Home Business & Finance Money, Markets, and Democracy: Politically Skewed Financial Markets and How to Fix Them
Fixed Versus Floating
From the poor example set by China currency’s peg, it ought not to be concluded that a floating system is ideal. As the best way for a society to manage its money is through a gold standard, the problem lies not with a fixed rate as such but with how it is fixed. For if all societies adhered to a gold standard, as they would in a perfect world, then their respective currencies would necessarily trade at determined values with each other. Suppose country X sets its currency at 25 units equal to one ounce of gold. Now, further suppose country Y establishes its own currency at 50 units equal to one ounce of gold. The currency of X will be worth twice as much as that of currency Y. That is, one will pay 2 units of Y to obtain 1 of X or, reciprocally, 0.5 units X to obtain 1 unit of Y. Were it to deviate from this rate, an arbitrage possibility would arise. Gold could be bought more cheaply in one place and then immediately sold more dearly in another. Such an opportunity will be quickly exploited and, consequently, eliminated—at least until a differential from the theoretically correct rate is reached that reflects the costs of transporting gold between the two countries.
Exchange rates were fixed in this way during the classical gold standard period extending from the 1870s to 1914. For instance, the world’s dominant currency at the time, the British pound, was equal to 113 grains of pure gold, whereas the upstart US dollar was set at 23.22 grams. That meant the British pound regularly traded circa $4.86. While fixed exchange rates were also a defining feature of Bretton Woods from 1945 to 1971, they were not established in the same manner as the classical gold standard. Recall that Bretton Woods was actually a gold exchange standard. Only the US committed to exchange its dollars for gold at a set rate. Other nations simply promised to keep their currencies fixed versus the American greenback. The entire framework was essentially an international set of price controls, a variant of the regime that countries like Argentina and China have tried post-1971. A gold standard is different. The currency is not fixed by the central bank’s willingness to go against the grain of the market by altering interest rates and buying and selling foreign currencies. Rather, a gold standard stabilizes exchange rates through the government’s commitment to the yellow metal as the foundational ground of money.
The virtues of a fixed exchange rate system, then, depends on its being the outcome of an authentic gold standard. I have already pressed the case for that monetary framework, so I will not recapitulate all the arguments other than to say that the gold standard is the system most congruent with limited government, fiscal probity, monetary rectitude, and a circumscribed financial sector. On top of these points, let me add the merits specific to fixed exchange rates. Firms and investors benefit from the diminished risk of engaging in international commerce, having greater assurances that their calculations will not be upset by unfavorable movements in the FX market. Companies also cannot rely on the crutch of a depreciating currency to make up for a lack of global competitiveness. In a fixed rate world, they are compelled instead to undertake the capital investments needed to render their operations and workers more efficient and productive. Fixed rates, too, impose discipline on politicians and central bankers by rendering it manifest to the public that they have opened up the monetary spigot. For it is one thing for a depreciation to occur slowly over time, as it often does in a floating system. It is quite another thing for a depreciation to occur in a big way all at once, as it does in a fixed system. The last is psychologically far more striking.
In a fixed rate universe as well, the business of currency trading would occupy a much smaller part of economic life than it does today. Think of how much human ingenuity and talent currently devoted to a $5.3 trillion per day industry could be liberated to engage in more worthwhile pursuits than trying to figure out whether the upcoming US retail sales report portends a rally in the Euro/Japanese yen cross-rate. Disabling public officials from adjusting the FX rate to suit their short-term political interests also precludes currency wars. These are not the sorts of wars that involve mass violence. But they can still do substantial harm, involving as they do countries engaging in tit-for-tat depreciations of their currency with the intent of advancing their exports at the expense of other nations. This dampens business activity by heightening the uncertainty among firms as to their ultimate revenues and costs. Worse, it conduces to an environment hostile to free trade. Commercial interactions with other nations come to be seen as a zero-sum game requiring tariffs, import quotas, and export subsidies to win. This is very much how events unfolded in the 1930s. Back then, a cycle of competitive depreciations went hand in hand with beggar-thy- neighbor policies that drastically reduced international trade. As was the case at that time, nationalist sentiments are bound to thrive amid a currency war, hindering the development of a cosmopolitan outlook suited to liberal democracy. Where we in the West politically reside, after all, individuals are meant to identify with each other as fellow humans beings bearing universal rights and dignity, instead of as members of irreducibly separate groups.
As a practical matter, though, gold cannot reasonably be expected to be revived any time soon as the basis for a new fixed rate regime. Thus we must resign ourselves to the prevailing system of floating currency prices.
The orthodox rationale in support of the status quo is that it enables governments to undertake monetary measures to smooth the business cycles in their respective economies. Invoking the Mundell-Fleming hypothesis, it is argued that the state confronts a trilemma. The state cannot simultaneously uphold free capital mobility and a fixed exchange rate, while conducting its own monetary policy.4 5 If the government desires monetary independence, it must either impose restrictions on capital flows in and out of the country or allow its currency to float. Inasmuch as capital controls pose a tension with democratic commitments to individual freedom, letting the exchange rate be moved about by market forces is chosen as the more attractive option. It is surely right to prefer floating rates, as Milton Friedman did, on the grounds that property rights imply that individuals possess the right to take their assets anywhere they like in the world.  For now, the bottom line is this: floating FX prices are to be preferred because fixed rates can only be properly had with gold.
|< Prev||CONTENTS||Next >|