The downside of fixed exchange rates

LW: Martin Wolf has drafted another superb Wednesday column. He begins with these words:

“What would have happened during the financial crisis if the euro had not existed? The short answer is that there would have been currency crises among its members. The currencies of Greece, Ireland, Italy, Portugal and Spain would surely have fallen sharply against the old D-Mark. That is the outcome the creators of the eurozone wished to avoid. They have been successful. But, if the exchange rate cannot adjust, something else must instead. That "something else" is the economies of peripheral eurozone member countries. They are locked into competitive disinflation against Germany, the world's foremost exporter of very high-quality manufactures. I wish them luck.”

Martin Wolf, "The eurozone's next decade will be tough", Financial Times (6 January 2010).

http://www.ft.com/cms/s/0/19da1d26-fa2f-11de-beed-00144feab49a.html

The remainder of the column is just as informative, just as well-written, and should be read in its entirety. Martin ends on a sober note:

“When the eurozone was created, a huge literature emerged on whether it was an optimal currency union. We know now it was not. We are about to find out whether this matters.”

I've said this before, and will say it again: Martin Wolf's column alone is worth the price of an online subscription to the Financial Times. Non-subscribers, I understand, are allowed to download three articles each week. If you are a non-subscriber, do reserve one of your free weekly downloads for Martin Wolf. Martin rarely disappoints.


DOW: Let me begin by saying I endorse what Larry says above about the wisdom of Martin Wolf and double endorse his recommendation to download Martin’s weekly column.

Let me add that many economists -- I was one of them -- were never a supporter of the euro precisely because we did not think Europe as a whole was sufficiently integrated to allow a single currency to operate across such a varied economic landscape with such diverse policy objectives and different institutional structures. But I was sympathetic to the need to reduce the transactions costs associated with currency conversions and fluctuating exchange values, and I hoped that the introduction of a single currency would sufficiently discipline economic policy and improve economic performance so as to limit any problems caused by the introduction of a rigid and unchangeable unit to effect transactions and carry out investments over such a wide area. Opening up Europe as a whole to flows of people and capital was also a good idea that could help a continent overcome a terrible history of nationalistic turmoil.

Our fear was the euro would shift the internal balance of payments adjustment process among these countries entirely to changes in the level of income (and hence employment), as fixed exchange rates inevitably do, rather than allowing changes in relative prices to absorb some of the adjustment effects, as more flexible exchange rates tend to do. Wider swings in growth and more persistent external imbalances would result if a fixed exchange rate were imposed and the unemployment rate would be higher. If this happened, the economic situation in some of these countries would worsen over the long-run, not improve, at least relative to the other countries. This is what appears to have happened some of the peripheral countries.

The peripheral countries now have a difficult decision to make. By accepting the euro they have turned the conduct of their monetary policy over to the European Central Bank. It is no longer available to them as a domestic policy instrument. Moreover, now their fiscal policy must be directed at their external concerns rather than their internal problems. For these countries, fiscal policy is no longer a domestic policy instrument. The fixed exchange rate of the euro has become the sole concern and focus of economic policy in these countries. They will either have to discipline their internal policies to the demands of their external monetary relationships or they will have to abandon the euro.

As Martin Wolf mentions in his article, the late Charles Kindleberger of MIT argued that an open economy required a hegemon to bring stability to the external environment within which countries conduct their external economic relations. In the case of the eurozone it is Germany. But because of the nature of its own structural relationships Germany is not capable (or even willing) of carrying out this role. Consequently, the peripheral countries of the eurozone are left to fend on their own not only without support from other countries but with the constraints imposed by others tightening on them. Their immediate outlook is bleak and their adjustment process to deal with their problems is becoming increasing difficult.

In the same way for the same reasons as Kindleberger set forth the world economy requires a hegemon to provide it the stability and lend it the time required to adjust domestic productive structures and trading patterns to the incessant changes brought about by technological change and rising incomes. This hegemon is the United States, whose currency is the main international currency and whose economy is the main absorber and provider of goods and services at the international level. The U.S. attempted to avoid the role as hegemon at the end of the Second World War, or at least minimize it, through the establishment of a set of international monetary institutions -- the Bretton Woods System -- to which it transferred many of the operations necessary for the efficient functioning of the world economy. By doing so, it hoped to release itself from the constraints entailed in managing the world economy.

But the United States quickly learned that, in the end, there must be a spender and borrower of last resort in a crisis, and the IMF and other international agencies it created were not up to the task. Moreover, it quickly learned, to its sad regret, that that a fixed exchange rate system at the world level required domestic policy discipline on the part on the global hegemon and its failure to live within its means and conduct its domestic policy with the goal of international stability in mind would bring down the entire system. The world (and, equally, the Americans) has lived with the consequences of the inability of the United States to conduct its economic policies in a manner worthy of its responsibilities since the late 1960s and early 1970s. Nowhere is this clearer than in the sharp deterioration in long-term world and U.S. economic performance since that time and an increasingly chaotic international economy.

The upside of fixed exchange rate systems is that they provide the stability required for rapid economic advance and spreading global prosperity. The downside of fixed exchange rate systems is that they require discipline on the part of governments in the conduct of their monetary and fiscal policies, especially on the part of the hegemon, and a willingness to adjust to changes taking place outside their domestic economies.
As Martin points out, we are about to find out whether the peripheral members of the eurozone can summon the discipline necessary to deal with their deteriorating economic circumstances. One wonders whether the United States, which is far more important to the world economy and encompasses far more people than the smaller countries of the eurozone, can do the same.

Thanks to Larry Willmore for the Tdj.