Alternative Exchange Rate Systems and Reform of the International Financial Architecture
Testimony before the Committee on Banking and Financial Services
United States House of Representatives
Alternative Exchange Rate Systems
Countries have three basic choices in determining the monetary linkage between their economy and the rest of the world, assuming that they maintain a currency of their own as most do:
- they can let their currency float freely in the exchange markets against all other currencies;
- they can fix the price of their currency against a specific foreign currency or a basket of foreign currencies;
- or they can pursue intermediate approaches, letting rates float to some extent but intervening to limit those fluctuations either ad hoc ("managed floating") or pursuant to some pre-determined parameters ("target zones," "crawling bands," etc.)
There is increasing intellectual and policy consensus that "fixed but adjustable" pegs, the traditional means of "fixing" the exchange rate, do not work well for either industrial economies or emerging market economies.1 Hence they must either float to some extensive degree or fix permanently and thus credibly. Both courses have clear costs as well as benefits.
Floating permits a country to maintain a degree of national control over its monetary policy (and other national macroeconomic policies) because it does not have to use them so often to defend the exchange rate. However, markets can substantially overshoot the economic fundamentals; they can thus push a currency far below its underlying economic value, generating inflation and large debt servicing costs, or far above that level, hurting the country's competitiveness and throwing its trade balance into large deficit.
Fixed exchange rates can avoid those costs if the authorities can successfully set the rate at a sustainable level and convince the markets of both their ability and will to keep it there. Moreover, fixed rates reduce the transactions costs of international trade and investment. In addition, a fixed rate can provide a useful anchor for price stability by linking a small country to the world economy (and especially to a large country with relatively stable prices, like the United States or Germany). The option of adjusting the "fixed" rate also provides a country with an additional policy tool that can be used to correct an excessive external deficit or surplus.
However, governments may set or try to sustain a rate at unsustainable levels and private capital flows will eventually then force devaluations or revaluations that can be extremely costly. Successful defense of a fixed rate can often be costly too, requiring a country to raise interest rates and/or otherwise slow its economy to avoid speculative attack. Because of these costs, there is thus a clear trend away from fixed rates. This is true especially in emerging market economies, in the wake of the Asian/global crisis where a number of relatively fixed-rate countries were forced to abandon their pegs and countries with various types of floating rates generally fared better.
In the present world economy of huge private capital flows, there is in fact a growing consensus that countries can enjoy the benefits of fixed exchange rates only in two ways: by maintaining extensive capital controls, to directly limit their vulnerability to private speculation, or by adopting such a credible commitment to fixity that the markets will believe them through thick and thin and desist from speculative attack. Capital controls obviously reduce a country's access to some types of foreign investment but there is increasing interest in that approach and it has been adopted by a few countries (Chile, Colombia, Malaysia recently and, in different forms, China and India).
If a country wants to avoid the costs of both currency flexibility and capital controls, and therefore seeks maximum credibility for its fixed exchange rate, one approach is to install a currency board as in Argentina since 1991 and Hong Kong since 1983. Under that approach, a country only issues local currency that is fully backed by a foreign currency (the dollar in both these cases) at a fixed rate. Such an arrangement proscribes the national authorities from changing the rate or conducting an autonomous monetary policy. The currency board thus substitutes for a central bank (which inter alia means that the country will probably not have a lender of last resort to respond to internal financial crises, a point to which I return below).
Even a currency board may not achieve full credibility, however. The country could change the laws by which the board was established, or at least the ironclad rules under which it is supposed to operate. Even Argentina, whose currency board has achieved considerable credibility, still experiences interest rate increases of about 3 percent whenever US interest rates rise by 1 percent-whereas dollarized Panama experiences a rise of less than 0.5 percent.2
Hence there has developed considerable interest in countries such as Argentina, Mexico and even Canada for adopting the dollar as their national currency. The case for dollarization is essentially the same as the case for currency boards, the gold standard in bygone days, or any system of irrevocably fixed exchange rates as outlined above. Hence it makes sense for two types of countries3:
- those which are very small and very dependent on the world economy, like Hong Kong, and hence would simply be buffeted too sharply by constant exchange-rate fluctuations;
- those with a history and/or recent experience of hyperinflation, like Argentina in 1991, which desperately need a strong anchor for domestic monetary stability and whose population is willing to pay the price thereof (in terms of high interest rates, recession and unemployment).
Relatively few countries meet these criteria. Certain countries for which currency boards or dollarization have recently been proposed-Brazil, Indonesia, Mexico, Russia-clearly do not. Hence I believe there is a very limited universe of countries where this approach would make sense.
