Short-Run Volatility

Prior to the advent of floating rates, some of its supporters anticipated that stabilizing speculation would smooth exchange rate movements and prevent an abrupt increase in variability. Thirteen years of experience have proved otherwise. Whether measured in bilateral or effective terms, nominal or real terms, the short-run variability of exchange rates has been much greater during the period of floating rates than under the Bretton Woods system. A representative calculation is that the short-term (monthly or quarterly) variability of nominal exchange rates for the seven major currencies was about six times greater under floating rates than during the last decade of adjustable par values (International Monetary Fund (1984a)). In addition, there has not been a sustained tendency for exchange rate variability to decline over time. Finally, and of interest for linking exchange rate variability to exchange rate uncertainty, most exchange rate changes under floating rates have been unexpected (as revealed by market indicators of expected exchange rates, such as forward rates).

Critics of floating exchange rates contend that one of the main reasons why rates have been so volatile is that market participants lack an anchor for medium-term exchange rate expectations. Without such an anchor, short-term events (be they news, rumors, or shifts in policy) induce large revisions of expectations about future exchange rates, which in turn induce large changes in current rates. Without an anchor, too, the risks of self-fulfilling destabilizing speculation (such as bandwagon effects or speculative bubbles) are increased.

This short-run variability, or volatility, of exchange rates is said to be costly because its associated uncertainty reduces the volume of trade and investment.¹⁴ These costs are claimed to be especially heavy for developing countries which do not have well-developed financial markets, particularly forward cover arrangements.¹⁵

The high short-term volatility of exchange rates under floating is not in dispute. What is contentious is the proper yardstick for evaluating that volatility and the costs associated with it. Defenders of the present system make the following points.

First, while the variability of nominal exchange rates has been higher than the variability of the ratio of national price levels, it has been lower than that for other asset prices (such as national stock market prices, changes in commodity prices, or changes in interest rates).¹⁶ This higher variability of exchange rates is said to reflect the fact that exchange rates are jumpy, forward-looking auction prices that anticipate future events, whereas prices and wages are sticky, backward-looking administered prices that largely reflect past contractual commitments. Hence, some greater variability in exchange rates is to be expected. The fact that all asset prices have been so variable during the floating rate period is often explained by the accompanying turbulence in the global economic and political environment.¹⁷

Second, and probably more challenging, the defenders argue that there is little evidence that short-run exchange rate volatility has been very costly in either a relative or absolute sense. The question of relative costs hinges on which markets are best able to handle disturbances. The point is that if exchange rates were more rigid, then disturbances would be transferred to goods or labor markets, or would induce limitations on trade and capital movements, both of which might be more costly than the exchange rate movements themselves. As to the absolute cost, the defenders of the present system note that a large body of econometric work has produced only sporadic evidence of a link between measures of exchange rate volatility and the volume of international trade (International Monetary Fund (1984a)). It is also argued that the development of various hedging techniques and futures markets has increased the ability of market participants to both reduce their exposure to risk and to purchase relatively low-cost insurance against it.¹⁸

Large and Persistent Misalignments of Real Exchange Rates

A second indictment of the present system is that real exchange rates of major currencies have been subject to large and persistent misalignments. The term misalignment is commonly interpreted as a deviation of the actual real exchange rate from its “equilibrium” level.

In practice, misalignment has usually been estimated by, or inferred from, three types of calculations. First, it can be calculated as the cumulative departure of the nominal exchange rate from the path implied by purchasing power parity. This is equivalent to calculating the deviation of the current real exchange rate from its level in some “equilibrium” base period. Second, misalignment is sometimes inferred from the sheer size of real exchange rate movements themselves. The implicit assumption here is that the equilibrium real exchange rate will change only gradually in response to structural changes in competitiveness and comparative advantage. The third method is to compute misalignment as the deviation of the real exchange rate from the level that would yield an equilibrium in the balance of payments (given anticipated macroeconomic policies over the following two to three years). The equilibrium balance of payments, in turn, is defined as an “underlying” current account balance equal to “normal” net capital flows. In addition, this equality must be achieved without resort to either undesirable levels of unemployment, or “undue” restrictions on trade, or “special” incentives to incoming or outgoing capital.¹⁹

As representative (albeit dramatic) examples of such calculations, one might offer the following: in the second quarter of 1985, the real effective exchange rate of the U.S. dollar was over 50 percent above the level implied by purchasing power parity (using 1980 as the base);²⁰ between 1975 and 1976, the real effective exchange rate of the pound sterling fell by 20 percent, only to rise by nearly 75 percent between 1976 and 1981; and using an “underlying balance” approach to calculating the equilibrium real exchange rate, one recent study estimated that the misalignments of the U.S. dollar and the Japanese yen at end-1984 were 39 percent and 19 percent, respectively.²¹

Although it was originally thought that real exchange rate movements under floating rates would be dominated by the gradual changes in competitiveness needed to restore current account equilibria, it is now recognized that large capital flows, often stimulated by short-term considerations, have usually been the predominant force.²² These capital flows, in turn, have been influenced by inter-country differences in interest rates that have reflected different stances and mixes of monetary and fiscal policy and by changes in expectations about the future course of these policies and their impact on future interest rates and future exchange rates. In addition, rigidities in goods and labor markets have meant that nominal exchange rates have borne the brunt of the adjustment, often “overshooting” their long-term values, to compensate for the stickiness of nominal wages and prices in the short run.

