The views expressed in this annual report are solely those
of the authors; they are not intended to represent a formal
position of the Federal Reserve System.
Economic historians will look back on the 1980s as the decade
in which the experiment with floating currencies failed.
—The Economist, January 6, 1990
Ever since Adam Smith first explained how the free
market, like an invisible hand, guides self-interested individuals
to produce what is efficient and best for society, most economists
have supported a laissez-faire approach to most economic problems.
The information and technical requirements needed to allocate
scarce economic resources efficiently and desirably are considerable.
As a result, economic planners are unlikely to do a better job
than individuals responding to market-determined prices. Indeed,
experience suggests that economic planners almost always do much
worse. And even when the market fails to allocate resources efficiently,
finding a better, nonmarket solution is often difficult.
When it comes to exchange rates, though, the laissez-faire approach
has not lived up to its billings. The free market system of floating
exchange rates established in the early 1970s was supposed to
provide a mechanism for correcting trade imbalances and stabilizing
economic activity. It was also supposed to allow exchange rates
to better reflect underlying economic fundamentals—such as
incomes, money supplies, and interest rates. Ultimately, the link
between rates and fundamentals was to lead to more predictable
exchange rates than under the fixed rate system of Bretton Woods
(1944-1970). Contrary to these expectations, the post-Bretton
Woods era has witnessed trade imbalances generally larger and
more persistent, economic fluctuations generally as wide and as
frequent, and exchange rates much more volatile and unpredictable.
Are fixed exchange rates a viable alternative? Many say no.
They argue that fixed rates are economically and politically infeasible
and that trying to impose them will only create instability, not
avoid it. As evidence, the proponents of floating rates cite the
collapse of Bretton Woods. Nevertheless, we maintain there is
a convincing case that a fixed exchange rate system is feasible
and should be established. Theory shows it feasible, and overlooked
empirical evidence shows it possible. Such a system requires international
monetary policy coordination, which entails more than just agreeing
on the world's money growth. But this coordination is a small
price to pay for the benefits of eliminating the costly uncertainty
of floating exchange rates.
What's Wrong With Floating Exchange Rates?
By 1974, the major industrialized countries had ended the fixed
exchange rate system agreed on thirty years earlier at Bretton
Woods, New Hampshire. Many economists hailed the end of the Bretton
Woods system as a triumph for free markets: No longer would exchange
rates be set by governments and subject to the vagaries of political
developments. No longer could speculators get rich by anticipating
and, at times, even precipitating exchange rate adjustments. And
no longer could fiscally irresponsible economies export their
inflationary policies to the rest of the world.
Expectations for the post-Bretton Woods era were high: Market-driven
exchange rates would more efficiently correct trade imbalances
and help stabilize aggregate demand across countries. Floating
rates would also leave countries completely free to pursue independent
monetary policies. And exchange rates would be determined by underlying
economic fundamentals, just like the prices of other goods and
services. So, even though rates might fluctuate more than under
Bretton Woods, these fluctuations would become fairly predictable.
Sixteen years have passed, but most of these benefits are yet
to be realized or, if realized, the gains from them appear to
be small.
Initially Appealing . . .
Advocates of floating exchange rates base their case on the
proposition that free markets tend to allocate resources efficiently.
More specifically, they claim that a floating rate system has
two main benefits: economic stability and policy independence.
The first benefit—economic stability—would be achieved
because a floating system helps make prices for internationally
traded goods and services more flexible. As a result, floating
rates would help balance international trade and stabilize aggregate
demand across countries.
Floating exchange rates would help balance trade in the following
way. When a country runs a trade deficit (imports more goods and
services than it exports), some other country (or countries) runs
a trade surplus (exports more goods and services than it imports).
To bring trade into balance, the prices of goods and services
produced in the deficit country must fall and those in the surplus
country must rise. If the prices of goods and services are slow
to adjust (as is often argued, at least for downward price adjustments),
then the trade imbalance will persist. With floating exchange
rates, the trade imbalance causes the value of a deficit country's
currency to fall relative to the surplus country's currency because
relatively fewer goods and services are being purchased from the
deficit country. The decline in the exchange rate implies that
the terms of trade (the price of the goods and services of the
deficit country in terms of the goods and services of the surplus
country) will decline, even if price levels do not change. Therefore,
the demand for goods and services of the deficit country increases
while the demand for those of the surplus country falls.
