As the world struggles with “mysterious” long-term financial instability and economic weakness, perhaps it’s time to reconsider the policy of fluctuating national currencies, which was implemented in 1971 when President Nixon broke up the unified global monetary system that had existed in different forms for hundreds of years. Prior to Nixon’s move, the major world currencies were fixed in value to the dollar, which in turn was anchored to gold, creating a more or less unified global monetary system that linked interest rates and inflation fairly closely across countries. Since 1971, the dollar and other major currencies have been disconnected, with different rates of interest and inflation, and allowed to fluctuate relative to each other.
Supporters of floating exchange rates today generally acknowledge that some of the new system’s predicted benefits have not come to pass. Large, permanent trade deficits haven’t disappeared — indeed, they have gotten far larger. Government stockpiling of foreign-exchange reserves, assumed to be unnecessary under floating exchange rates, hasn’t declined — it has expanded dramatically. Inflation? Much higher. Fiscal discipline? Out the window. Average annual GDP growth and unemployment? Both worse with fluctuating currencies.
According to Mundell — agreeing with another Nobel laureate, Friedrich Hayek — floating exchange rates stimulate currency speculation, which then itself becomes a driver of financial instability. Further, large currency areas are better able to absorb financial shocks than small ones — “just as a large lake can absorb the impact of a meteor better than a small pond.” Mundell has said that on this basis, “the ideal currency area would be one comprising the entire world.”
The fixed currency systems of the past — under the gold standard before 1914 and the Bretton Woods system from 1944-71 — were far less prone to systemic financial crises, Mundell says. Since currencies were allowed to float 46 years ago, the world has been buffeted by a series of connected crises, with their underlying cause — large swings in the major exchange rates — largely undiagnosed.
In the early 1980s, the Federal Reserve sharply tightened monetary policy and the dollar soared, resulting in a whipsaw of prices and interest rates that bankrupted many U.S. farmers, oil producers, and manufacturers. The huge savings-and-loan crisis of the period was another result. The international debt crisis broke out because developing nations couldn’t repay dollar-denominated debts that had doubled in value.
In the mid 1980s, the U.S. pressured Japan and Germany to help lower the dollar by raising their own currencies. The yen skyrocketed threefold relative to the dollar by 1995. Japan’s market crashed, followed by a decades-long deflationary malaise.
After the U.S. intervened in currency markets to help Japan with its overvalued yen in 1995, the yen depreciated by 40 percent and the dollar rose 35 percent. China had recently devalued too. The smaller Asian economies were pincered — on one side by depreciating regional currencies, on the other side by a soaring dollar to which some had pegged their currencies. The Asian financial crisis ensued in 1997–98.
After the high dollar of the late 1990s pushed the U.S. into recession in 2001, the Federal Reserve lowered its target interest rate to an unusually low level, where it stayed for two years.
This low rate stimulated a “carry trade” — i.e., investors used low-interest dollars to buy higher-interest currencies, especially in emerging markets, putting upward pressure on their exchange rates. To prevent excessive appreciations, some nations bought large quantities of dollars and increased their money supplies. The result was a spike in international inflation, especially in commodities such as oil, which rose ten-fold from 2002–08. Meanwhile, the glut of dollar reserves flowed back into U.S. financial assets, creating a bubble.
In the summer of 2008, U.S. inflation was heating up; the Consumer Price Index hit an annualized rate of 5.6 percent and oil reached a high of $145 per barrel. The Fed reacted by broadcasting a change of policy — from accommodating the subprime crisis to fighting inflation. Surprised markets scrambled for dollars, reversing the carry trade and causing the dollar to soar 25 percent in three months. Prices and profits crashed, the financial system froze, and the Great Recession ensued.
After 46 years of serious financial crises under floating currencies, it should be clear we can do better.
Since then, the Fed’s three rounds of monetary stimulus have pushed the dollar down relative to the euro and other large currencies. When the stimulus stops, the dollar tends to soar again. This volatility has left both sides of the Atlantic financially unstable and economically weak for a decade.
After 46 years of serious financial crises under floating currencies, it should be clear we can do better. Monetary-policy rules that don’t have real-time exchange rates built into them are inadequate for a globalized system.
Today’s system is a jumble because pure floating currencies can lead to terrible outcomes, especially for developing nations. Therefore, most nations use the dollar as an anchor or reference point. When the dollar swings by huge margins versus the euro or yen, they get into trouble. So they have neither firm, fixed exchange rates nor truly floating rates. It’s a state-managed fudge, prone to huge imbalances that blow up into crisis every few years.
On the occasion of Professor Mundell’s birthday, it’s time to reconsider his call to return to a unified international currency system with fixed exchange rates.
— Sean Rushton is director of the Project on Exchange Rates and the Dollar at the Jack Kemp Foundation.