Published in Dawn, Mar 27, 2019 , a leading Pakistani newspaper, in context of public debate about moving to a floating exchange rate regime —
In 1971, when Nixon shocked the world by abandoning the convertibility of dollars to gold, he dragged all of us, unwillingly, into the modern era of floating exchange rates. Since then, economic theories have changed. But old habits die hard; economists and policymakers today continue to think and operate as if they live in the old world. This article examines the question of fixed versus floating exchange rate regimes from the new perspective of Modern Monetary Theory (MMT).
In a floating exchange rate regime, the Central Bank allows the supply and demand for dollars and rupees to determine the exchange rate. This can lead to sharp and erratic movements in exchange rates because of speculation, shifting expectations, and manipulation. The “fear of floating” refers to Central Bank efforts to stabilize exchange rates by buying and selling dollars to counteract the market forces. These efforts ensure that movements in exchange rates are smooth, stable, and predictable, making foreign trade much easier for exporters and importers.
The Bretton-Woods institution of the IMF was formed in 1945 to ensure stability of exchange rates in the post-WW2 era, by lending currencies to member nations facing temporary balance of payments deficits. Post-WW2, instead of adapting to the strange and unfamiliar demands of a floating exchange rate regime, the vast majority of developing countries preferred to peg their soft currency to the dollar (or some basket of hard currencies). This is known as a “managed float” or “dirty float” regime because the Central Bank intervenes to ensure that the floating exchange rates remain fairly close to some fixed rate determined by policy makers.
This is said to have several advantages. One is that foreign investors have some confidence about the ability to enter and exit capital markets at known exchange rates; boosting foreign trade and investment, considered keys to rapid growth. The second is that domestic traders, exporters and importers, can make plans required to do business, and make investments, because they can determine their costs and revenues in advance, with some degree of confidence. The third is a widespread misperception that a “strong” currency represents a strong economy, and is a symbol of national pride. In fact, these half-truths represent an emotional attachment to a “golden” past, which prevents the adjustments, mental and institutional, required to learn to live in a world of floating exchange rates.
“Fear of floating” is the idea that the foreign exchange (FX) market would be so erratic and unstable that nearly all foreign trade would suffer heavily, perhaps isolating the economy from the benefits of global trade and capital flows. But free flotation has the benefit that the Central Bank no longer needs any FX reserves to stabilize the currency; FX crises like the ones we experienced recently simply cannot occur. One of the major recommendations of MMT is that governments should avoid acquiring liabilities denominated in foreign currencies – one of which arises when we attempt to manage the exchange rate. If we look at major financial crises all over the world in the past few decades, we find that most of them involve government defaults on foreign debts. To move forward, we must replace current Bretton Woods conventions in which all foreign trade is denominated in dollars. Instead, we must learn to think in terms of currency swaps, based on balanced commodity trades. It is this mental shift, learning to think in new ways, that is the hardest part. The current system gave the USA the extraordinary power to print $30 trillion dollars to rescue global financial institutions, without suffering any adverse consequences. Just like the Communist Bloc invented bilateral frame agreements to carry on trade without dollars, today the whole world needs to create a consensus on a new method for global trade, which would be fair to all countries, and avoid the disastrous trade wars currently taking place.
Currency crises result when central banks ‘manage’ the exchange rate at the wrong level. This results in a constant need to pump dollars into the market to cater to the excess demand for FX created by over-valuation. Eventually, reserves are depleted, and new loans are necessary, leading the country into a debt-trap. Equally important, import-substitution strategies fail, because domestic substitutes cannot compete with imports made artificially cheap by over-valuation. What is worse is that industries based on the ability to get cheap imports come into existence. For example, despite vast agricultural resources, Pakistan imports USD2.5 billion worth of food, including oilseeds. Breaking out of this over-valuation trap is slow, painful, and difficult, because we must allow industries based on cheap imports to collapse and initially subsidize the emergence of new industries, which will be profitable only if competing imports are too expensive because the PKR is correctly valued. This will take time, and will require confidence of the private sector in the stability of FX policy regime, to make the necessary long-run investments in new types of business.
