Inflation and exchange rate flexibility
Excerpts from a speech by H. Johannes Witteveen. Managing Director of the International Monetary Fund, to the American Economic Association and the American Finance Association in San Francisco, U.S.A., on December 28, 1974.
A question which is perhaps more controversial than that of the role of inflation in compelling a transition to flexible exchange rates is that of the possible role of the flexible exchange rate system in promoting inflation.
There are various reasons, much discussed in the literature, for thinking that exchange flexibility and in particular freedom from the obligation to adhere to any particular exchange rate should make it easier for a country to cope with inflationary pressures and to preserve internal financial stability.
In the first place the option of allowing one’s currency to appreciate should enable the monetary authorities of a country to buffer it against the impact of demand pressures from abroad whether these arise from lax demand policies practiced in other countries or from structural shifts in foreign trade, though in the latter case adjustments will still be required as among particular industries. It should also enable them, though at some cost in terms of exchange stability, to protect the monetary system against an influx of reserves that would otherwise be difficult to offset. The degree of insulation against external shocks that is achieved in this way is reduced by a number of factors. Thus, the more inflationary countries may for a time attract a sufficient volume of investable funds to prevent their exchange rates from falling, and those of the less inflationary countries from rising. Again, the low level of foreign trade elasticities in the short run means that when exchange rates do move the buffer against external demand variations will be fully effective only after a time lag. Nevertheless, the monetary insulation will operate immediately, and I think that countries like Germany or the Netherlands would feel that the regime of floating rates had served to protect them, at least in some measure, against imported inflation. At the same time, it has to be borne in mind that insofar as this mechanism tends to prevent the spread of inflation it also tends to concentrate and magnify it in the countries in which it originates.
“With respect to the average rate of inflation in all countries taken together, floating exchange rates may have been a slight additional fillip to inflation.”
A second, though related, advantage of the flexible rate system from the standpoint of stabilization policy is that the instruments of demand management, particularly monetary policy, operate much more powerfully on the domestic economy when they are not subject to the leakages that affect an open economy under fixed exchange rates. Monetary contraction need no longer be frustrated by an influx of reserves and money from abroad and will, by promoting exchange appreciation, exercise a deflationary effect on the current account balance of payments. Here again, some of the deflationary effect will be achieved at the expense of other countries, but these countries have both the incentive and the possibility to follow suit with effective stabilization policies of their own.
Balancing these arguments in favor of flexible rates, there are two arguments frequently advanced against flexible rates from the standpoint of stabilization policy. There is, first, the contention that governments, especially democratic ones, are naturally prone to pursue expansionary policies and that exchange flexibility removes the inhibitions formerly imposed upon this tendency by fear of running out of reserves and of incurring the political odium of devaluation. There is some force in this contention, though the fact that under floating rates the effects of overexpansion must be kept at home with immediate repercussions on the domestic cost of living should provide, to some extent, a substitute discipline, if possibly a less effective one. I must add that there is not much evidence that the transition to floating rates in 1973 has led to a perceptible loosening in demand management. The expansion in money stocks which laid the foundation for the boom took place from 1970 to 1972 which, despite an interlude of floating in 1971, was on the whole a period of fixed rates.
Another familiar argument against floating rates which seems somewhat dubious in practice is the contention that spontaneous inflation pressures within a country which would, under fixed rates, have been dispersed harmlessly over a wide area where they could be more easily dealt with might, under floating rates, be “boxed in,” as it were, in the country of origin in a way that makes them more difficult to control. This might have some validity under a system of free floating when countries were forbidden to intervene to support the exchange rate, but under the system of managed floating which actually prevails countries are free to intervene in support of the rate and when domestic inflationary pressures are strong are very likely in practice to do so.
There are, however, some other reasons for suspecting that floating rates may on balance have contributed to the average rate of inflation among countries in the last year or two. Most of these operate from the side of costs rather than of demand. For example, there is the question of the risks attached to international transactions and to the production of internationally traded goods. We have seen some rather large fluctuations in exchange rates since generalized floating began, particularly as between the U.S. dollar on the one hand and the currencies participating in the EEC snake on the other, where the amount of stabilizing official intervention has been rather small. Thus, the deutsche mark appreciated by some 30 per cent vis-a-vis the dollar from February 14, 1973 to July 1973, then depreciated by 22 per cent by a date in January 1974. Five months later, by May of this year, the mark had risen again by 20 per cent to a new peak, only to fall 10 per cent to a new trough in September. Since then it has risen again by nearly 10 per cent. It can be argued that these fluctuations have shown a declining tendency. Nevertheless, they have been large, and must have added to the risks of doing business not only as between the two countries in question but among all those countries whose currencies are tied either to the dollar or to the DM, or even those which try to steer a middle course between the two.