Such misalignments in the real exchange rates among major currencies have been costly, so it is argued, because: (1) they distort resource allocation and generate “boom and bust” cycles in the tradable goods sector that leave unemployment in their wake; and (2) because they encourage protectionism, as firms and governments attempt to overrule the unjust verdict of the market place by turning to administrative solutions.²³

By now, there is widespread agreement that the floating rate era has been marked by cases of serious misalignment. Not so clear are the extent of these misalignments, their cost, and perhaps most of all, whether alternative exchange rate systems could eliminate or reduce them. In this connection, defenders of the present system offer the following arguments.

First, not all of the large swings in real exchange rates that have been observed over the past thirteen years represent misalignment. Some of it represents desirable adjustments to changes in real economic conditions, such as continuing inter-country differences in labor productivity, permanent changes in the terms of trade (sometimes associated with discovery of, or large price changes in, natural resources), permanent shifts in savings-investment relationships across countries, or safe-haven considerations. For example, a good portion of the appreciation of sterling between 1977 and 1981 could be represented as an equilibrium response to the United Kingdom’s enhanced status as an oil exporter.²⁴ Even under a system of pegged exchange rates, such changes would call for changes in real equilibrium exchange rates. Under that regime, these changes would occur primarily via changes in national price levels, aided by occasional changes in parities. Under floating rates, the required changes in relative prices occur primarily via changes in nominal exchange rates and they happen more quickly. But, according to defenders of the present system, this need not imply that the latter form of adjustment is inferior to the former.

Second, although misalignment may not be so difficult to define, it can be very difficult to measure when concepts like “normal” capital flows, “undue” restrictions on trade, “special” incentives to incoming or outgoing capital, “cyclically-adjusted” current accounts, and “anticipated” macroeconomic policies have to be estimated. For example, a country that is a “normal” net capital exporter under one set of macroeconomic policies, tax considerations, and political events abroad may become a normal net capital importer under others. For example, if, say, one third of the recent private net capital inflow into the United States was regarded as “normal” (reflecting attractive perceived investment opportunities and a relatively low domestic savings rate), then estimates of the current misalignment of the U.S. dollar would be considerably below estimates that assume a normal net capital flow of zero for the United States. Yet some would argue that the theory and evidence for preferring the latter assumption to the former are weak. An additional complicating factor is the existence of a large statistical discrepancy in world balance of payments accounts, whose geographical attribution is highly uncertain.

Supporters of the present system acknowledge that misalignments of key currencies carry costs but suggest caution in identifying misalignments as primary factors in explaining both the recent weakness of manufacturing employment in the United States and the resurgence of protectionist pressures in major industrial countries as a group.

While it is true, for example, that the ratio of manufacturing employment to total nonagricultural employment in the United States declined sharply over the 1979-83 period, it also declined in 1969-71 against the background of a depreciating real exchange rate for the dollar; in fact, it has declined in all periods of recession since 1969. Further, this ratio increased in 1984 when the real exchange rate of the dollar was appreciating sharply. Likewise, the same ratio rose in the Federal Republic of Germany during 1976-79 when the deutsche mark was appreciating, and fell during 1980-83 when the deutsche mark was depreciating. In Japan, the manufacturing employment ratio has been flat since 1978, despite a strong real appreciation of the yen from 1982-84.²⁵ All of this suggests that one has to specify the type of disturbance moving the real exchange rate before one can predict the link between the real exchange rate and the sectoral allocation of resources. As Obstfeld (1985) points out, an increase in foreign demand for domestic manufactures may cause both a currency appreciation and an expansion in manufacturing employment, whereas a shift to restrictive monetary policy will induce both currency appreciation and contraction in manufacturing employment.

