The Fallacy of Floating Exchange Rates 16 comments
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The Nobel Laureate in Economic Science, Robert Mundell, remarked at the 2009 American Economic Association meeting in January that the idea of floating exchange rates is "the worst idea proposed in the 20th century." This remark from a top economist appears very strange but on reflection is actually very sensible.
The assumption behind floating exchange rates is that the currency of a country is demanded when other countries buy the goods and services of that country, or when other countries invest in that country. Supply of that currency, on the other hand, comes from that country's demand for the goods and services of other countries and its investment in other countries. The proponents of freely floating exchange rates argue that such supply and demand are best left to the market to equilibrate.
But this assumption is not valid today. Consider Japan, a leading industrial nation now bleeding under the pressures of a strong Yen. The strength of the Yen does not come from Japan's strong exports, which actually fell sharply in recent months and actually plunged 35% in December 2008. The strength of the Yen also does not come from heavy direct investment in Japan. The strength of the Yen is mainly based on speculative demand on the expectation that it will rise against other currencies, and this expectation is realizing itself. The price of a currency, which guides international trade and commerce, is now dictated by the whims of speculators.
For several months already Japan has experienced a notable and historically rare trade deficit. Exporters to Japan might think this development would be to their advantage. But no. Japan's imports are falling fast. The Yen's strength has not helped push exports to Japan. What interest then does it serve? The Yen's strength merely feeds the profits of speculators who use the might of leveraging and funds entrusted to them by investors to force the Yen's appreciation. Although imports may be cheaper, the Japanese are not spending because they are losing their jobs and businesses are closing down.
In the early 1980s, the "super dollar" was hurting America, and the industrial nations at the Plaza Accord in 1985 saw it fit to intervene to bring about the orderly depreciation of the US dollar. They acted without feeling guilt for the intervention. Why is intervention problematic today? If anything, speculative forces today, armed by leveraging and assisted by a myriad of derivative products, are many times stronger than those in the 1980s. We need to awaken to the fact that speculative supply and demand today overwhelms demands and supplies based on the economics of trade and commerce. We must not let speculative demands and supplies disrupt the normal functioning of our economies.
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This article has 16 comments:
If anything, we seem to be in a period of de-leveraging today, so this part of the argument seems weak, or bit late if we are talking about position unwinding.
Of course, you are quoting Robert Mundell so you have said enough.
Good analysis. I'm amazed at how little discussion there has been these historic shifts, i.e., yen today at 88 vs. USD vs. Euro vs Sterling, etc. As an exporter to Japan my customers are all scared and they wonder if we in the US are scared and I tell them we are too. Just like the oil price increases were triggered by speculators, so the yen. There really is no other explanation. I would be favor of a new currency that unites all industrial countries in a common market. If you really think about it, what other choice do we have at this point?
The mattress beckons. That means monetary deflation, the great bugaboo of the modern worldwide economy. Interesting time, eh?
You are certainly right about the speculative flows in the current market environment. There are many recommendations in the currency market to short the euro against the yen. The long yen trade could well be another trend following frenzy similar to the one that pushed crude oil to $147 last spring. While you are right to be questioning the economic disruption that is being caused by excessive speculative flows, the problem is separating desirable speculation that plays a role in market liquidity from the disruptive and mindless trend following that pushes asset prices to dangerous levels. How should this issue addressed?
Jack
It is not possible to determine the relative value of currencies with precision, even if theoretically we can say that there is one. Everyone agrees, for example, that each country has a certain amount of water within its borders at any given time but that does not mean we can know with precision how to calculate the amount.
The only way we could determine the amount of water, or money, within the borders of various countries would be to control them rigidly. But history shows that it isn't possible to control human affairs to that degree.
Asian societies have accepted more economic and cultural control from central governments than Western countries have. This is also true for most of the countries within the borders of the old Soviet Union.
The United States was founded on the concept of freedom of religion and thought, and the fact that American values evolved so far from the European continent (when distances of thousands of miles were enormous) allowed the idea of freedom and free enterprise to become even more developed in America (and Australia and New Zealand) than in Europe.
It might be necessary for Asian countries to form an alliance so that their historical values of collective, centralized economics including controlled currencies, can exist. My guess is that Russia will form an alliance with them as well.
But America will continue to lead the 'free' world, which will certainly include Canada, Australia and New Zealand.
It is possible that Europe will be attracted by collectivism again and it is also possible that Mexico and Central and South America will be. But now that distances are much less important, America will certainly fight, both economically and militarily, to make sure it doesn't happen.
The twentieth century will be prosperous and peaceful if we human beings can learn to live together with different values, philosophies and religions.
If not, the 21st century will see more wars, both economic and military.
Thanks for an awesome response to a great article, written by Mr Ho... very much appreciate both. I only wish I had something as profound to add.
Is it better to have our livelihoods and currencies dictated by the whims of politicians and bureaucrats? The perversion of this concept is that floating exchange rates are not beholden to any self-declared omniscient, omnipotent committee to force down our throats. Instead market forces, reality, and freedom of capital flows align currencies with real output and future perceived prospects. This will not always be perfect at any given moment in time, but markets always align efficiently in the long term.
Currency manipulation by central banks and other bureaucrats has caused such severe harm to ordinary citizens throughout history that I am shocked to hear it proposed whatsoever. Why don't humans ever learn from their mistakes?