Submitted to the Wall Street Journal
October 14, 1998
To the Editor:
What is missing in the debate between proponents of a fixed-exchange-rate regime, such as the editors of the Wall Street Journal (”Reforming the World,” 7 October), and proponents of a floating-exchange-rate system, like Milton Friedman (”Markets to the Rescue,” 13 October), is the primary cause of exchange rate variations within current international monetary arrangements.
The editors assert that a country’s exchange rate is a matter of policy. Governments “use exchange rates to manipulate trade flow.” Devaluations are chosen by governments, or forced on them by the IMF, to make their exports more competitive in world markets thereby stimulating foreign demand for their exports.
Mr. Friedman counters by explaining the distinction between fixed exchange rates and pegged exchange rates. Fixed exchange rates can only be maintained when countries surrender monetary discretion. Under a pure gold standard, for example, each country would define a unit of its currency as an amount of gold and produce currency to match its gold holdings. With a pure dollar-reserve standard, such as Hong Kong’s currency board, each country would define a unit of its currency as an amount of dollars and produce currency to match its dollar holdings. In either case, each country’s currency would increase or decrease to precisely match any increase or decrease in its reserves and thus, leave its fixed exchange rate intact.
In a pegged-exchange-rate regime, like the gold-reserve standard after the First World War, the dollar-reserve standard after the Second World War, and the current international monetary regime, countries maintain discretion over monetary policy behind the veil of promises to maintain relatively fixed exchange rates between their currencies and some international reserve, such as gold or the dollar. By creating the illusion that its currency has a hard link to its reserves, a country can inflate its currency in excess of the increase in its reserves without immediately suffering a decline its purchasing power.
Inevitably, significant excesses of monetary inflation of a country’s currency relative to its reserves builds pressure for devaluation. When a government announces devaluation, as the United States did in 1934 and again in 1971, it is merely recognizing the reality of the consequences of its monetary inflation. Its inflationary policy has eroded the purchasing power of its currency which will be suffered both domestically, with price inflation, and internationally, with devaluation.
The undesirable effects of monetary inflation cannot be eliminated with floating exchange rates. Then the price inflation and devaluation occur gradually instead of being bottled up behind the government’s unsustainable peg. But whether the currency is pegged, as the dollar was in the 1920s and 1930s, or floats, as the dollar has since 1971, monetary inflation and credit expansion cause a boom-bust cycle.
Financial and economic instability are caused by central-bank monetary inflation and credit expansion. Devaluations in a pegged-exchange-rate regime are but a symptom of this cause and floating exchange rates do not prevent booms and busts. Instability can only be eliminated by taking control of monetary policy from governments, for which the temptation to inflate money and expand credit is irresistible.