While one can hedge in forward markets against some of these risks, these markets are not well developed for all relevant maturity periods, and the spreads charged on forward contracts are relatively high. Besides, production of international trade goods or investment in such production involve many types of exchange risks which cannot be hedged by short-term forward contracts. Of course, devaluation and revaluation risks would exist under a par value system also; moreover, in some cases the adjustment of exchange rates facilitated by a flexible system will serve to offset other risks, such as the risk of divergent developments in domestic currency costs. But the sort of short-to-medium-term fluctuations in rates to which I have drawn attention have characterized the flexible rate system up to now, and it would be strange if required profit margins had not been widened to cover such risks.
These fluctuations probably promote inflation in yet another way. Exchange rates influence the distribution of demand between domestic and foreign products, and rate fluctuations will involve demand shifts which will later in some measure be reversed. These demand shifts may well exercise a ratchet effect on inflation. Given the downward rigidities in wages and prices characteristic of modern industrialized economies, shifts in purchase patterns brought about by the exchange rate changes, or even the expectation of such shifts, may tend to raise prices in the countries of depreciating currency without effecting a corresponding price reduction in the countries of appreciating currency. It might be argued, in view of the slowness with which demand patterns respond to exchange rate changes, that this ratchet effect would not be very important for fluctuations as short term as those to which I have just referred. However, there is evidence that prices are adjusted to meet changes in competitors’ prices evoked by exchange rate movements in advance of the expected shifts in demand, and that these anticipatory price adjustments are more marked in the upward direction.
This brief review of the interrrelationship of inflation and exchange rate flexibility seems to yield some tentative conclusions. In the first place, the influence of inflation on the exchange rate regime has been more considerable than the influences operating in the opposite direction. As regards the bearing of the exchange regime on inflation, I would say that floating makes it easier for countries with relatively strong anti-inflation policies to achieve the desired results; but that the price for this is more inflation in countries already inflating more strongly. Thus, floating which is partly caused by differences in rates of inflation in its turn increases these differentials. With respect to the average rate of inflation in all countries taken together, floating exchange rates may have been a slight additional fillip to inflation, particularly through their effect on the risk element.
An important distinction has to be drawn between the role of the floating technique in permitting prompt adjustment to underlying trends or even to cyclical reactions in the balance of payments and its role in permitting shorter-term fluctuations. The first aspect is almost entirely beneficial from the standpoint of inflation control, as indeed from the aspect of adjustment in general. The second aspect is the one that may cause trouble both for stabilization policy and, indeed, for adjustment also.
In a decision adopted last June the Executive Directors of the Fund have agreed on a set of guidelines or principles which its members will attempt to follow to avoid disruptive exchange rate movements under floating. The course of action which the guidelines encourage is that of smoothing out day-to-day and week-to-week fluctuations in rates, resisting over-rapid movements of rates in any particular direction, and resisting undue deviations in rates from their medium-term norm, if such can be discerned. This would tend to eliminate the additional risk resulting from excessive short-run fluctuation in exchange rates.
In the further development and application of these guidelines I therefore see a possible remedy for any net tendency that may exist for the floating rate system to promote inflation. This argues strongly for the development of the international consultation and cooperation which could make these guidelines effective.
“We shall not cease from exploration”
The following excerpts are from a television interview of Robert S. McNamara, the President of the World Bank, shown on the public television network in the United States on February 6,1975.
The interviewer was Bill Moyers, who is producing a series on international affairs. [At this point the discussion turned to the reported ebb of interest in foreign aid in the United States.]
McNAMARA: In the United States, we’ve had an increase in real income of 100 per cent in 25 years. Now, what’s it represented by? Automobiles, some of them bought on time, credit; much improved housing, much of it mortgaged; increased participation by our children in colleges, some of them on a credit basis; and when income declines 5 per cent, it’s very difficult to adjust that consumption pattern 5 per cent. Not that the consumption pattern doesn’t have a third TV set or a second automobile or a vacation home that could be taken out of it, but it’s very difficult to take it out after you’ve bought it and it’s on mortgage payments.
MOYERS: So you say, they feel frustrated?
McNAMARA: They feel frustrated. And there’s a malaise, and I think the malaise is the result of this sense of frustration. It’s a result of an expectation gap, rather than lack of progress. And we fail to distinguish between these two. We set our hopes higher than we’re capable of realizing. And when we didn’t realize them, we became disappointed and frustrated. And, in a sense, ineffective.
MOYERS: Is there a paradox in the fact that part of the problem these (developing) countries face is the result of an increase in fuel prices, which goes into fertilizer and other projects? That the Arab and oil-producing countries are coming in to give them help, in a sense to subsidize the price of that oil and we are, if we increase our help, we’re having to increase our help, in effect, to subsidize the wealth of the oil-producing countries. Isn’t that a paradox?
McNAMARA: The economic assistance—if we increase it, which we haven’t, but I hope we will—it would not go to subsidize the transfer of oil. The oil price increase occurred at a time when several other major changes in the world economy were adversely affecting the developing countries and it’s this package of problems that have to be dealt with. The oil price is only one of them.
