When assessing the performance of the international monetary
system, one is tempted to paraphrase Winston Churchill on
democracy: The system of flexible exchange rates is the worst
possible one, except for all the others.
Critics of the current system correctly point out the costs
imposed on the economy by the swings that have occurred in the
value of the dollar. For instance, U.S. exporters made painful
adjustments when the dollar strengthened between 1997 and 2002,
resulting in considerable economic distress for stockholders,
workers, and communities across the country.
The subsequent weakening of the dollar eased much of that pain.
But the recent uptick in the greenback’s value has once again
brought complaints about the “strong dollar.”
Many exchange-rate changes can be hedged. But such financial
engineering consumes resources that could be put to alternative
uses were the international financial system not subject to
exchange-rate gyrations.
Critics of flexible rates tend to overlook or minimize, however,
the costs of alternative systems. Were the dollar, yen, and euro
fixed to each other, the costs of adjustment to economic change
would be born by prices, wages, and employment. To maintain the
external value of the dollar, the Fed would need to raise interest
rates more aggressively. Instead of a weakening dollar, Americans
would be confronted by deflation. Growth would slow or even turn
negative in such a scenario.
Large movements in exchange rates, such as we have experienced
in recent years, reflect profound shifts in global economic forces.
Changes in competitiveness, national taxation of investment, and
perceived risk generate economic tsunamis in the form of shifting
capital flows. These upheavals occur under any system of exchange
rates, fixed or floating.
The post-1997 rise in the dollar was partly a consequence of the
Asian financial crisis, as global capital migrated to American
shores. Lucky that it did, boosting the dollar’s value, for
otherwise there would have been no recovery in Asia or the rest of
the world.
American consumers underwrote the global recovery with their
voracious appetite for the very products made in Asia. A
capital-driven rise in the dollar financed that spending and the
resultant global recovery.
Now there has been a shift at the margin in the attractiveness
of investment in Asia. Not U.S. weakness, but China’s impressive
strength is driving that shift.
The pre-World War I classical gold standard operated with fixed
exchange rates and economies experienced large capital flows. The
international economy also saw relatively free movement of people
across borders. War and the rise of totalitarian nation-states put
a damper on both.
The development of the modern welfare state now makes
immigration costly to the recipient countries. Likewise, generous
unemployment payments have raised the costs of adjustment to
capital flows under fixed exchange rates. Developed countries
experiencing outflows can no longer permit deflation to run its
course, because of the unemployment costs.
A return to a world of peace, free trade, and prosperity would
be the best of all worlds. A system of fixed exchange rates might
be a byproduct of a return to a liberal international economic
order. In the meantime, flexible rates facilitate the adjustment to
the global economic changes we confront.
Gerald P. O’Driscoll, Jr. is a senior fellow at the
Cato Institute
and former vice president and economic adviser at the Federal
Reserve Bank of Dallas.
