QUERETARO, Mexico, Dec. 12 (UPI) -- Economists disagree. About exchange rates they disagree especially. You can float it, fix it hard or loose, peg it, or even get rid it of by dollarizing or pooling your currency with that of others, as in the case of the euro. Many choices, and they matter enormously.
When an economy goes wrong the exchange rate is often the barometer. The currency may plummet. But the exchange rate is never a mere barometer. It is part of the weather and may be the cause of the storm.
Take Asia. In 1997 the until then successful "emerging" economies of Asia suddenly went into crisis. The currencies of many of the countries in the region collapsed. Recession was deep. These currencies had previously been "pegged" to the U.S. dollar in arrangements that allowed a controlled downward movement; this is often known by economists as a "crawling peg."
A crawling peg has its advantages. It brings predictability to trade and investment decisions but without tying the currency down; there is still some room for maneuver. Crawling pegs have often been favored by emerging economies seeking to reduce inflation and bring stability to their economies. A tumbling currency quickly pushes prices up, and may create a vicious circle that raises prices and pushes currency down further. A crawling peg can forestall this problem and without locking the currency into a rate that may make exports uncompetitive. That is the rationale behind crawling pegs. But they have often disappointed.
Mexico had a crawling peg in 1994. Its currency followed a schedule, moving down against the dollar by a tiny amount each day but by less than the then inflation rate. As a result the exchange rate helped to bring inflation down but the Mexican peso appreciated steadily in real terms, making Mexico's exports more expensive and its imports cheaper. Mexico, just like the Asian economies, ran steadily higher trade and current account deficits in the years leading up to its crash, which began in December 1994. And when the crash came its currency fell hugely, from around 3 to the US dollar to 9 in a matter of months.
After Mexico and Asia the International Monetary Fund began to state that semi-fixed exchange rates, such as a crawling peg, were not a good idea. It began to argue that either a floating exchange rate or a "hard" fix was best. This conclusion was unsound, in your correspondent's view.
Argentina is an example of a country with a "hard" fix. It runs a sort of gold standard but one in which dollars substitute for gold. The peso money supply is fully backed by dollars. Demand a dollar from the central bank and it will give it to you. The peso you hand over disappears from circulation. In this way, falling international reserves reduce the money supply and drive up interest rates. That makes pesos more attractive to hold, and reduces growth and therefore imports, helping--in theory, at least--to restore international reserves. Like the gold standard, the idea is that the mechanism is self-correcting. But in the real world the mechanism has been proven not to work.
Reducing Argentine growth simply made Argentina all the less attractive to investors. It worsened the fiscal position and made the banking system frail. The fixed exchange rate left Argentina uncompetitive. Argentina is now seeking to renegotiate its debts in a maneuver that rating agencies are deeming a default. It appears to be on the verge of devaluation. Another alternative that of replacing the peso entirely and dollarizing, would, in this correspondent's view, prove just as disastrous as the currency board, giving Argentina a strong currency, which would keep the country uncompetitive and unable to adjust its monetary or exchange rate policies.
In some regards Argentina's experience has echoed the inter-war failure of the gold standard. Winston Churchill opted for a return to the gold standard in 1925. The decision is generally regarded as being disastrous, provoking low growth and rising unemployment. The gold standard and the fixed exchange rates associated with it left no room for changes in economic development and in competitiveness that take place over time. Britain was losing its economic pre-eminence in the 1920s to the United States. The world moves on. Fixed prices don't. Eventually, below the surface, there is a seismic shift and earthquake takes place. These earthquakes can be avoided simply--by not fixing exchange rates, which are, after all, no more than a price, the price at which one currency is exchanged for another.
The euro represents yet another experiment in exchange rate policy. Different countries have abandoned their own currencies and opted for a shared one--and a shared monetary policy. The members of the euro zone negotiated and chose rates at which their currencies would enter the shared euro. The aim is to create, economically, at least, a United States of Europe: a very large and very powerful common currency area in which trade and investment flows are unhindered by currency uncertainty and currency transactions.
Has the euro, now extant for almost three years, proven a success? Many would argue not on the grounds that the euro has been weak against the U.S. dollar. But in reality this is poor grounds to condemn the new currency. The dollar's strength is a reflection of what may prove unwise flows into U.S. assets. It is too early to judge the euro a success or a failure. Its true test will come over time.
What if the German economy continues to perform poorly and to require a very low interest rate to remain out of recession? What if that same interest rate encourages overly rapid growth and inflation in other countries, such as Spain or Ireland? The euro experiment is based on convergence, in policies and economic performance. But what if Spain and Italy tackle obstacles to growth, such as poor labor policy, and France and Germany fail to do so? Persistent differences in performance between the different countries of Europe may mean that the shared exchange rate and monetary policies begin to prove a problem. Currency systems need to prove themselves over time. Argentina's currency experiment was generally deemed a success on its fifth birthday, in 1996, and is falling apart on its tenth. It is not certain that the euro will be thriving in ten years' time.
Mexico, Asia, Russia, and Brazil: all have entered crisis in the past five years with exchange rates playing a central role. All are now faring better having floated their currencies. This correspondent's rule for currencies is this: do not expect too much of them; they are only prices. They should not be used as policy tools. Tackle real problems such as monopolies, or unjust or irrational taxes, or foolish labor laws, or excessive bureaucracy, if you want to improve economic performance. Do not fix exchange rates, any more than you would fix the price of a loaf of bread or a motorcar. For one day the fix will blow up in your face.
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