Supporters of the present system also argue that exchange rate misalignment is only one of several important factors explaining the rising tide of protectionism. They note, for example, that many of the current protectionist measures or proposals have been sector oriented or country specific and have been influenced by long-lasting shifts in competitiveness arising from factors other than exchange rate shifts. In clothing and textiles, for example, restrictions have been directed against developing countries with a comparative cost advantage and restrictions have become progressively more severe over a quarter of a century, almost irrespective of changes in exchange rates. Nor does the degree of protection of the agricultural sector and of the steel sector correlate well with exchange rate movements. More generally, it can be argued that pressures for protection will be greater not only when a country’s exchange rate is overvalued but also, inter alia: the higher and more rapidly increasing is its unemployment rate, the smaller and less generous are its existing trade adjustment programs, the higher is its ratio of imports to consumption, the larger is employment in import-competing industries, and the higher is the level of general government intervention.²⁶

Finally, defenders of the present system recall that misalignment and overshooting of the exchange rates among the major currencies were by no means unknown during the Bretton Woods era, especially in its later years.²⁷ For example, the effective real exchange rate of the dollar depreciated by 28 percent from 1969—73. Similarly, if a currency had long been overvalued under the Bretton Woods system, and the authorities at last decided on a devaluation, they usually chose a new parity which undervalued the currency at the current level of prices. One common justification for such excessive devaluation was that it was necessary to replenish the level of reserves which had become unduly low during the period of overvaluation.²⁸ In short, defenders argue that the current system ought not to be compared to some unobservable textbook ideal but rather to the also-flawed real-world alternatives.

Lack of Discipline and Coordination in Macroeconomic Policies

The third criticism of the present exchange rate system is that it has not promoted discipline and coordination in the conduct of macroeconomic policy. Indeed, this is probably the single most damaging charge because short-term volatility and longer-term misalignments are both widely regarded as manifestations of this failure to get underlying monetary and fiscal policies “right.” ²⁹

Under floating exchange rates, one can expect: (1) the current exchange rate to be heavily influenced by the expected future exchange rate; and (2) the expected future exchange rate to be heavily influenced by expected future macroeconomic policies. Since instability in current policies generates uncertainty about future policies, it is clear why disciplined and consistent policies are judged to be a sine qua non for greater stability in exchange rates.

Evidence of a lack of discipline and coordination in macroeconomic policy over the past thirteen years is not hard to find. Critics of the present system point to, inter alia, the near-doubling of average industrial-country inflation rates between 1963-72 and 1973-85 (from 4.2 percent to 7.6 percent) and to the tripling of the average ratio of industrial country (central) government fiscal deficits to gross national product (GNP) over the same period (from 1.2 percent to 3.7 percent). They also note that there have been frequent occurrences of large changes in monetary and fiscal policies being made in a seemingly independent fashion, with too little thought given to their international repercussions. They point in particular to the 1979-83 period when the stance and mix of policies in the major industrial countries (particularly the heavy reliance on monetary restraint) produced historically high real interest rates, low commodity prices, and sluggish economic activity with adverse “spillover” effects for developing countries’ debt service, export earnings, and growth performance.³⁰ Finally, critics note that efforts at better coordination during the floating rate period have not produced binding agreements on either monetary and fiscal policies or on exchange rates.

The view that discipline and coordination of macroeconomic policies in industrial countries needs to be improved is now widely accepted. The main point at issue is what contribution the exchange rate system can make toward achieving that objective. Critics of the present system maintain that the obligation to defend the parity in a fixed rate system obliges the more inflationary countries to discipline themselves in order to avoid repeated (and politically costly) realignments. On the other hand, supporters of the present system offer the following arguments.

First, experience suggests to them that greater fixity of exchange rates is neither necessary nor sufficient for enforcing discipline on macroeconomic policy. They note, for example, that the deceleration in growth rates of narrow and broad money that took place in most of the major industrial countries in 1979-82 (in the face of high unemployment) was accomplished without exchange rate targets; hence, greater fixity of exchange rates is not “necessary” for anti-inflationary discipline. Similarly, even during the Bretton Woods era, there were too many cases of exchange rate targets giving way to employment targets when the two came into conflict to believe that greater fixity of exchange rates is “sufficient.” In fact, they would say that history is more kind to the proposition that the exchange rate regime is determined by the degree and inter-country dispersion of discipline in macro-economic policies than to the reverse line of causation.

Second, some observers argue that the exchange rate regime does not necessarily have a comparative advantage over other institutional mechanisms for imposing discipline on national authorities. For example, if greater discipline in monetary policy is sought, then pre-announced money supply rules, or even various types of commodity standards are alternative roads to making a nonaccommodation strategy more credible. As regards discipline for fiscal policy, fixed rates may, so the argument goes, be even less effective than flexible rates. This is because (under fixed rates) an expansionary fiscal policy that is not monetized draws in capital from abroad and leads to an increase in foreign exchange reserves; hence, reserve movements impose no discipline. In contrast, expansionary fiscal policy (with tight monetary policy) under flexible rates induces currency appreciation that may in turn lead to political pressure from the traded goods sector for fiscal restraint.³¹ And if discipline against inflation is the primary concern, measures that substitute rules for discretion in determining the world money stock, or that put a tax on inflationary wage settlements (such as tax-based incomes policy) may represent more direct constraints.