By making the prices of internationally traded goods and services
more flexible, floating exchange rates would also supposedly help
stabilize aggregate demand and employment across countries—adjustments
that proponents say would be much slower and more economically
painful if exchange rates were fixed. Consider, for example, a
country in an economic downturn. Its domestic investment and production
decline, unemployment rises, and income and consumption falter.
The weak economy drives the price of the country's currency down.
This decline, in turn, lowers the price of its exports, stimulating
foreign demand and helping offset the decline in domestic demand.
In this way, floating rates tend to act automatically as economic
stabilizers.
The second benefit of a floating exchange rate system, backers
claim, is that it would give each country autonomy over its monetary
policy. Under a floating rate system, monetary policies in each
country can freely respond to domestic economic problems while
international currency markets determine the appropriate level
of exchange rates. Policy independence would also let each country
choose the average rate of money supply growth to help meet its
government's need for revenue.
Although proponents of floating exchange rates recognize that
the benefits of stability and policy independence are not costless,
they nevertheless argue that the costs are relatively small and
manageable. An obvious cost is that currency prices can vary.
People who buy and sell goods and services internationally must
face the risk that the currency they accept in trade may change
in value. The greater the volatility of exchange rates, the greater
the potential risk. Even so, proponents of floating rates argue
that this risk is unlikely to be so large. Since they believe
that exchange rates are tied to economic fundamentals and since
these fundamentals tend to change slowly, they expect exchange
rate fluctuations to be modest—or at least fairly predictable.
Moreover, they argue that financial markets will quickly provide
ways to hedge unpredictable movements in rates.
. . . Eventually Disappointing
Sixteen years under a floating exchange rate system have not
yielded the expected benefits, nor have the system's costs been
as small as anticipated. Judged against its proponents' initial
expectations, the floating rate system has proved disappointing.
One expected benefit of floating exchange rates was that they
would contribute to economic stability by helping correct trade
imbalances. But since 1974, trade imbalances generally have been
larger and more persistent. We can see this by looking at net
exports (a common measure of trade imbalances) for four major
industrialized countries: West Germany, Great Britain, the United
States, and Japan. Germany's trade balance fluctuated between
deficit and surplus from 1961 until 1981; since then, it has been
running a persistent trade surplus. In Great Britain and the United
States, the absolute levels of trade imbalances have been larger
and more persistent after Bretton Woods. Japan is an exception;
its persistent trade deficit during Bretton Woods has been corrected
since rates began to float.
Floating exchange rates seem to have performed somewhat better
as automatic economic stabilizers, but the effect has not been
general. A comparison of the same four countries' cyclical fluctuations
in real output during and after Bretton Woods shows that only
in Japan were fluctuations smaller in the floating rate period.
In Germany, fluctuations were about the same during and after
Bretton Woods. In Great Britain and the United States, fluctuations
in real output have been larger after Bretton Woods.
The second benefit of floating exchange rates, allowing countries
to pursue their own independent monetary policies, has been realized;
but the advantages from this autonomy seem small. With an independent
monetary policy, a country can use such policy to influence the
course of its economy. Though academics continue to debate how
effectively monetary policy can influence economic activity, among
policymakers there is a growing consensus that stable and predictable
policy rules coordinated across countries are best. For example,
the Group of Seven (G-7) nations (the United States, West Germany,
Japan, Great Britain, France, Canada, and Italy) have met several
times in the last five years to develop a framework for discussing
economic issues. This effort has gradually led to a greater degree
of policy coordination and to joint attempts to reduce exchange
rate volatility. And the European Community, which has agreed
to eliminate most trade barriers among members by 1992, is seriously
considering a European Monetary Union with coordinated monetary
policies, fixed exchange rates, and ultimately a single currency.
