AVERTING CURRENCY CRISES
T H E F I X I S O U T
Fixing exchange rates is
not necessarily the way to solve
Mr. Friedman is a senior fellow at the Hoover Institution.
Split infinitive. The English-speaking world may be divided into 1) those who neither know nor care what a split infinitive is; 2) those who do not know, but care very much; 3) those who know and condemn; 4) those who know and approve; and 5) those who know and distinguish.
1) Those who neither know nor care are the vast majority, and are a happy folk, to be envied by most of the minority classes. . . .
SUBSTIUTE ``devaluation'' for ``split infinitive,'' and Fowler's classification is an accurate statement of the present range of opinion on international currency arrangements.
Class 1 is indeed the vast majority. Class 2 includes most financial journalists and participants in the stock market; class 3 has at its helm the editorial page of the Wall Street Journal; class 4 consists mostly of currency speculators; class 5, of most professional economists. It will come as no surprise that I include myself in class 5.
The recent spate of currency crises in Asia has activated the members of class 3. The Wall Street Journal editorial page writes: ``we think that devaluing a currency invariably causes more problems than it cures; the alternative would be sharply tightening monetary policy and forcing the economy to adjust'' (italics added). A few examples suggest that this position is untenable as a general rule, though correct if often is substituted for invariably.
Chile, 1982. In June, 1979, Chile, which had been allowing its exchange rate to fluctuate, pegged its peso to the U.S. dollar; that is, it specified a fixed rate at which the Chilean central bank stood ready to exchange pesos for U.S. dollars and U.S. dollars for pesos.
All went well for two years. Then the Federal Reserve, with the support of the newly elected President, adopted a severely restrictive monetary policy in order to stem the inflation of the 1970s. That change plus the accompanying Reagan tax and regulatory policies led to a major rise in the foreign-exchange value of the U.S. dollar. Chile followed the Wall Street Journal's advice to the letter by ``sharply tightening monetary policy and forcing the economy to adjust.'' The result: economic collapse, with real output falling by 14 per cent in 1982. If Chile had not pegged the peso to the dollar but had continued to let the exchange rate fluctuate, the peso would have depreciated relative to the U.S. dollar while remaining fairly stable relative to other major currencies. Chile might still have experienced a recession, but if so, it would have been a slowdown in a rapidly growing economy, not an economic collapse. In August 1982, Chile abandoned the peg. By 1984, the economy was growing again at the annual rate of 6 per cent. A costly lesson.
East Asia, 1997. By contrast with the Chilean episode, the major source of the Asian currency crises was not U.S. monetary policy but domestic monetary policies. The central banks of the countries involved tried to achieve two objectives -- peg the exchange rate and promote domestic expansion -- with a single instrument: control of the domestic money supply (more precisely, the banks' own liabilities). The resulting domestic inflation led to overvalued exchange rates. Most of the countries tried ``sharply tightening monetary policy and forcing the economy to adjust,'' though, wisely, for only a short time. As the Chilean example suggests, refusing to devalue promptly would almost surely have produced a severe depression ending in devaluation under worse economic conditions. The initial mistake was pursuing an excessively expansionary monetary and fiscal policy. Not devaluing would have been a second mistake that would only have increased the harm done by the first mistake.
The Asian currency crises are the latest example of a long series of similar crises dating back at least to Diocletian. Time and again a country has set a fixed price for its currency in terms of an external asset -- traditionally, gold or silver; more recently, the currency of a major country, such as the U.S. dollar. And time and again, countries have rebelled at the external discipline, often, as in Britain in 1797 and 1914 and in the U.S. in 1862, to facilitate the financing of war by the issue of fiat money.
Since the end of World War II and the triumph of the Keynesian revolution, discretionary monetary policies to influence the domestic economy have become the rule. Conflict between these policies and the external discipline of a fixed exchange rate have become the major reason for rejecting the external discipline, as in the recent Asian episode.
Hong Kong, 1997. The contrast between Hong Kong -- whose currency has remained fixed in terms of the U.S. dollar, despite a serious financial crisis set off by fears of devaluation -- and the other East Asian countries illustrates the difference between two superficially similar but basically very different exchange-rate regimes, both referred to as ``fixed exchange rates.''
One such regime is a pegged exchange-rate system under which national central banks undertake to maintain the value of their currency at a fixed rate in terms of a commodity or another currency. That is the system that was set up at Bretton Woods in 1946. The U.S. agreed to peg its currency to gold (at $35 an ounce), and the other participating countries agreed to peg their currencies to the U.S. dollar. The system did not come into full operation until 1959, started to come apart in 1967, and collapsed in 1971, when President Nixon ``closed the gold window,'' i.e., refused to honor the obligation that the U.S. had assumed at Bretton Woods.
The other ``fixed exchange rate'' regime is a unified currency: the dollar in the fifty states of the United States and Panama; the pound sterling in Scotland, England, Wales, and Northern Ireland. The gold standard before World War I is a slightly more complex example: the pound, the dollar, the franc, and the Mark were simply different names for specified amounts of gold, and the various countries stood ready to exchange their national currencies for those amounts of gold or, conversely, gold for national currencies.