MOYERS: What are the other two or three?
McNAMARA: The others are drought conditions in much of Asia and part of Africa, which led to food scarcities, serious food shortages and rising food prices; dramatic increases in prices in the industrialized world because of prosperity. The rates of development, the rates of economic advance in Western Europe, Japan, North America, in 1971, -72 and -73 were among the highest on record. This strained the production system. Demand put pressure on supply. This tended to stimulate the price increase. That’s been the major reason for worldwide inflation.
As that occurred, governments tried to take action to correct it. The actions led to recession. As the recession occurred, the export market of these developing countries began to shrink; and they depend on exports for foreign exchange, to pay for their imports; the imports they need for more fertilizer, more irrigation, a foundation for their economic advance. So that occurred.
At the same time, their terms of trade began to deteriorate. It simply means the price of their imports went up more rapidly than the prices of their exports. And the combination of these several things: the increase in the price of oil, the shortage of food, and rising prices of food imports, the reduction in their export markets, and the deterioration of their terms of trade; it’s that package of adversity that we have to try to help them deal with.
MOYERS: All of this comes down to a feeling not unlike that of a man who said to me recently in Dallas: I woke up one morning and the world that I knew, the known and the tried and the identifiable world, financially was gone.
What happened to that? I think you’ve said something of what happened to it. But then the question becomes, even though the technical terms are beyond most people, including me: Is the world developing new monetary and financial structures to deal with this strange new world that has suddenly emerged?
McNAMARA: Yes. I think that that’s part of our responsibility and we’re trying to help in that. And the events of the last two or three weeks should be a cause of optimism for your Dallas friend because the finance ministers of the world, the governors of the International Monetary Fund and the World Bank met here in Washington to consider this problem. And they took several actions to begin to deal with the financial problem.
MOYERS: In laymen’s terms, what do they mean?
McNAMARA: Well, the first problem is that caused by the fact that the oil that we’re buying, we can’t pay for in goods today, because the oil producers lack the capacity to absorb the goods. In a sense, that’s good, because if we don’t pay for it in goods, there’s no pain to us. We’re paying for the oil, in part, with paper. And we pass the paper over to the oil producers. And then that paper must circulate through the world, evenly, so that they’ll take the Bangladesh paper and Italian paper and the paper from Great Britain and all nations equally and if that paper stops circulating, then we have a serious disruption in the world economy. There was danger that the paper would stop circulating, the risks of standing behind it were getting greater than the commerical banking system of the world could accept. It was necessary for governments to agree to begin to accept some of those risks. That’s essentially what was done.
Last week and the week before, the finance ministers agreed to set up two funds, one known as the Safety Net Fund that Secretary Kissinger had proposed and was to be set up by the OECD nations and the other, known as the Oil Facility of the International Monetary Fund, which is to be set up by all the nations that are members of that. And these two funds will help assure that these pieces of paper continue to flow evenly and help assure, therefore, that there is no serious distortion of the economies of these consuming nations, caused by a failure of the paper to flow evenly during the next year.
Similarly, these finance ministers approved the expanded World Bank Lending Program. We borrow from OPEC, we put those funds to work in the developing countries. This is another form of what’s known as recycling, all designed to minimize the impact of this oil price increase. Ultimately the world will have to adjust to it. They’ll have to adjust to the oil price increase by transferring goods to the oil producers.
MOYERS: Are you saying inflation is here to stay as a worldwide phenomenon?
MCNAMARA: No. No. I’m just talking about adjusting to the oil price increase by paying for it in real terms. And that’s going to have to be done in goods. And when it’s done, it’s a real penalty. You can’t close your eyes to it.
MOYERS: Who pays the penalty?
McNAMARA: All of us. All the oil consumers pay it. But the amount of the penalty is absorbable within our society. It might amount to 2 to 3 per cent of one year’s income and we can absorb that. We need not allow this to disrupt the societies of the industrialized nations and we should not allow it to disrupt the societies of the developing nations. And I’m not arguing whether it’s right or wrong.
MOYERS: But you are saying some structure is emerging that will give some consistency to the world?
McNAMARA: Exactly. Some structure is emerging which will allow the world to adjust over a period of time to this price, assuming the price continues.
MOYERS: You’ve been in this job now six years. You have the image to many people of the modern manager: Harvard Business School, Ford Motor Company, Secretary of Defense for seven to eight years. Have you learned anything at the World Bank that would startle or scare your old friends about the nature of the world economy?
McNAMARA: Well, I’ll tell you one thing I’ve learned. I’ve learned my wife was right. She pointed out to me four or five years ago a passage from T.S. Eliot, which I haven’t forgotten, since then, and he wrote these lines in his Fourth Quartet:
‘We shall not cease from exploration
and the end of all our exploring
will be to arrive where we started
and know the place for the first time.’
And I think that my service with the World Bank is part of this journey of exploration. And it’s tremendously expanded my understanding of nations and peoples.