Third, although trying to describe the “counterfactual” is always a speculative exercise, some have argued that a fixed exchange rate between the United States and the rest of the Organization for Economic Cooperation and Development (OECD) was not likely to have prevented either the recent real appreciation of the U.S. dollar or its international effects.³² The argument here is that fixed rates and fiscal expansion in the United States would still have meant relatively high U.S. interest rates and a large net capital inflow. The capital inflow in turn would have lowered foreign money supplies and (unless sterilized) increased the U.S. money supply. The effects of these money supply changes would thus have been to raise U.S. prices relative to those abroad. One would still get a real appreciation of the U.S. dollar, but this time operating mainly via national price levels rather than via the nominal exchange rate. Alternatively, attempts to prevent these money supply changes from taking place under fixed rates (via capital controls or sterilization operations) would only lead to a higher level of interest rates and would remove, so the argument goes, the inflationary pressure for a fiscal reversal. The alleged moral of this scenario is that fiscal reform rather than exchange rate reform is the necessary ingredient for preventing misalignment and its effects.

Fourth, supporters of the present system caution that there are “natural” limits to coordination of policies, whatever the exchange rate regime. Exchange rates and interest rates are by their very nature “competitive” in the sense that one country’s gain is frequently the other’s loss. Also, the compromise of growth and inflation objectives at the national level often leaves little room for further compromise on demand policies at the international level.³³ Given these limits, past efforts at coordination (such as the U.S. dollar support package of November 1, 1978, the agreements of the Bonn economic summit of 1978. and the September 1985 Group of Five agreement in New York on exchange rates and adjustment policies)—while perhaps still far from optimal—should, in their view, not be seen in too bad a light.

Finally, supporters of the present system are wary of comparisons between the period of floating rates and that of par values. They note that many features of the global economic environment that are important for macroeconomic performance but are not proximately related to the exchange rate regime, were also changing during the period of floating rates.³⁴ For example, inflation performance during the floating rate period may have been distorted by the two rounds of large oil price increases (1973-74 and 1979-80) and by the huge expansion (57 percent) in international reserves in 1970-72 associated with the collapse of the Bretton Woods system.

Promotion of External Payments Adjustment

Although it has perhaps not provided all that was hoped for prior to the advent of floating rates, supporters of the present system maintain that exchange rate flexibility has made a positive contribution to external payments adjustment on at least three counts.

First, the extent of payments adjustment in the floating rate period (1973-85) has been somewhat better than that during the last decade of adjustable par values (1963-72), at least for the seven largest industrial countries—and this despite the occurrence of some unusually large external shocks during the floating rate period (including the two large increases in world oil prices in 1973-74 and 1979-80). Simple measures of payments imbalances, such as the ratio of current account balances alone to GNP or the ratio of current accounts plus normal capital flows to GNP, show smaller mean imbalances and less persistence (that is, serial correlation), on average, for 1973-85 than for 1963-72.

Second, the symmetry of adjustment is alleged to have improved. Recall that two well-known charges against the Bretton Woods system were: that surplus countries were subject to a much weaker discipline than deficit countries; and that reserve centers, particularly the United States, had an unwarranted privilege because they could finance payments deficits by liability as opposed to asset settlement. Both of these asymmetries are said to have been much reduced under floating: there is no evidence (among industrial countries) that mean payments imbalances are larger or more persistent for surplus countries, and the privilege (some would say dangers) of liability settlement has since been extended to many countries, including developing ones.

Third, exchange rate flexibility has, according to its proponents, reduced the cost of adjustment. The argument here is that when exchange rates are less flexible, the burden of adjustment falls more on expenditure-reducing measures and less on expenditure-switching ones, with heavier costs in terms of real output and employment.³⁶ They further point out that econometric studies indicate that exchange rate depreciation is likely to be effective in improving the trade balance in the medium to long term, and that there is no evidence that price elasticities for traded goods have declined since the onset of floating rates.³⁷

The contribution of exchange rate flexibility to external payments adjustment is still a matter of some dispute. Critics of the present system offer the following counter-arguments.

On the extent of external adjustment, they note that current account performance of some large industrial countries has been anything but satisfactory over the past three years; that current account performance for the smaller industrial countries has been significantly worse, on average, during 1973-84 than during the last ten years of Bretton Woods; and that reversal of current account imbalances, even for the larger industrial countries, has typically taken an extremely long time (on the order of three to seven years).³⁸ In addition, they mention that more sophisticated measures of equilibrium payments balances suggest that there have been many instances during the floating rate period of unsustainable or undesirable payments outcomes.³⁹ In short, the extent of external payments adjustment under floating rates may have been marginally better on average than during the Bretton Woods period but it was far from satisfactory.