However, one additional criterion has recently been suggested for dollarization: close economic links between a country and the United States. The argument is that such a country, in addition to enhancing its monetary stability, could achieve significant savings in transaction costs because of those extensive trade and investment links. For example, studies show that transactions between Canadian cities are 20 times those between similar Canadian and American cities despite ten years of a free trade area and the geographic propinquity, common language and culture of the two countries; the main barrier may be the different currencies and the fluctuating exchange rate between them. This is one of the main economic arguments for creating the euro as a common currency for countries that have already developed extensive trade and other economic ties in Europe.
Hence dollarization could lead to a further increase in trade and investment between countries that are already integrated to a substantial degree. The associated costs would be reduced if there are already relatively free flows of capital and labor between the country and the United States, since such flows represent the alternative mechanisms of adjusting to economic conditions that affect the two economies differentially.
Dollarization can thus be conceptualized as a "currency board plus,"4 in three senses. First, it imparts even greater credibility to a country's commitment to forever renounce the devaluation option. Second, it assures that the country will import stable prices and presumably lower interest rates from the United States. Third, it minimizes transaction costs and promotes further long-term integration with the US economy.
All this of course comes with a price. The country gives up two major policy instruments, which have traditionally been viewed as integral elements of national sovereignty: monetary policy and the exchange rate. In addition, by abolishing its central bank, it abolishes its lender of last resort so has no agent to respond to a domestic financial crisis (which is still possible, despite dollarization, if the domestic banking system is unsound). The absence of a central bank also eliminates the normal supervisor and regulator of the financial system, although a separate agency can be created for that purpose.
Given the tradeoffs involved, it bears repeating that, in my judgment, dollarization makes sense only for countries in one (or some combination) of three positions: a very small and open economy that has no real autonomy over its exchange rate anyway, a country desperate to overcome a legacy of hyperinflation, or a country that is already deeply integrated with the United States. All others should continue to seek alternative exchange-rate systems more suited to their positions as relatively closed economies that are relatively noninflationary and not tightly linked to the United States.
The Case for an Intermediate Regime
Given the costs and problems of both truly fixed exchange rates and free floating, the real issue for most industrial and developing countries in today's world-including the United States-is the degree of currency flexibility and the policy under which that flexibility will be managed. For the reasons noted, very few countries will adopt currency boards or dollarization. Very few will now try to sustain "adjustable pegs." Even fewer will float freely, subjecting their economies totally to the whims of the market.
Hence the practical policy issue is the nature of the intermediate regime to be adopted:
- what range of fluctuation is consistent with underlying economic fundamentals and hence acceptable?
- what policy tools can be deployed to keep rates within those ranges?
- should the ranges be decided in advance, preannounced or kept secret, or decided and implemented ad hoc?
- should the country in question pursue managed floating on its own or in tandem with other countries, as the members of the Economic and Monetary Union in Europe have chosen to do via their common currency?
There are obviously a large number of variants that can be adopted in response to these questions. A great deal of experimentation is now underway as individual countries seek to develop effective answers to them. There are two main prototypes, however, on which most debate focuses and which I will address in the remainder of my statement with an emphasis on the G-7 countries rather than the emerging market economies:
- "ad hoc managed floating," or "guerrilla warfare with the markets" as it is often described by Secretary of the Treasury-designate Lawrence Summers, and
- "target zones" or "crawling bands" under which industrial and developing countries, respectively, set and announce ranges within which they will let their economies float and defend those ranges as necessary.
The Case for Target Zones
G7 currency gyrations in recent years have far exceeded any conceivable shifts in economic fundamentals. The dollar rose by 80 percent against the yen and 40 percent against the D-Mark from early1996 to mid-1998 and late 1997, respectively. One result is that trade deficits in the US are at record levels, retarding our income levels and generating strong protectionist pressures despite a 25-year low in the US unemployment rate (and probably setting us up for a very sharp, and possibly very disruptive, fall in the dollar at some early point).
In addition, the sharp swings in the yen-dollar rate contributed importantly to the outbreak of the Asian crisis. Every 10 percent decline of the yen takes $20 billion off the trade balances of the rest of Asia. The plunge of the yen last summer led China to the brink of devaluation, which would have reignited the crisis at a particularly inopportune time.
