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Essay/Term paper: Floating exchange rates: the only viable solution

Essay, term paper, research paper:  Economics

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Floating Exchange Rates: The Only Viable Solution

Stentor Smith

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 float freely.

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 return.

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

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.


Becker, Gary S. "Forget Monetary Union--Let Europe's Currencies Compete."
Business Week 13 November 1995: 34.

Brooks, David. "A First Class Eurocrat." The American Spectator March 1992: 46-

"Currency Reform: A Brief History of Funny Money." The Economist 6 January 1990:

Dowd, Kevin. "European Monetary Reform: Pitfalls of Central Planning." USA Today
March 1995: 70-73.

Eichengreen, Barry and Charles Wyplosz. "Mending Europe's Currency System." The
Economist 5 June 1993: 89.

"Europe's Currency Tangle." The Economist 30 January 1993: 21-23.

"Europe's Totem Pole." The Economist 23 September 1995: 14-15.

"Fixed and Floating Voters." The Economist 1 April 1995: 64.

Frenkel, Jacob A. and Morris Goldstein. "Europe's Emerging Economic and Monetary
Union." Finance & Development March 1991: 2-5.

Friedman, Milton. "Free-Floating Anxiety." National Review 12 September 1994:

_________,"Introduction." The Merits Of Flexible Exchange Rates. Ed. Leo Melamed.
Fairfax, Virginia: George Mason University Press, 1988. xix-xxv.

Habermeier, Karl and Horst & Ungerer. "A Single Currency for the European
Community." Finance & Development September 1992: 26-29.

Hoffman, Ellen. "One World, One Currency?" Omni June 1991: 51+.

Hornblower, Margot. "No One Ever Said It Would Be Easy." Time 1 March 1993: 32+.

"Interview with Alan S. Blinder." The Region December 1994. Online. Kimberely.

Javetski, Bill and Patrick Oster. "Europe: Unification for the Favored Few."
Business Week 19 September 1994: 54.

Krugman, Paul R. "Europe's Fatal Monetary Vision." U.S. News And World Report 16
August 1993: 45.

Lawday, David and Warren Cohen. "Capsizing Currencies." U.S. News And World
Report 16 August 1993: 43-45.

Lewis, Flora, et al. "Is Monetary Union a German Racket?" New Perspectives
Quarterly Winter 1993: 26-38.

Lewis, Paul. "Role Shifts for Central Bankers." The New York Times 15 November
1994: D1.

Magnusson, Paul. "The IMF Should Look Forward, Not Back." Business Week 3
October 1994: 108.


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