The symmetry of external adjustment between surplus and deficit countries may have improved under floating rates, but critics contend that some asymmetries have become worse. In particular, the burden of external adjustment is alleged to fall much harder now on the developing than on the industrial countries.⁴⁰ Further, it could be argued that within the industrial-country group, external adjustment has been least effective in the very countries with the most substantial spillover effects on the world economy. Also, whereas the United States is admittedly no longer the only country to enjoy the privilege of liability settlement, some might argue that it now enjoys a new unwarranted privilege—namely, to finance an unusually large part of its fiscal deficit with the rest of the world’s savings.

Finally, while exchange rate changes may well improve the current account in the medium to long-term, critics note that there can be substantial “J-curve” effects in the short to medium term. Further, even in the long term, exchange rate changes will not be an equally effective instrument for achieving external balance in all countries; instead, its relative effectiveness depends in good measure on the economy’s structural characteristics. Specifically, both theory and empirical evidence suggest that the smaller, more open, more highly indexed economies suffer proportionately larger domestic price feedbacks and obtain less lasting relative-price advantages from exchange rate changes than do the larger, less open, and less indexed economies.⁴¹ Therefore, the extent to which exchange rate flexibility reduces the cost of adjustment is not the same for everybody.⁴²

Insulation from Inflation Abroad

Prior to the actual experience with floating exchange rates, it was thought by many that floating exchange rates would be premier insulators against a whole range of foreign disturbances. The last thirteen years have shattered that illusion. It is now widely accepted that the insulating properties of floating rates are more modest.⁴³ Specifically, floating rates can provide good insulation against a rise in the world price level because an appreciation of the domestic currency proportionate to the increase in foreign prices prevents wealth or relative price effects from taking place. But floating rates cannot insulate against relative price changes among different classes of traded goods because they cannot alter relative prices at that level of aggregation. Beyond that, the relative insulating properties of floating rates vis-a-vis fixed rates cannot be generalized without specifying the nature of the disturbance (monetary or real), the origin of the disturbance (domestic or foreign), what is to be insulated (real output or consumption), and who is to be insulated (the home country alone or the home and foreign country taken jointly).”⁴⁴

Having acknowledged this, defenders of the present system still emphasize that the insulation provided by floating rates against inflation abroad should not be underrated.⁴⁵ After all, it was the very inability to protect themselves from imported inflation that induced some countries to abandon the Bretton Woods system in the early 1970s.⁴⁶ Also, so long as there remains a significant risk for the future that some countries will not follow reasonable monetary and fiscal policies, it would in their view be premature to abandon the protection offered by floating rates against this risk.

Critics of the present system might reply that the dominant shocks of the 1970s and the 1980s (that is, relative price changes among different classes of traded goods such as oil, and sharp changes in interest rates) have been the very ones against which floating rates have a comparative disadvantage in insulation vis-à-vis fixed rates. In addition, they observe that available empirical evidence suggests that the international synchronization of real and monetary variables has been even higher during the period of floating rates than during the era of par values,⁴⁷ This evidence would be consistent with a greater incidence of common external shocks and common policy responses to them under floating rates but it could just as well imply greater transmission of disturbances under floating rates. Some critics of the present system would go further and conclude that because floating rates cannot provide good insulation against the representative set of foreign disturbances, the case for policy activism to combat such disturbances, including greater use of exchange market intervention, is strengthened.⁴⁸

Independence and Effectiveness of Domestic Monetary Policy

One reason why floating rates seemed attractive in the latter years of the par value system was that by then the incompatibility of fixed exchange rates, high international mobility of capital, and independence for domestic monetary policies had become readily apparent. This was particularly the case in the Federal Republic of Germany and Switzerland where restrictive monetary measures (taken to avoid imported inflation) brought forth an unending sequence of capital inflows, official intervention to support the U.S. dollar, and more capital inflows. Floating rates offered a way out of that dilemma. Specifically, since there would no longer be an obligation to use exchange market intervention to peg the exchange rate, exchange market pressure could take the form of exchange rate changes rather than reserve movements and the foreign component of the monetary base would be stable. In short, floating rates would allow countries to regain control over their own money supplies. A second attraction was that floating rates, at least in theory, were supposed to strengthen the output and employment effects of expansionary monetary policy via the positive effects of the induced exchange rate depreciation on the trade balance.

More than a decade later, even the supporters of the present system would probably acknowledge that the case for the independence and effectiveness of monetary policy under floating rates was exaggerated. Many of the constraints on monetary policy seem in retrospect to be as much related to the openness of national economies as to the exchange rate regime per se. These constraints show up in either a reduced ability to control the instruments of monetary policy (the nominal money supply under fixed rates), or a reduced ability to control some of the targets of monetary policy (the level of real output), or an increased caution in the use of monetary policy because of potentially dangerous effects on expectations.

