions as they do fail, it is better to acknowledge in advance the need for currency flexibility.
The IMF’s approach to forcing currency fixity on developing economies is especially disruptive. Beyond forcing deflationary policies on those countries, it forces IMF officials to make dire statements about the consequences should currency pegs be broken. In June of 1998, IMF officials assured global financial markets that allowing the Russian currency peg to break would lead to disaster— even citing the possibility of nuclear threats from a destabilized Russia. The IMF lent the Russians $5 billion, which promptly went out of the country before the Russians not only devalued but also defaulted on their debt. The attempt to maintain a currency peg for Russia was far more destabilizing than simply allowing the currency to float downward as it became clear that the Russians were simply unable to maintain the peg. Russia continues to have a more serious problem insofar as it cannot collect the revenues necessary to meet the government’s basic commitments and more borrowing is impossible in view of its default. However, maintaining a currency peg does nothing to solve that problem. The IMF has elected to lend Russia another $5 billion to enable it to repay the IMF the $5 billion it borrowed last August. If that sounds oddly circular, it should.
The latest example of an ill-advised effort to peg the currency of an emerging economy came in the case of Brazil. In November of 1998, a Brazilian package was put in place that included a commitment by the Brazilians to maintain a currency peg. In January of 1999, the Brazilians allowed their currency to be devalued in the face of heavy deflationary pressure. Since then, the Brazilian situation has stabilized somewhat due partly to the accommodative monetary stance of the Federal Reserve and the favorable effect on global financial markets.
China is the remaining developing economy that has maintained a currency peg at the expense of rising deflationary pressure. Since the Chinese currency is not convertible, it is feasible for China to maintain a currency peg indefinitely, although not advisable. China continues to suffer from considerable excess capacity and a broad set of problems associated with too much state lending to non-viable, state-owned enterprises. Again, while all of these problems would not be addressed by allowing the currency to float, insisting on maintaining the peg of the Chinese currency to the dollar has made China’s deflationary problem worse.
Today’s most serious deflationary problem—Japan—could be somewhat alleviated by a policy of easier money that would include a sharp depreciation of the yen. This would help Japan in two ways. It avoids the deflationary consequences of a shrinking export sector which produced a drag of 1.2 percentage points on Japan’s negative 3.5% growth rate during the fourth quarter of last year. The ill-advised U.S. policy to push up the yen last June resulted in increased deflationary pressure in Japan and the global economy and contributed to the difficulties in Asia and the rest of the world over the balance of 1998.
A second reason to allow a weaker currency associated with a reflationary monetary policy in Japan would be to accelerate restructuring there. Many valuable franchises exist in Japan that foreign investors would buy at an accelerating pace given a cheaper yen. Japan desperately needs to accelerate the restructuring of its economy but domestic managers appear reluctant to follow this course. A weaker yen that accelerates purchases by American and European businesses of Japanese enterprises would accelerate the restructuring process and help Japan start to contribute to world economic growth.
Pressures for a return to exchange rate fixity continued unabated in many official circles in today’s economy. G-7 ministers, especially those in Europe and Japan, constantly propose efforts to re-peg currencies as a means to stabilize capital markets. The experience of the past thirty years demonstrates that pegging currencies where monetary policies are not fully coordinated is, in fact, destabilizing.
The only way I can account for the official preoccupation with pegging exchange rates in much of the global economy today suggests confusion in the minds of many policymakers whose primary preoccupation in the postwar period has been fighting inflation. Today, twenty years after the battle against global inflation was being fought, many of these central bankers in the IMF have replaced the productive goal of avoiding inflation during an era of excess demand, such as prevailed through the early 1980s, with the deflationary goal of preventing currency devaluations during an era of excess supply that has emerged late in the twentieth century. The prevalence of excess capacity (supply) has meant that the battle of currency devaluations has been lost in the developing countries of the world with the list of losers extended from Thailand, Indonesia, and South Korea in 1997 to Russia in 1998 and Brazil in 1999. After devaluation, most of these countries have experienced relief from the deflationary pressures that attempting to maintain currency pegs have brought on, although the problems of Indonesia and Russia go well beyond those associated with a currency regime. Still, currency devaluations have been preferable to currency pegging in the deflationary world that has emerged in the late 1990s.
Mr. Chairman, with your permission, I would like to append my testimony today with a longer article on the experience over the last ten years of industrial and developing economies with devaluations. Uniformly, the much-feared inflation has not materialized and the economies have performed better as indicated by rising equity markets. Again, the lesson is the same. Currency devaluations are not a panacea and, in some cases, currency revaluations are needed as in the case of Germany in the early 1990s. The basic point is that unless different economies wish to maintain the same monetary policy, currency pegging is simply an unrealistic goal. Emerging markets that peg to the dollar are very unlikely to wish to follow the same monetary policy pursued by the Federal Reserve in the interests of maintaining stable prices in the United States. Allowing currency flexibility against the dollar is simply an acknowledgement of that fact and is likely to lead to a more stable international financial system.
John H. Makin is a resident scholar at AEI.