The Hong Kong dollar is another example. Since its currency reform of 1983, Hong Kong's dollar has been unified with the U.S. dollar. A currency board, the Hong Kong Monetary Authority, assures that Hong Kong dollars are printed only on the deposit of the appropriate amount of U.S.-denominated assets (one U.S. dollar for every 7.8 Hong Kong dollars). As a result, the dollar assets held by the Monetary Authority are more than adequate to enable it to redeem every Hong Kong dollar outstanding. Hong Kong does not have a central bank and does not conduct a discretionary monetary policy. Its monetary policy is made in Washington at the Federal Reserve Board. Thus the Hong Kong decision to unify its currency with the United States' is based on the implicit assumption that U.S. monetary policy will be better than the policy that would be followed by a Hong Kong central bank.
Though currency boards have a long history, they have only recently re-emerged as a current option for individual countries. Argentina, Estonia, and Lithuania have recently adopted currency boards. As I wrote in 1972, ``For most [developing] countries, I believe the best policy would be . . . to unify its currency with the currency of a large, relatively stable developed country with which it has close economic relations, and to impose no barriers to the movement of money or prices, wages, or interest rates. Such a policy requires not having a central bank.''
IN December 1991, political leaders approved the Maastricht Treaty, which committed the European Community to replacing the European Monetary System with a single European Central Bank that would issue a single currency, the Euro. A common currency is an excellent monetary arrangement under some circumstances, a poor monetary arrangement under others. Whether it is good or bad depends primarily on the adjustment mechanisms that are available to absorb shocks that impinge differentially on the various entities using a common currency.
The United States is an example of a situation favorable to a common currency. Though it is composed of fifty states, its residents overwhelmingly speak the same language, watch the same television programs, see the same movies; can and do move freely from one part of the country to another; goods move freely from state to state; wages and prices are reasonably flexible; and the national government raises in taxes and spends roughly twice as much as state and local governments. Fiscal policies differ from state to state, but the differences are minor compared to the common national policy. Unexpected shocks may well affect one part of the country more than others -- as for example the embargo on oil did in the 1970s, creating boom conditions in some states, and depressed conditions in others. The different short-run effects were soon mediated by movements of people and goods, by offsetting financial flows from the national to the state and local governments, and by adjustments in prices and wages.
By contrast, the European Community exemplifies a situation unfavorable to a common currency. The residents of its component nations speak different languages, have different customs, and have far greater loyalty and attachment to their own countries than to the idea of ``Europe.'' Although it is a free-trade area, goods and capital move less freely than in the United States. The member countries, not the European Community and its agencies in Brussels, are the important political entities. Government spending by them dwarfs spending by Brussels. Regulation of industrial and employment practices is more extensive than in the United States, and differs more from country to country than ours does from state to state. Wages and prices are more rigid, and labor less mobile.
In those circumstances, flexible exchange rates are a powerful adjustment mechanism for shocks that affect various entities differently. Any favorable or unfavorable shock that affects only one or a few countries can be met by a change in one price, the exchange rate, rather than requiring changes in thousands on thousands of separate wages and prices. It is worth dispensing with this mechanism to gain the advantage of lower transaction costs and external discipline only if there are adequate alternative adjustment mechanisms.
The 1992 crisis in the European Monetary System, which was a reaction to the financial impact of German reunification, is a striking example of this proposition. France followed a so-called ``franc fort'' policy, adopting a tight monetary and fiscal policy to preserve the link between the franc and the Deutsche Mark. It has since suffered double-digit unemployment, and economic recession. Britain and Italy chose to let their exchange rates float. Both have since prospered, achieving lower unemployment and faster growth than the countries that maintained the peg between their currencies and the Mark. And they have done so while keeping inflation in check.
Proponents of the Euro often cite the gold-standard era from 1879 to 1914 as demonstrating the benefits of a common currency. The gold standard did have some benefits, but it also had its costs. The price level fell from 1879 to 1896 and rose thereafter, and sharp fluctuations occurred within each period, especially serious in the 1890s. The standard was viable only because prices and wages were flexible, governments were small -- spending in the neighborhood of 10 per cent of national income rather than 50 or more as now -- and the public was willing to tolerate, or had no way to moderate, wide swings in output and employment. Take away the rose-colored glasses and it was hardly a system to emulate.
Currently, a subgroup of the common market -- perhaps Germany, Benelux, and Austria -- comes closer to satisfying the conditions favorable to a common currency than does the common market as a whole. And they now have the equivalent of a common currency. Benelux and Austria have linked their currencies to the Deutsche Mark, although they still retain central banks and could break the link at will. Any country that wishes to link its own currency to the Deutsche Mark more firmly can do so on its own, simply by replacing its central bank with a currency board. Yet no member of the European Community has done so -- a clear sign that external politics, not internal economics, is behind the drive for a common currency.
The primary political motive is to link Germany with France and the other countries so closely as to make another European war impossible. The vision is of a United States of Europe. The goal is admirable, but I believe that a single currency will exacerbate rather than soothe political tensions by converting divergent shocks that could have been readily accommodated by exchange-rate changes into divisive political issues. In addition, disputes are bound to arise among the governors of the European Central Bank, each reflecting the interests of his own country. Political unity can pave the way for monetary unity. Monetary unity imposed under the conditions that prevail in the EC will, I fear, prove a barrier to the achievement of political unity.