Still, supporters of the present system maintain that floating rates have been instrumental in facilitating “. . . the pursuit of sound monetary policies geared more directly to domestic conditions.” ⁴⁹ They are credited with having increased countries’ control over their own money supplies without resort to capital controls. It is claimed that floating rates have also allowed countries to choose trend inflation rates and to carry out effective anti-inflationary policies. These extra degrees of freedom would not be so prized in a world in which all countries consistently implemented sound and credible policies of their own accord. But, so the supporters of floating rates argue, they are valuable assets in the real world where one’s trading partners can sometimes suffer quite serious lapses of discipline in macroeconomic policy.

Critics of the present system see the contribution of floating rates to monetary policy as more modest, if it exists at all. They note that whereas the exchange rate appreciation that goes with a tight monetary policy can aid the home country’s anti-inflation efforts, it does so at the expense of handicapping the efforts of partner countries to control their own inflation rates; to them, it is thus a new type of “beggar-thy-neighbor” policy. They argue in addition that, at the margin, floating rates have not increased the independence of monetary policy all that much. After all, the considerable volume of official intervention during the floating rate period suggests that most industrial countries view the exchange rate as a policy target as well as a policy instrument.⁵⁰ When the exchange rate moves by a significant amount in a short period, even those countries whose exchange arrangements are classified as “independently floating” develop implicit exchange rate targets and adjust monetary policy accordingly. They also doubt whether floating rates have increased the potency of expansionary monetary policy. In this regard, they mention that: significant feedback effects of exchange rate depreciation on money, wages and prices limit the gain in competitiveness; J-curve effects in the response of the trade balance to exchange rate depreciation mean that, in the short to medium term, the external sector will weaken, not strengthen, the domestic impact of expansionary monetary policy; and that currency substitution can lead to much larger swings in exchange rates than the authorities may find desirable. Finally, the critics question whether monetary policy ought to be geared toward domestic conditions. They contend that one of the main reasons why exchange rates have been so variable over the floating rate period is because monetary policy has not taken external considerations enough into account.⁵¹

Resilience of Present System

Thus far, the appraisal of the present exchange rate system has been based on implicit comparisons with other exchange rate systems (including both those implemented in the past and those proposed for the future). Supporters of the present system question, however, whether, given the strains of the past decade (the major changes in the price of energy products, a number of important bank failures, sometimes large intercountry differences in inflation rates, monetary policies, and policy mixes, and so on), “any less flexible system would have survived” without increased reliance on restrictions on trade and capital flows.⁵² The present system is thus viewed as being particularly resilient to the operating environment—no small advantage if it is assumed that there are significant costs associated with changing exchange rate systems.

To what is this resilience attributable? Three contributing factors might be identified.

First, the wide choice of exchange arrangements permitted by the Fund’s Articles of Agreement means that it is possible to accommodate different country preference on the flexibility of exchange rates and the mix of domestic economic policies. Countries who feel that the benefits of fixed rates outweigh the costs can choose pegged exchange arrangements, while those that view exchange rate flexibility as essential can opt for floating. In between these two poles, there is room for adjustable pegs (the European Monetary System (EMS)) as well for different degrees of exchange market intervention within the group of countries classified as “independently floating.” Supporters of the present system recall that the Bretton Woods system operated successfully while there was a consensus about the assignment of responsibilities for exchange rate action and monetary policy between the reserve-center country and others, but collapsed when this consensus evaporated. To the extent that the degree of exchange rate stability deemed appropriate differs from country to country, the present system can be said to be compatible with these differences.

Second, the present system permits decentralized market-based decisions to act as a “safety valve” when it is not possible to reach centralized decisions about the sharing of the adjustment burden and about the equilibrium pattern of exchange rates. Because the market “takes a view,” it is possible to avoid, so say the supporters of floating rates, the centralized management delays of the latter years of the Bretton Woods system.

Third, the present system contains enough “flex” in exchange rates to avoid what defenders of floating rates regard as the crucial flaw of all adjustable peg systems, namely, the incompatibility of high international mobility of capital and fixed exchange rates with narrow margins. They argue that so long as private market participants have greater resources than central banks, market views on exchange rates can change rapidly, and parities have to be changed from time to time to reflect changes in real economic conditions, any system that places tight limits on exchange rate movements will be subject to successful speculative attack; alternatively, attempts to preserve existing parities will force resort to increased restrictions on capital flows.

