Oxford: The currency conflicts that we have witnessed in recent weeks and months highlight the fact that current global exchange rate arrangements are not fit for purpose.
The basic issue concerns what is known in international economics as the (N-1) theorem. This states that if there are N currencies, there can be, at most, (N-1) independent exchange rates. Suppose there are only two countries, each with its own currency. Then it is easy to see that the number of independent exchange rates can be zero or one but not two. The first case corresponds to a float: neither country has an exchange rate target. In the second case, one of the countries sets the exchange rate and the other is passive. The third and impossible case is where each country wants to set the exchange rate at a different target level. In this case, there is conflict. The (N-1) theorem simply extends this reasoning to N countries and much of the history of exchange rate regimes concerns how the (N-1) problem is resolved. An obvious case in point is the breakdown of the post-war Bretton Woods system in 1971. De facto, this system was a dollar standard. Each country fixed its exchange rate to the dollar and could change the rate if it chose to do so. The US was the passive Nth country. The system broke down when the US wanted to alter its exchange rate. This meant the other countries giving up their exchange rate targets, which they were reluctant to do. In the ensuing struggle the US succeeded, as it was bound to, but only by breaking up the system.
The (N-1) theorem can be applied to any group of countries. Its relevance is sharpened if we apply it to the group of large, key countries such as the US, the euro zone, China and Japan. A small country’s choice of exchange rate regime does not matter to other countries. Not so with a key country. Its exchange rate arrangements and policies affect many other countries. So if the key countries have conflicting or inappropriate exchange rate targets, this matters for global stability. The contemporary relevance of this proposition is evident. The US is suffering from a shortage of aggregate demand and is likely to engineer a further monetary expansion, which will depreciate the dollar. China is reluctant to see its exchange rate appreciate because that would hurt its export industries, so it is likely to intervene in the foreign exchange market to prevent the appreciation.
But this means the euro and the yen will appreciate a lot more than they would otherwise. That is the last thing Europe and Japan need right now since they too are in a recession. Many emerging and developing countries also fear that capital inflows generated by looser monetary policy in the US will appreciate their currencies and cause an unwelcome decline in their international competitiveness, all the more so if China refuses to let its exchange rate take some of the strain. Not surprisingly, several countries in Asia and Latin America have already taken steps to restrict capital movements. Plainly, the probability of a disorderly outcome of competitive devaluations, trade protection and capital controls has increased significantly.
Why has the world ended up in this quandary? The reason is that since the collapse of Bretton Woods, we do not have anything that can be called an exchange rate “system”. An effort to devise one was made in the 1970s but was given up. The amendment of the IMF Articles that was agreed in 1978 established the principle of freedom of choice in exchange rate arrangements. (The amendment also forbade “exchange rate manipulation” but the term was never clearly defined and the provision became a dead letter.) This ushered in a free-for-all based on the idea that each country should adopt any exchange rate regime that best suits its goals and circumstances. As we saw above, from the global standpoint, this is a crazy idea, especially when pursued by the key countries. And it will become crazier as the number of key countries (India, Brazil, etc.) increases in the coming decades. To prevent global monetary chaos, key countries must agree on a common exchange rate system. Only small and minor countries can be allowed the luxury of unconstrained freedom of choice.
Agreement on a system for key currencies, and on how to get there, will not be easy and will take time. A necessary first step is agreement on the final objective. What should be the eventual shape of an exchange-rate system for key currencies? All alternatives have their disadvantages. A fixed exchange-rate regime would imply a loss of monetary autonomy. It would imply adjusting to asymmetric shocks by internal wage and price changes. That would be inefficient as well as intolerable. (The current strains in the euro zone exemplify the costs of such a regime.) For the key countries, this would be a political non-starter. Another alternative is to adopt clean floating. But this too is unlikely to be acceptable, because governments regard the exchange rate as too important a price to be left entirely to the mercy of market forces. Unmanaged floating can sometimes lead to exchange rate behaviour that is manifestly insane, for example, the US dollar bubble in the mid-1980s. Many intermediate regimes can also be ruled out as unworkable. For example, a return to Bretton Woods-style adjustable pegs would be incompatible with today’s high capital mobility.
In my opinion, there is only one option that has the potential to be desirable as well as eventually acceptable. Key countries should agree to float but with one major proviso. This is that they periodically agree on reference exchange rates that are appropriate for international adjustment, intervention being allowed only if it is undertaken to influence market exchange rates in the direction of reference rates. Such a scheme would require regular dialogue between the key countries, along with some macroeconomic policy cooperation and some willingness to abide by the rules. These are not easy requirements to satisfy, and many details would have to be sorted out. But the impetus for agreement could come from the realization that the status quo is clearly a recipe for disaster.
Vijay Joshi is a Fellow of St John’s College, Oxford, and an Emeritus Fellow of Merton College, Oxford.
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