forbes.com
Wild currency fluctuations are destabilizing the
world economy and our own stock market. A
great economist explains the play.
A primer on exchange rates
By Milton Friedman
Three types of exchange rate regimes are
possible and have existed at various times in
various countries.
Fixed rate or unified currency
The clearest example is a common currency: the
dollar in the U.S.; the euro that will shortly reign
in the common market. Almost identical is the
balboa in Panama, which is interchangeable with
the dollar one-to-one, and the currency boards
in Argentina and Hong Kong, which are
committed to creating currency only in exchange
for a specified amount of U.S. dollars (one peso
to $1 in Argentina, 7.8 Hong Kong dollars to
$1) and to keeping dollar reserves equal to the
dollar value of all currency outstanding. A pure
gold standard is a variant of this type of regime.
The key feature of the currency board is that
there is only one central bank with the power to
create money—in the examples cited, it's the
U.S. Federal Reserve System. Hong Kong has
no central bank; Argentina does—but without
the power to create money.
Hong Kong and Argentina have retained the
option of terminating their currency boards,
changing the exchange rate, or introducing
central bank features, as the Hong Kong
Monetary Authority has done in a limited way.
As a result, they are not immune to infection from
foreign exchange crises originating elsewhere.
Nonetheless, currency boards have a good
record of surviving such crises intact. Those
options are not retained by California or
Panama, and will not be retained by the countries
that adopt the euro as their sole currency.
Pegged exchange rate
This prevailed in the East Asian countries other
than Japan. All had national central banks with
the power to create money and committed
themselves to maintain the price of their domestic
currency in terms of the U.S. dollar at a fixed
level, or within narrow bounds—a policy they
had been encouraged to adopt by the IMF.
Such a peg is fundamentally different from a
unified currency. If Argentina has a current
account deficit; i.e., the dollar receipts from
abroad are less than the payments due abroad,
the quantity of currency (high-powered or base
money) automatically goes down. That brings
pressure on the economy to reduce foreign
payments and increase foreign receipts. The
economy cannot evade the discipline of external
transactions.
But under the pegged system, when Thailand had
a current account deficit, the Bank of Thailand
did not have to reduce the quantity of
high-powered money. It could draw on its dollar
reserves or borrow dollars from abroad to
finance the deficit. It could, at least for a time,
evade the discipline of external transactions.
In a world of free capital flows, such a regime is
a ticking bomb. It is never easy to know whether
a deficit is transitory and will soon be reversed or
is the precursor to further deficits. The
temptation is always to hope for the best, and
avoid any action that would tend to depress the
domestic economy. Such a policy can be
effective in smoothing over minor and temporary
problems, but it lets minor problems that are not
transitory accumulate until they become major
problems. Moreover, at this stage, the direction
of any likely change is clear to everyone—in the
Thailand case, a devaluation. A speculator who
sold the Thai baht short could at worst lose
commissions and interest on his capital, since if
the baht were not devalued, the peg meant that
he could cover his short at the same price at
which he sold it. On the other hand, a
devaluation would bring him large profits.
The resulting collapse in the dollar value of the
currencies of the four East Asian countries is an
oft-told tale that has been experienced even by
large and highly developed countries. The United
Kingdom, which had a central bank and at the
same time pegged its currency, experienced a
foreign exchange crisis in late 1967, when the
pound was pegged to the U.S. dollar, and again,
this time along with France, Italy and other
members of the European Monetary Union, in
1992 and 1993, when the peg was not to the
dollar but to exchange rates agreed to under the
European Monetary Union.
Floating rates
The third type of exchange rate regime is one
under which rates of exchange are determined in
the market on the basis of predominantly private
transactions. In a pure form, clean floating, the
central bank does not intervene in the market to
affect the exchange rate though it or the
government may engage in exchange transactions
in the course of its other activities. In practice,
dirty floating is more common: The central bank
intervenes from time to time to affect the
exchange rate but does not announce in advance
any specific value that it will seek to maintain.
That is the regime currently followed by the U.S.,
Britain, Japan and many other countries.
Under a clean floating rate, there cannot be and
never has been a foreign exchange crisis. There
may be internal crises, as in Japan, but not
accompanied by a foreign exchange crisis. The
reason is simple: changes in exchange rates
absorb the pressures that in a pegged regime
lead to crises. The foreign exchange crisis that
affected Korea, Thailand, Malaysia, and
Indonesia did not spill over to New Zealand or
Australia because those countries had floating
exchange rates.
The IMF muddies the water
The Mexican crisis of 1995 is the most recent
example of a major currency crisis in a country
with a central bank and pegged exchange rates.
Mexico, it is said, was bailed out by a $50 billion
financial aid package from a consortium including
the International Monetary Fund, the U.S., other
countries and other international agencies. The
reality is that "Mexico" was not bailed out.
Foreign entities—banks and other financial
institutions that had made dollar loans to
Mexico—were bailed out. The internal recession
that followed the bailout left the ordinary
Mexican citizen with a sharply reduced income,
facing higher prices for goods and services. That
remains true today.
The Mexican bailout helped fuel the East Asian
crisis that erupted two years later. It encouraged
individuals and financial institutions to make loans
to and invest in the East Asian countries,
reassured about currency risk by the belief that
the IMF would bail them out if the exchange pegs
broke.
I do not blame the lenders for accepting the gift
of insurance. I blame the IMF for offering the gift
by the way it handled the Mexican and other
crises.
The Mexican bailout was on a much larger scale
than earlier ventures. It led to the IMF being
viewed as a lender of last resort, a function it
was not equipped to perform. When the Asian
crisis broke, the IMF quickly committed itself to
more than $100 billion in loans to the four
countries involved, subject to conditions on
government budgets, monetary policies, banking
regulations and the like. In retrospect, many
observers, myself included, believe that much of
the advice was based on the IMF's experience
with countries whose problems derived from
excessive government spending and budgets.
The advice was not appropriate to East Asia,
where the problem was not a fiscal crisis but a
banking crisis—in Japan as well as in the
pegged-rate countries.
What should we do?
Of the three possible exchange rate regimes for a
developing country, either a truly fixed rate with
no national central bank or a floating rate plus a
national central bank is preferable to a pegged
exchange rate. That lesson emerges clearly from
East Asia but is also supported by much earlier
experience. |