Critics of the present system acknowledge its resilience but argue that this is less important than its performance. They point out that the exchange rate system is basically a facilitating mechanism for more fundamental economic objectives, such as high employment, sustainable growth, price stability, and expanding and balanced international trade. Whatever its durability, an exchange rate system should be judged in terms of its contribution to those objectives. And on this scale, they find the present system of floating rates wanting.⁵³ They also maintain that the characteristics that make the present system relatively resilient may have other undesirable implications for its performance while it lasts. For example, the great diversity of exchange arrangements may make it more difficult to define “rules of the game” for macroeconomic policies that are sufficiently specific to be effective. Indeed, it is the very lack of such recognized rules of the game, especially for major industrial countries with floating rates that, according to critics, is responsible for the severe misalignments of the floating rate period. Similarly, while they agree that the present system allows the market “to take a view” when centralized decisions are not feasible, they argue that the present system does not offer a sufficient framework for reaching a satisfactory multilateral decision; in addition, the market’s view is too often the “wrong” view. Finally, the same “flex” in exchange rates that provides a defense against “hot money” flows often proves a liability when exchange rates become divorced from fundamentals and get carried along by self-fulfilling destabilizing speculation.

Target Zones for Exchange Rates of Major Currencies

One proposal for improving exchange rate stability that is specifically addressed in both the Reports is the adoption of target zones for the exchange rates of major currencies. As indicated earlier, the Group of Twenty-Four Deputies felt that the adoption of target zones “could help achieve the objective of exchange rate stability and a sustainable pattern of payments balances.” ⁵⁵ In contrast, the majority of Group of Ten Deputies considered that “. . . the adoption of target zones is undesirable and in any case impractical in current circumstances.”⁵⁶

In this subsection, attention is focused on three questions: what is meant by a target-zone approach to exchange rate management; what is the rationale for it; and what is behind the skepticism about and/or the opposition to, that proposal.

In the Group of Ten Report, target zones are described as follows: “. . . the authorities concerned would define wide margins around an adjustable set of exchange rates devised to be consistent with a sustainable pattern of balances of payments.” ⁵⁷

Target zones differ from the present system of floating rates in two respects: the authorities establish a target zone for the exchange rate for some future period; and the authorities partially direct monetary policy to the exchange rate to discourage the exchange rate from moving outside its zone. Target zones differ from “pure” or “clean” floating in that the authorities are permitted to intervene in the exchange market, and indeed, are encouraged “to take a view” on the desirable level of the exchange rate. At the same time, there are no formal or rigid commitments to intervene in exchange markets in all circumstances—a characteristic that differentiates target zones from the adjustable peg system. Finally, in addition to the absence of a formal intervention obligation, target zones differ from a system of rigidly fixed rates in that the zones themselves are to be occasionally reviewed and changed if deemed necessary (to reflect, for example, differential inflation and any need for balance of payments adjustment).

Most target zone proposals envisage the members as being the five largest industrial countries. Other countries could then “fix” or “flex” on the members of the target zones as they saw fit. Target zones would reflect estimates of real equilibrium exchange rates because the real exchange rate is the most relevant rate for resource allocation and balance of payments adjustment; however, for operational purposes, they would be defined in terms of nominal exchange rates. Monetary policy and exchange market intervention are viewed as the two policy instruments to be used for external balance while monetary and fiscal policy are assumed to be adequate to the task of countering “inflationary and deflationary pressures.” ⁵⁸

It is possible to conceive of a whole spectrum of possible approaches to target zones. The various approaches could be distinguished by reference to the following four characteristics: the width of the target zones (outside of which the exchange rate is viewed as “out of line”); the frequency of changes in the target zones; the degree of publicity given to the zones (such as public announcement versus confidential disclosure in official circles, or “loud zones” versus “quiet zones”); and the degree of commitment to keeping exchange rates within the zone.

At one end of the spectrum, “hard” target zones would imply narrow margins, infrequently revised zones, public announcement of the zones, and a monetary policy that was directed at keeping the exchange rate within the zone. In this sense, hard target zones might be considered a close relative of the EMS’ fixed but adjustable parities with narrow margins and a “divergence indicator.” Unlike the EMS, however, there would be no rigid commitment to exchange rate intervention; nor do hard target zones imply any analogue to the credit facilities of the EMS.

At the other end of the spectrum, “soft” target zones would be characterized by wide, frequently-revised, confidential zones, and by a monetary policy that pays only limited attention to the level of the exchange rate. Soft target zones differ from existing procedures for Fund surveillance (such as, the requirement for reporting real exchange rate changes in excess of 10 percent to the Executive Board) in that the former introduces a more explicit and formal framework for defining the appropriate pattern of exchange rates and for specifying the links between exchange rates and macroeconomic policies.⁵⁹

Objective Indicators

A second specific proposal for improving exchange rate stability and for strengthening the analytical basis of Fund surveillance, is to introduce a set of “objective indicators” or “targets” for macroeconomic outcomes and policies into the multilateral discussion and negotiation of macroeconomic policies in key-currency countries. This proposal is presented in paragraph 78 of the Group of Twenty-Four Report as follows:

• “Multilateral surveillance and bilateral (Article IV) consultations should form two stages of the surveillance process, rather than two parallel operations. The first stage would involve multilateral discussions and negotiations to be conducted on a regular basis within the framework of the IMF about a mutually consistent set of objectives, and a set of policies to collectively achieve these objectives. The aim might be to search for a set of outcomes or ‘objective indicators’ or ‘targets,’ that appear to be sustainable in the medium term and desirable to all parties. This should be quite feasible when the multilateral surveillance exercise is limited to a few major industrial countries, such as the key currency countries. The second stage would involve a comparison between the actual outcomes and the recommended targets or indicators, and a discussion of what measures would be appropriate when the two differ. This stage might most efficiently be conducted on a bilateral basis as part of Article IV consultations.”