Another advantage of an independent monetary policy is the control
it gives a country over seigniorage, the revenue obtained from
money creation. But for most countries, seigniorage is a relatively
minor share of total revenues. In the United States, for example,
seigniorage accounts for less than two percent of federal revenues.
Further, relinquishing control of money growth by coordinating
monetary policies with other countries does not mean a country
loses seigniorage; it only means losing control of the amount
received.
Meanwhile, the costs of floating exchange rates have been far
greater than many expected. Exchange rate volatility has been
large, and much of it seems largely unpredictable. Unpredictable
fluctuations are a risk (or cost) borne by people who buy and
sell goods and services internationally. Although the market
has provided means of hedging this risk, the cost of unpredictable
exchange rate fluctuations still has not been eliminated.
The greater volatility of exchange rates in the post-Bretton
Woods period is clearly seen in Chart 5 (in the printed copy of
the Annual Report). But exchange rate volatility is risky only
if it is unpredictable. The advocates of floating rates contend
that economic fundamentals are a driving force behind exchange
rate fluctuations. So even though rates could be volatile, exchange
rate fluctuations would be largely predictable, based on knowledge
of current and past fundamentals. As a result, they argue, exchange
rate risk would be small.
Recent economic research, however, shows that for the most part,
exchange rate fluctuations under floating rates have not been
predictable. 1
The research tried to gauge how helpful economic fundamentals
are in predicting exchange rate fluctuations. This was done by
evaluating the forecasting accuracy of two competing types of
models for predicting exchange rates. The first type, structural models, relies on the relative differences in past and current
economic fundamentals to forecast exchange rates. The second type,
a naive model, simply says that the best forecast of future exchange
rates is the current rate. Because changes in fundamentals have
no predictive power in the naive model, it implies that fluctuations
in exchange rates are unpredictable. Comparisons of the models'
forecasting accuracy revealed that, in most cases, the naive model
outperformed the structural models. Even when it did not, exchange
rate fluctuations were still difficult to predict. These results
support the view that exchange rate volatility has been largely
unpredictable under floating rates.
In what sense is exchange rate uncertainty a cost? Consider
a German company buying electronic equipment from a U.S. manufacturer.
On delivery of the goods, say in six months, the German company
is willing to pay for them in dollars at the agreed price. To
the extent that the exchange rate in six months cannot be predicted,
the buyer is exposed to exchange rate risk. The risk doesn't vanish
if the U.S. manufacturer agrees to accept German marks on delivery;
in that case, it just falls on the seller. Generally, we expect
to find some form of risk sharing between buyer and seller. In
practice, a hedge is usually purchased. Estimates of the cost
of such hedges range from 0.5 to 3 percent of total foreign sales.
In the United States, for example, total trade in goods and services
was $1.3 trillion in 1989, so the estimated cost of hedging ranges
from $6.5 billion to $39 billion. That cost puts a heavy burden
on the United States and its trading partners.
These estimates, however, may understate the cost of exchange
rate risk. Many businesses, finding the price of an exchange rate
hedge too high, may choose not to trade internationally. In other
words, the cost of exchange rate risk applies to potential as
well as actual international transactions.
Are Fixed Exchange Rates Better?
That the floating exchange rate system adopted in the early 1970s
has not worked as anticipated does not necessarily imply that
a better system is available to replace it. The conventional argument
rules out fixed rates as an option by claiming that such systems
are unsustainable. Some evidence—notably the Bretton Woods
collapse—seems to bear this out.
We maintain, however, that the conventional argument is flawed:
It does not take seriously a distinctive trait of today's currencies.
When that trait is seriously considered, theory suggests there
is a demonstrably better system. If countries are willing to coordinate
their monetary policies, they can fix exchange rates and eliminate
the burden of exchange rate risk on international trade.
In Theory Yes . . .
Those who argue that fixed exchange rates cannot work assume,
at least implicitly, that currency is essentially no different
from other goods. Since exchange rates are the relative prices
of currencies and since standard price theory demonstrates that
it is impossible to fix the relative prices of goods in the long
run, skeptics argue that a fixed exchange rate system is not feasible.
