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Non-Tech : Derivatives: Darth Vader's Revenge -- Ignore unavailable to you. Want to Upgrade?

To: Daniel Chisholm who wrote (864)	3/27/1999 8:23:00 AM
From: Henry Volquardsen	Respond to of 2794

Daniel, I disagree with Mr Soros. Freely floating foreign exchange markets are no more inherently unstable than freely floating equity markets. Fixed exchange rates and managed regimes are much more inherently unstable. A quick review of recent history shows that every currency crisis occurred in a managed currency. When a currency is maintained at artificial levels pressures build up that eventually break the system. Free floating markets allow the markets to adjust daily and the pressures can not build up. An example of the inherent instability is Europe in the early 90s. Europe tried to maintain a tight currency grid. However not all the economies involved were in harmony. The UK in particular was out of sync with continental currencies. The tight grid did not allow the currency values to adjust. At that point in the UK's economic cycle a weakening currency would have discouraged imports and encouraged exports and foreign investment, just what the economy needed. Remember the system (international accounts) is a zero sum game and it is going to get what it needs one way or another. So if you are not going to allow exchange rates to fluctuate you will need to find some other way to either increase foreign investment or reduce the trade deficit, the balance of payment demands it. In the UKs case the solution was to raise interest rates, significantly. The most obvious reason for this was to make sterling investments more attractive to foreigners. It also had a impact on demand. The higher rates crushed demand, this generated the needed decline in imports but in a much more destructive fashion than currency fluctuations. Currency movements would have ecouraged a more subtle shift away from imports. The interest rates caused significant collateral damage. Higher mortgage rates caused a collapse in home prices. All in all the attempts to manage the currency caused significantly more instability in the markets than freely floating currencies. Do freely floating currencies offer a defense against speculators? I think an argument can be made that they do. In the UK example the currency grid gave speculators a fixed point of attack. They knew exactly where the governments would be. This added additional speculative pressure at these points. Eventually the pressure caused a break, the UK was forced to leave the currency grid. I believe Mr Soros is reported to have made a billion dollars speculating against sterling at this time. A short time later the same pressures built up in the currency grid again. Initially the Scandis came under the most attack but it eventually spread throughout the system, even to currency relationships where the economics did not justify pressure. The initial response was to head down the same road as the UK and interest rates rose aggressively. But just when it looked like the system might collapse the Europeans came up with a very clever response. They said the bands remain 2.25 for the long term but we are going to temporarily widen the bands to 20% for the duration of this crisis. What that was effectively doing was removing the fixed point of attack. The bands were widened to the point where they were essentially free floating. The specualtors now had no fixed point of focus. The pressures were reduced almost overnight and the EMS survived to give birth to the Euro. It has worked elsewhere as well. Henry