Although the Group of Twenty-Four Report is not explicit about what form domestic policy-oriented targets would take, it might be assumed that they would cover the major targets of policy (such as rates of inflation and unemployment, the growth of real output, the balance of payments, fiscal positions, and possibly, the exchange rate), as well as some of the major policy instruments (the money supply, government expenditures, taxes, or structural measures); presumably, they would be framed in a medium-term setting.

In principle, the process of setting targets and instruments should be similar to that which explicitly or implicitly takes place in national governments, with of course the important distinction that the process would be multilateral. The targets could be specific numbers, or ranges or zones, or if even more flexibility was required, simply obligations to avoid large or sudden changes in the chosen variable. Perhaps the best analogy in a domestic context is the setting of official targets for the growth rates of monetary aggregates. Such targets provide a presumption that the authorities will conduct policies so that the growth rates of aggregates would evolve within the specified ranges. If the targeted aggregate moves outside its expected range, it is presumed that the authorities will act to counter this movement, or will explain why the earlier target is no longer appropriate. Even when the targets are not always attained, they provide, so their supporters argue, a relatively straightforward way of monitoring and explaining the authorities actions; also, when the targets are announced, they may provide an anchor for expectations.

Improvements Within Existing Institutional Setting

As noted earlier, the Group of Ten Report concludes that “. . . the fundamental approach of the Articles [of Agreement of the Fund] remains valid and . . . the key elements of the current . . . system require no major institutional change,”⁷⁵ and that “. . . no major changes are required in the present institutional setting for exercising surveillance over national policies.”⁷⁶ Instead, the Group of Ten Report recommends that improvements be sought within the framework of the present system. These improvements would focus on the following four areas.

First, “. . . the adoption of sound, credible, and stable policies”⁷⁷ at the national level, especially in major countries, would contribute “fundamentally” to exchange rate stability. Also, the “. . . liberalization of capital markets and, more broadly, removal of restrictions and structural rigidities”⁷⁸ so as to reduce the burden placed on foreign exchange markets in absorbing short-term disturbances would, so it is argued, reduce the short-run volatility of exchange rates.

Second, “. . . in setting national policies, the international implications and interactions of those policies should receive an appropriately high priority.”⁷⁹ This, it is argued, would improve the compatibility of policies among countries and the convergence of economic performance around sustainable non-inflationary growth. As such, it would lead to greater exchange market stability. To achieve better international coordination of policies, “. . . close and continuing cooperation among countries and a strengthening of international surveillance”⁸⁰ are identified as central elements.

Third, strengthened surveillance should be built on “. . . enhanced dialogue and persuasion through peer pressure rather than mechanically imposed external constraints.”⁸¹ Specific measures to strengthen surveillance cover both bilateral and multilateral surveillance.

Among the proposals for improving bilateral surveillance that appear in the Group of Ten Report are those that address the policymaking level at which governments are represented in the consultation process; the possibility of a confidential exchange of views between the Managing Director and the Finance Minister at the end of the consultation process for important countries; the degree of candor in the assessment of national policies and of their international impact; identification of necessary improvements in the scope, quality, and timeliness of data; improvements in analytical techniques; the use of supplemental surveillance techniques; and the continued development of enhanced surveillance procedures. In addition, mention was made of the publicity to be given to the outcome of the consultation process and to other Fund reports and summings-up.

Turning to multilateral surveillance, the Group of Ten Report proposes that there be “. . . a separate chapter” of the World Economic Outlook devoted to “. . . analyzing the repercussions of national policies of Group of Ten countries and of their interaction in the determination of exchange rate developments and international adjustment.”⁸² In addition, the Group of Ten Report proposes that the Group of Ten should review the conclusions of this chapter, when appropriate, at Ministerial level.

Finally, the Group of Ten Report argues that “. . . neither capital controls nor intervention can be relied upon to attain lasting stability of exchange rates.”⁸³ On official intervention, the Group of Ten Report endorses the conclusions reached in the Report of the Working Group on Exchange Market Intervention (1983). With respect to controls on international capital flows, this Report concludes that such controls would carry “substantial” economic costs and that free capital movements are beneficial to “. . . the expansion of trade and to efficient resource allocation.”⁸⁴