Do floating exchange rates offer permanent solutions?

From 1944 up to 1971, national expenditures were valued in relation to the US dollar which itself was valued in terms of gold.

The US dollar had been accepted as a measure of other currencies because the US had emerged out of the World War II as the strongest economy, its currency the most stable and desirable.

By the end of the 1960s, the US economy was not completely dominant in international markets.

Germany and Japan were performing better with their exports. The US was experiencing perennial current account deficits. That is, it was importing more than it was exporting.

American economists attributed this to the fact that the US dollar was overvalued in comparison with the German mark and the Japanese yen.

In 1971, president Nixon of the US delinked the dollar from gold. The US government no longer pledged to exchange the dollar for gold.

The dollar had been playing its role as the main reserve currency and as part of the international monetary system which had been formed at Bretton Woods and whose institutions were the International Monetary Fund (IMF) and the World Bank.

In 1973, the international monetary system changed from fixed to flexible or floating exchange rates. For some time, academicians had been advocating for this change.

Not everyone believed that flexible exchange rates would provide better solutions to international trade and financial problems.

One of the most outspoken opponents of the free-floating exchange rates was Dr Arthur F Burns, former chairperson of the board of governors of the Federal Reserve System.

Said he: “I remain sceptical about the desirability of a general system of floating exchange rates. I hold this view even though I recognise the usefulness of floating rates in particular situations such as the present.”

At that time, one would hear cynics say the US provides a market in which foreigners sell a lot, but buy little. Hence, the campaign to depreciate the dollar so that American exports could be more competitive in foreign markets while imports into American market became less competitive. They hoped it would reduce the current account deficit of the US.

Dr Burns gave four reasons why he questioned the desirability of the flexible exchange rate.

First, in his judgement, the floating exchange system would continue to elude its advocate. Large movements of exchange rates would expose governments to strong pressure from such interest groups as business, labour and agriculture, all seeking protection from the unwelcome swings.

Second, he feared that a system of floating exchange rates might lead to political friction with other countries. From time to time, suspicions and accusations might arise that this or that nation is manipulating exchange rate at the expense of other countries interests.

Of course, even under the fixed rate system, some nations were trying to defend fixed rates that they were unrealistic. He felt this problem would be worse under the flexible system.

Thirdly, the flexible exchange rate system was fraught with the sort of uncertainties that would in time lead to erosion of international trade, particularly in the purchase of equipment which generally required long term financial planning. The uncertainties would weaken in the long run private foreign investment.

Fourth, Dr Burns feared that exchange rate fluctuations under a floating regime might worsen difficulties some governments had in carrying out suitable fiscal and monetary policies. For example, he believed that temporary exchange rate depreciating would translate into permanent price level increases through upwards revisions.

How far have flexible exchange rates been accepted since the early 1970s? The flexible exchange rate system has over time been variously described as a managed floating exchange rate. It is recognised that changing economic condition among nations require continuing changes in exchange rates, but central banks do not just want the swings to take place. They act.

The die-hard opponents of the flexible exchange rate say it is a ‘non-system’ since no one knows in full what its rules are. These people look with nostalgia to days of fixed exchange rates. As for us in Malawi, we must be vigilant to see how the new system will work.