Freely floating the rupee shifts the exchange rate risk from the government to the private sector, but insulates the economy as a whole from macroeconomic crises, and also mitigates the harmful effects of fiscal deficits to a large extent. The domestic economy has to learn to operate in a new type of economic environment, where imports are more expensive and riskier to obtain. The FX risk inhibits foreign competition which allows infant industries greater room to grow. These methods were invented and used by East Asian economies to create the miracle of growth which transformed them from agricultural to industrial economies. Also extremely effective was the tactic of systematic undervaluation of currency, which allows the Central Bank to accumulate foreign exchange reserves, instead of losing them. This creates the surplus required to support domestic industries, to allow them to grow into export tigers. Today, instead of using failed models like the Washington Consensus, based on free market ideologies, we need to learn new strategies from the rising sun in the East.
POSTSCRIPT: An amusing illustration of the fear of floating was the attempt by the Hunt brothers to corner the world silver market. They were convinced that floating would not work, and the world would go back to gold and silver. The world gold market was too big to capture, so they decided to buy all the silver in the world! They almost succeeded, and only active hostile intervention of the US Fed blocked their attempt. This intervention was not due to concerns about the bad effects on monopoly on the public and the world, but due to Hunt brothers falling on the wrong side of contemporary power politics — for some portions of this story see: “Speculative Financial Attacks“.
For important background information, see “The Vital Importance of Understanding International Financial Architecture“ -This explains in some detail the history of how the Gold Standard emerged, and how the first World War led to its collapse. At least some of the political strains which led to the first world war were actually caused by the defects of the Gold Standard as a system for international trade. It also explains why post-war efforts to restore the Gold Standard failed. The second post in this series, “International Financial Architecture: Part II“ explains how the second world war was partly caused by the collapse of the Gold Standard, which led to sufficient de-linking of the international economy that war was more profitable than trade. The realization that the pre-war gold standard would be impossible to restore in the post-WW2 led to a search for alternative agreements on how to conduct international trade in the Bretton-Woods conference. This created the gold-exchange standard in the post-WW2, which broke down in the Nixon shock of 1971, when Nixon delinked the dollar from Gold. These two posts end with the Nixon shock, while the present post continues the story (but only for a popular audience) after the Nixon shock. Many more details are required to fill in this post Nixon-shock story, to bring it up to the Global Financial Crisis. A 50m video-lecture which summarizes the contents of the two posts/lectures above for a poular audience is given below:
For some speculations about the emergence of a new kind of global trading system which corresponds to the rise of EU and China as major forces in international trade, and the corresponding decline of the US, see “Demise of the Dollar?“.
Finally, this post, and related posts illustrate a methodological point of central importance. Macroeconomic theories cannot be understood without understanding the historical context in which they emerged. Even more important and subtle, history cannot be understood without understanding dominant Macro theories. This is because Macroeconomics theories (right or wrong) express our understanding of contemporary economic events, and SHAPE our responses to these events. History is a record of how we human beings respond collectively to changing social and environmental circumstances, while our responses are shaped by our theories regarding these changes. I understood this point by studying the “Methodology of Polanyi’s Great Transformation“ and have been using this, and other great insights, to shape my understanding of history and macro. Contemporary economics is methodological committed to the opposite point of view — that is, economics is a collection of scientific laws which is independent of historical context. How this strange and hopelessly wrong point of view emerged and came to be dominant is explored in my post on “Method or Madness?“. My paper on “Deification of Science and its Disastrous Consequences”, which is linked in my post on “Is Scientific Methodology Axiomatic?“, also discusses this same issue in much greater detail. In this connection, see also, “The Misconceived Project of Social Sciences“.