The conventional argument against the feasibility of fixing
prices goes like this: The relative price of two goods can be
fixed only if buffer stocks of the goods exist to absorb excess
demand. Eventually, however, the demand for a good relative to
its supply must become so large that it depletes any buffer stocks
held. Once these stocks are depleted, price fixing is impossible.
But the conventional argument does not apply to exchange rates
because today's currencies are fiat: they are intrinsically worthless
pieces of paper that are virtually costless to produce. This means
that a government can always avoid depleting the buffer stock
of its currency simply by printing more. Therefore, fixing exchange
rates is feasible, and any rate will work. 2
That fixed exchange rates are theoretically feasible, however,
does not mean they are politically acceptable. Under fixed rates,
the country with the fastest growing money supply gets the most
seigniorage (revenue) from money creation. More important, some
of this seigniorage is collected from residents of other countries
because, with fixed exchange rates, the inflation caused by one
country's money growth is experienced by residents of all countries.
This outcome is bound to be politically unacceptable to other
countries. A country can prevent another from exporting inflation
by letting its own exchange rate appreciate. As a result, countries
will not adhere to fixed rates unless they are willing to coordinate
their monetary policies.
The policy coordination necessary for fixed exchange rates,
however, is not that all countries agree to have their money supplies
grow at roughly the same rate. Even if these money growth rates
were the same and other economic fundamentals unchanged, recent
research shows that exchange rates can fluctuate simply because
people think they will. 3
(This result may explain why exchange rates have continued to
be volatile even though the G-7 countries have been moving to
coordinate long-term monetary policies over the past decade.)
The policy coordination required to fix exchange rates has two
components:
Central banks would have no problem meeting the first component.
If a central bank temporarily ran out of a foreign currency, it
could always swap its own currency for the other with the appropriate
foreign central bank. This arrangement prevents exchange rates
from fluctuating because of speculation, since it guarantees that
any amount of a currency demanded will always be supplied at the
fixed price. And if countries meet the second component, they
will have no incentive to overissue their moneys. 4
. . . And Yes in Practice
Our case for fixing exchange rates is based on more than just
theoretical speculation. Despite the collapse of Bretton Woods,
there is a well-functioning yet often-overlooked system of fixed
exchange rates in place today. Its existence demonstrates the
feasibility and advantages of a fixed rate system.
The Bretton Woods system is usually cited as evidence of the
fragility of fixed exchange rate systems. If the fixed rates do
not reflect underlying economic fundamentals, so the argument
goes, the rates are not sustainable. Even if rates are initially
set correctly, fundamentals can quickly change and cause currencies
to become under- or overvalued.
But Bretton Woods is not really a test of whether a fixed exchange
rate system will work. A fixed rate system requires that policy
coordination include an agreement among countries about the amount
of seigniorage and its distribution. This component of policy
coordination was missing from the Bretton Woods system, which
attempted to fix exchange rates while still allowing each country
some control over its own seigniorage.
A proper test of whether fixed exchange rates are feasible needs
evidence from a system with the two required components of policy
coordination in place. There is such a system, and it is running
smoothly—the monetary system of the United States today.
To many, the notion that the United States has a fixed exchange
rate system may come as a surprise. The notes issued by the Federal
Reserve System look like and are used as a single currency. Each
note is printed in black and green ink, each has “The United
States of America” inscribed on front and back, and each
says it is a “Federal Reserve Note” and “legal
tender for all debts, public and private.” Furthermore, the
notes exchange at par: a twenty-dollar bill swaps one-for-one
with any other twenty-dollar bill, one-for-two with any ten-dollar
bills, and so forth.
In what sense, then, does the United States have something other
than a single currency? A closer look reveals that, in fact, each
of the twelve district banks in the Federal Reserve System issues
its own notes. Each note is identified by its Federal Reserve
district bank in four ways: First, on the front left is a circle
with the district bank's name written around the inside. Second,
in the middle of that circle is a bold, black letter representing
the Federal Reserve district of origin—A for the first district,
B for the second, and so forth. Third, the letter symbol is the
first character of the serial number, which is printed twice on
the front of each bill. Fourth, the district's number is printed
on the front four times.
