Thank heavens for floating rates
Samuel Brittan: Financial Times: 07/05/04
It is some time since the IMF published anything as optimistic as the recent World Economic Outlook. Global growth for both this year and next is put at an above trend 4½ per cent, and the authors say that it "may be higher than projected". Nevertheless they would not be IMF staff if they did not stress threats to this benign outlook. They highlight for instance the risk of a collapse of confidence in the dollar resulting from the large US balance of payments deficit. Other commentaries, such as the IMF's own Global Financial Stability Report, focus on bubbles in asset markets. Yet others worry about deficient demand in the euro zone. And behind everything are concerns about so-called "geo-political threats", polite shorthand for terrorism and disruptions to Middle East oil.
I am not going to crystal-gaze about the severity of these threats or how they will evolve. What is highly likely is that the world economy would already be in grave trouble if it had still been enmeshed in the Bretton Woods system of pegged exchange rates. If Maurice Chevalier were still with us today he might have adapted his famous hit from the film Gigi "Thanks Heavens for Little Girls" to "Thank Heavens for Floating Exchange Rates".
With a fixed dollar exchange rate, the US Administration would be worrying no end about a payments deficit amounting to five per cent of GDP. The pressure to tighten macroeconomic policy prematurely would be much greater. Worse, the balance of payments threat would make protectionist pressures more respectable and there would be every kind of ingenious device for restricting both imports and capital exports.
There is no need to look at the crystal ball. In the last years of the Bretton Woods system the US did impose a so-called Interest Equalisation Tax, which was effectively a tax on the export of capital; and, to save foreign exchange US forces abroad, were forced to "Buy American" for their provisions often at a cost several times that of local supplies.
There were also then strictures on the US by the French and German governments for supposedly living on credit from the rest of the world, which was accumulating dollar reserves, increasingly unwillingly. Such grouses today would surely be adding to the causes of US-European friction. Thank heavens trans-Atlantic financial transfers are now mainly private.
Floating exchange rates were originally advocated by a rainbow coalition of free-market economists and radical ones who wanted to pursue more "expansionist" policies. The reform came not because of their combined advocacy, but because after the inflationary financing of the Vietnam War, the US was no longer in a position to carry on paying out gold to countries wanting to dump official dollar reserves. In addition US industry was pressing for a lower dollar (as it so often is). President Nixon accordingly shut the "gold window" in 1971, which left the dollar free to float. The key figure behind the decision was Paul Volcker, at that time not yet chairman of the Fed, but US Treasury Under Secretary. There was one more attempt to reconstruct a pegged exchange rate system. Since 1973, however, floating exchange rates have prevailed between the world's main currency areas, even though Volcker himself has long advocated a return to a more managed system.
In any case the floating of the dollar was not inevitable. A new volume has just been published on alternative history covering hypothetical events, such as what would have happened if Archduke Franz Ferdinand had survived Sarajevo*. A narrative in which the fixed rate exchange system had been patched up in the 1970s would have been every bit as plausible.
A different US Administration might have tried to renew the Bretton Woods system after increasing the official price of gold; or it might have slammed down the economic brakes in an attempt to maintain the parity. It is easy to forget how virulent at the time was the opposition to floating exchange rates. I was told by Raymond Barre, when he was a combative French Brussels Commissioner, that if the UK wanted a floating rate it could not join the Common Market (as the European Union was then called). I was too polite to say which alternative I would have chosen if pressed. Milton Friedman was told by Edward Heath that a floating exchange rate was incompatible with the Common Agricultural Policy - no such luck it turned out. Indeed I was myself given friendly advice by a senior city and Whitehall figure not to jeopardise my own career by advocating anything as unlikely and as unworldly as floating rates.
Moreover it took time for governments to adjust to the new regime. Initially President Nixon accompanied the floating dollar with a 10 per cent surcharge on imports, a perfect example of belt and braces. Even now the US frets about the "dirty floating" of China and Japan. Yet if these countries are stockpiling dollars, it is their own citizens who are forced to pay unnecessarily high prices for imports and the US that is being subsidised.
I had my own apostasy in the 1980s when I was among those supporting British membership of the European Monetary system, at that time more a mini-Bretton Woods than a preliminary to a single currency. I derived some debating ammunition from the overshooting and undershooting of the dollar-D Mark exchange rates. (For what it is worth, overshooting appears to have declined in recent years. Nothing like the switchback from 1.7 D Marks to the dollar in the late 1970's to 3.3 in the mid-1980's, and then back to 1.4, has been seen in the last decade.) But my main concern was with UK economic management which needed an anchor when monetary targets were not working as they were supposed to do and inflation targets had not been invented. Indeed a link with the highly stable German Mark before German unification in 1989 might have been helpful in providing a temporary anchor. By the time a reluctant Margaret Thatcher was pressurised into joining in 1990, the Mark had itself become a source of instability.
There is of course a danger in overselling floating rates. No exchange rate regime will cure cancer or even boost growth and employment without the right accompanying domestic measures. More seriously, it is not entirely clear which should be the areas between which exchange rates should be free to float. The next stage should surely be a more serious attempt by business to diversify the currencies in which it operates and by governments to encourage currency competition. In this way we will discover the most appropriate areas for the different currencies much better than by any econometric simulation. Of course businessmen dislike uncertainty, but it is not abolished under pegged exchange rates, merely channelled into other and more harmful forms.
Meanwhile, my advice to any EU accession countries contemplating joining the euro would be, in a language they still understand "nyet". Or in more Community Speech, "The time is not ripe. Keep your freedom as long as you can."
*What Might Have Been, edited by A. Roberts, Weidenfeld, £12.99.
|Site designed and managed by Andrew Heavens - andrew dot heavens at gmail dot com|