The instability of the dollar, yen and European currencies is likely to worsen with the creation of the euro. The euro-zone will resemble the US: a continental economy with modest reliance on external trade. It will be tempted to emulate America's tradition of benign neglect of the currency. This is especially true in light of the European Central Bank's mandate to focus on price stability, which implies the absence of any explicit policy towards the exchange rate. The dollar and euro will provide the bulk of global finance, and large fluctuations between them will be highly disruptive for the rest of the world as well as for the US and European economies themselves.
As noted above, both rigidly fixed and freely flexible exchange rates have been tried and found wanting. Fixed rates, unless carried to the extreme of monetary union, as in Europe, or a currency board, as in Argentina or Hong Kong, have proved too prone to degenerate into costly over- and undervaluations. Flexible rates tend to overshoot wildly and generate equally disruptive misalignments.
The goal of currency reform should be a "third way" between these two extremes. For the G7 this goal can best be pursued by maintaining substantial flexibility but modifying the method by which it is managed. For the past decade, the G7 has intervened periodically on an ad hoc basis without prior announcement. This technique has the advantage of surprising the market and has frequently succeeded (for example, to defend the dollar in 1995 and to defend the yen in 1998). However, the interventions have always come long after large misalignments have set in and severe economic damage has resulted. The absence of official guidance has left, indeed led, the markets to drive rates far from their long-term equilibrium levels.
A better approach would be to announce limits on the extent of permissible swings starting perhaps as much as 15 percent on either side of agreed currency mid-points (as in the European Monetary System since 1993). Rates would still float virtually all the time, as in the EMS. Any long-term disequilibria would be avoided by adjusting the ranges by very small amounts, which would be necessary to offset inflation differentials among the participants; very little if any adjustment of this type would now be needed among G-7 countries, whose inflation rates are very similar, but are more important for emerging markets (whose regimes of this type are thus called "crawling bands").
Within the wide limits envisaged, the G7 governments could surely agree on ranges that reflect underlying economic reality and are credible to the markets. Private speculation would then become stabilizing rather than destabilizing. As a rate approached the edge of a range, little money would be made by pushing further in the same direction because the markets would know that the authorities would not permit the limits to be breached. In contrast, considerable profit could result from reversing the rate back towards (or beyond) the mid-points. Both theory and empirical evidence from similar regimes that have already existed, such as the EMS since 1993, demonstrate that such "mean reversion" can be expected with some confidence.
Nevertheless, a rate might occasionally reach its limit and require official response. The initial instrument would be direct intervention in the foreign exchange market by the central banks. To assure credibility, however, participants would have to be prepared to alter their monetary policies to defend the ranges. In such instances, as Paul Volcker has argued persuasively for the United States, a country's long-term economic health would almost certainly be promoted rather than undermined by heeding the signal from the currency markets. With wide margins and credible national policies, however, the need actually to change monetary policy for currency reasons would probably be quite rare.
Many current officials oppose target zones (or any other rule-based intermediate currency regime) on the grounds that countries might have to raise interest rates to check a depreciation to the lower end of the band when the domestic currency was weak because of a weak domestic economy for which such monetary tightening would be inappropriate. This view ignores three alternative possibilities: that the currency ranges would be wide enough to accommodate most cyclical swings in exchange rates, that direct intervention would be adequate to check the slide without requiring any changes in monetary policy, and that cuts in interest rates by the countries with strong currencies (rather than increases in rates by those with weak currencies) would be appropriate to the cyclical situation. Given these possibilities, along with the Volcker-type view on the desirability of responding to signals from the exchange rate, the case for target zones-as contrasted with the main realistic alternative, ad hoc episodic management-is quite strong.
Similar considerations apply to the emerging market economies. The Asians' dollar pegs led to substantial overvaluations and large trade deficits. Their subsequent resort to free-floating regimes produced wildly excessive depreciations that forced them to deploy sky-high interest rates, further weakening their banks and deepening their recessions. They too should consider intermediate currency regimes, perhaps based on a common link to a trade-weighted basket of G7 currencies. Colombia, Chile and a number of other countries have used such systems successfully in the past.5
Hence I believe that the G-7, the IMF, and individual industrial and developing countries should all move toward adoption of target zones or similar regimes. The current debate over the future of the "international financial architecture" offers a propitious time to do so. I hope that this Committee will push the debate in this direction as it did so successfully in the 1960s.
4. A country that already has a currency board could move to dollarization very quickly. The details for Argentina are laid out in "Monetary Union for the Americas," J.P. Morgan Economic Research Note, February 12, 1999, p. 10. That note also describes the prospects for dollarization in Canada, Mexico, Brazil and the Andean Pact countries.