Granted, these differences among Federal Reserve notes are much
less distinct than those between, say, U.S. and Italian currencies.
Nevertheless, in a physical sense, U.S. currency is not strictly
uniform. The importance of these physical differences is that
they represent the possibility that the United States could choose
to have a floating exchange rate system among the currencies of
the twelve Federal Reserve districts. Instead, the United States
has chosen a system of fixed exchange rates.
That the United States has had no trouble maintaining its fixed
exchange rate system demonstrates that such a system is feasible.
Despite changes in economic fundamentals among Federal Reserve
districts, the United States has not been forced to adjust the
exchange rates between district currencies. This is not what the
skeptics of fixed rates claim would happen. What if the Ninth
District economy were declining while the other district economies
were expanding? Or what if the Ninth District were running a trade
deficit with the rest of the country? Then, skeptics would claim,
there should be some downward pressure on Ninth District currency.
This, of course has never happened, nor is it likely.
The reason the U.S. system of fixed exchange rates works is that
it has the two required components of monetary policy coordination:
First, the district Federal Reserve banks have an agreement to
swap their currencies for any other district's at the fixed rate
in any amount and at any time. Because of this agreement, we doubt
that many people have ever lost sleep over the exchange value
of their district's notes relative to another's. (Have you ever
checked to see which district Fed issued the notes you were being
handed?)
Second, district Fed banks also have an agreement on how to
set the rate of money growth and how to distribute the resulting
seigniorage. Each district bank participates in the policy process
(at Federal Open Market Committee meetings), and a unified policy
action is carried out for all twelve districts. No individual
district bank can pursue its own monetary policy. 5
Furthermore, all seigniorage is pooled and disbursed by the U.S.
Treasury. That is, by design, no district bank can gain by issuing
more of its notes than another. Even if all notes were issued
by, say, the Ninth District, the revenue would still be pooled
and disbursed by the centralized authority (the Treasury).
This example of the U.S. monetary system shows that when the two
required components of policy coordination are met, a fixed exchange
rate system is feasible.
What Should Be Done?
Policymakers have been led to believe that a floating exchange
rate system is best. They were told that allowing rates to float
would help balance international trade, reduce economic instability
across countries, and allow governments to pursue independent
monetary policies. They were also told that the cost of exchange
rate risk would be small.
They were misled. Floating rates have brought neither balance
to trade accounts nor stability to economic activity. Instead,
they have added a significant cost to international trade in the
form of greater uncertainty about exchange rates than most expected.
Policymakers were also led to believe that in the long run,
floating exchange rates are the only feasible system. They were
told that fixed exchange rates are not feasible and that exchange
rates must ultimately reflect changing economic conditions.
Again, they were misled. Exchange rates can be fixed by governments
if monetary policies are coordinated. Coordination requires that
countries agree to swap currencies at the fixed rates and agree
on a monetary policy and how to distribute the resulting seigniorage.
The question, then, is not whether countries can fix exchange
rates but whether they should. Should they coordinate their
monetary policies and eliminate unpredictable changes in exchange
rates? Or should they opt for policy independence and accept
the cost of exchange rate risk?
We think there is a convincing case for fixing exchange rates.
Experience suggests that the costs of coordinating monetary
policies are small compared with the benefits from eliminating
unnecessary exchange rate uncertainty.
* We owe a deep intellectual debt to Neil Wallace,
professor of economics at the University of Minnesota and adviser
to the Federal Reserve Bank of Minneapolis. His work on the
theory of money and exchange rates has motivated the ideas presented
here. Several of his important writings are listed in the suggested
readings at the end of this essay.
1 For details of this
research, see the articles by Meese and Rogoff (1983), Schinasi
and Swamy (1989), and Meese (1990) in the suggested readings.
2 The choice of a particular
exchange rate will, of course, affect the distribution of wealth.
For example, in the proposed monetary reunification of Germany,
the issue in choosing the exchange rate between East and West
German marks is not one of feasibility but one of wealth redistribution.
3 This point, made
by King, Wallace, and Weber (1989), is supported by the evidence
that exchange rate fluctuations are unpredictable. The article
is listed in the suggested readings.
4 A gold standard is
another way to achieve fixed exchange rates. Under a gold standard,
not only does each country give up control of its monetary policy
but monetary policy also becomes exogenous. That is, for countries
on a gold standard, the rate of increase of their money supply
is determined not by policy coordination on their part but by
the rate of gold production—a factor outside their control.
This loss of control may be an unacceptable cost.
5 While Federal Reserve
districts must coordinate monetary policies, they do not have
to coordinate fiscal policies. Each district (more correctly,
each state within a district) can freely pursue its own fiscal
policy, but none can finance its budget shortfalls by printing
money. Similarly, countries that agree to fix exchange rates would
still maintain autonomy over their fiscal policies.
Committee for the Study of Economic and Monetary Union. 1989.
Report on Economic and Monetary Union in the European Community.
April 12.
The Economist. 1990. A Brief History of Funny Money.
January 6, pp. 21-24.
The Economist. 1990. Time to Tether Currencies.
January 6, pp. 15-16.
Friedman, Milton. 1953. The Case for Flexible Exchange Rates.
In Essays in Positive Economics, pp. 157-203. Chicago:
University of Chicago Press.
Hakkio, Craig S. 1989. Exchange Rates in the 1980s. Research
Division Working Paper 89-04. Federal Reserve Bank of Kansas City.
Johnson, Harry G. 1969. The Case for Flexible Exchange Rates,
1969. Review 51 (June): 12-24. Federal Reserve Bank
of St. Louis.
Kareken, John, and Wallace, Neil. 1981. On the Indeterminacy
of Equilibrium Exchange Rates. Quarterly Journal of Economics
96 (May): 207-22.
King, Robert G.; Wallace, Neil; and Weber, Warren E. 1989. Nonfundamental
Uncertainty and Exchange Rates. Research Department Working Paper
307. Federal Reserve Bank of Minneapolis.
McKinnon, Ronald I. 1988. Monetary and Exchange Rate Policies
for International Financial Stability: A Proposal. Journal
of Economic Perspectives 2 (Winter): 83-103.
Meese, Richard. 1990. Currency Fluctuations in the Post-Bretton
Woods Era. Journal of Economic Perspectives 4 (Winter):
117-34.
Meese, Richard A., and Rogoff, Kenneth. 1983. Empirical Exchange
Rate Models of the Seventies: Do They Fit Out of Sample? Journal
of International Economics 14 (February): 3-24.
Melamed, Leo, ed. 1988. Foreword to The Merits of Flexible
Exchange Rates, pp. ix-xvii. Fairfax, Virginia: George
Mason University Press, 1988.
Schinasi, Garry J., and Swamy, P.A.V.B. 1989. The Out-of-Sample
Forecasting Performance of Exchange Rate Models When Coefficients
Are Allowed to Change. Journal of International Money and
Finance 8 (September): 375-90.
Solomon, Robert. 1977. The International Monetary System,
1945-1976: An Insider's View. New York: Harper & Row.
Townsend, Robert M. 1977. The Eventual Failure of Price Fixing
Schemes. Journal of Economic Theory 14 (February):
190-99.
Wallace, Neil. 1979. Why Markets in Foreign Exchange Are Different
From Other Markets. Federal Reserve Bank of Minneapolis Quarterly
Review 3 (Fall): 1-7. Reprinted in Federal Reserve Bank
of Minneapolis Quarterly
Review 14 (Winter 1990): 12-18.
Wallace, Neil. 1988. A Suggestion for Oversimplifying the Theory
of Money. Economic Journal 98 (No. 390): 25-36. Reprinted
in Federal Reserve Bank of Minneapolis Quarterly
Review 14 (Winter 1990):
19-26.
Annual Report
