Abstract

From the preceding review of approximately a decade of experience with managed floating, the overall performance of the present exchange rate system can perhaps best be characterized as remarkably good, given the harsh global environment, but with plenty of room left for improvement. At the risk of oversimplifying the complexity of some issues and of ignoring others, the main lessons of the experience with floating rates would seem to be the following.

From the preceding review of approximately a decade of experience with managed floating, the overall performance of the present exchange rate system can perhaps best be characterized as remarkably good, given the harsh global environment, but with plenty of room left for improvement. At the risk of oversimplifying the complexity of some issues and of ignoring others, the main lessons of the experience with floating rates would seem to be the following.

Lessons of the Experience with Floating Rates

(1) One should not overestimate the capacity of the exchange rate system per se to do good or evil. In this sense, neither the expectations of the proponents of floating rates nor those of its critics have been confirmed by experience. Floating rates have not provided complete or even good insulation against all types of external disturbances; they have not provided rapid and automatic equilibration of external payments imbalances; they have not removed the need for policy coordination across countries; they have not eliminated pressures for protectionism; they have not done away with or even significantly reduced the demand for international reserves; and they have not encouraged enough stabilizing speculation to keep real exchange rate movements within narrow bands corresponding to permanent changes in the terms of trade. But floating rates have also not led to a collapse in international trade and investment; they have not destroyed the discipline to fight inflation; they have not produced a continuous upward ratcheting of country and global inflation rates; they have not trapped high-inflation and low-inflation countries into vicious and virtuous circles for long time periods regardless of the authorities’ policy efforts; they have not reduced the size of price elasticities for traded goods, nor produced perverse long-term effects on current account imbalances; and they have not produced large increases in frictional unemployment owing to shifts of workers back and forth among industries in response to very short-term exchange rate fluctuations. The exchange rate system matters, but not as much as previously thought.

(2) Going in the opposite direction, there has been a tendency to underestimate the importance of disciplined and coordinated macroeconomic policies—things usually paired with the viability of fixed exchange rates—for the successful operation of floating rates. It is true that floating rates have allowed more autonomy than fixed rates in the use or control of policy instruments. But in a world where goods and assets are traded freely and are close substitutes across countries, this increased autonomy will not translate into increased policy effectiveness if monetary and fiscal policies are unstable and unbalanced at the national level and are uncoordinated across countries. This is because such policy behavior will set in train exchange rate movements that will ultimately prove “unacceptable,” either to the initiating country itself (because, say, of adverse feedback effects on the target variables) or to the international community (because, say, of the adverse effects of rate movements on their policy instruments and/or targets). In time, therefore, that autonomy will be curbed as the exchange rate itself becomes a target. All of this follows from the triple property of a floating system: (i) that current exchange rates are heavily dependent on expected future exchange rates; (ii) that expected future exchange rates are, in turn, heavily influenced by expected future macroeconomic policies; and (iii) that these expected future policies are heavily influenced by past policy behavior. This means that exchange rate policy can no more be divorced from basic macroeconomic policies under floating than it can under fixed rates. It is no coincidence that most of the periods of heavy strain on exchange rates under both managed floating and the adjustable peg system have been periods when macroeconomic policies were either unstable (i.e., highly inflationary), or unbalanced (i.e., with an inappropriate mix between monetary or fiscal policy), or uncoordinated (i.e., with inconsistent policy objectives across countries at prevailing exchange rates). It is also no coincidence that periods when exchange rates have been most “out of line” have also been periods when other key prices in the economy that are also influenced by the course of macroeconomic policies (i.e., real wage rates and real interest rates) have also been out of line. In short, floating rates and fixed rates are different in how they work to discipline macroeconomic policies but they are not so different in the discipline that it takes to make them work well.

(3) The fact that the present system is characterized by such a wide diversity of exchange arrangements and by such pronounced variations in “management” of exchange rates across countries does not imply that it is a “non-system” or that it lacks a logical foundation. Quite the contrary. This diversity is consistent with the proposition that the optimal degree of exchange rate flexibility differs across countries owing in large part to differences in their economic structures. Both theory and empirical evidence have indicated that the smaller, more open, more highly indexed economies (e.g., smaller European countries) suffer proportionally larger domestic price feedbacks and obtain less lasting relative price advantage from exchange rate changes than do the larger, less open, and less indexed economies (e.g., the United States).107 It is therefore not surprising that the former group has sought mechanisms to avoid frequent or substantial movements in exchange rates, and has in the main preferred other means of stabilizing real output and the balance of payments. Their desire to create “a zone of monetary stability” is thus understandable quite independently of political considerations. An analogous argument could be made for the revealed preference of developing countries for more “fixed” exchange arrangements, although here the list of relevant structural factors would be longer and more varied. In any case, perhaps the key implication of all this is that judgments about whether exchange rates fluctuated too much over the past decade are not likely to be uniform across countries, and for reasons that go beyond intercountry differences in philosophy about the efficiency of markets. Going one step further, these same intercountry differences in view as to optimal exchange rate flexibility strengthen the case for better coordination of policies. For in the absence of such consultation and coordination, it is unlikely that “common” views as to the proper distribution of the adjustment burden between exchange rates and other policy instruments will emerge on their own.

(4) In appraising the present exchange rate system, it is crucial to distinguish the period of floating rates from the effects of floating rates themselves. Otherwise, the exchange rate system is sure to be blamed for, and credited with, outcomes that are only marginally related to it. In this connection, floating rates do not seem to have been responsible for the high inflation and high unemployment rates, nor the slow growth in productivity, experienced by industrial countries over the past ten years. Nor do they emerge as the key factor behind the slowdown in the growth of world trade during the same period. No exchange rate regime would have emerged unscathed from the combination of shocks, portfolio shifts, and structural and institutional changes of the past ten years. Both Bryant and Lamfalussy reach the same verdict:

  • There is no set of exchange rate arrangements under which the 1973–75 and 1979–80 oil shocks would not have had traumatic consequences. It is impossible to imagine any arrangements that would not have transmitted major inflationary and contractionary impetuses back and forth among the major economies. I doubt that the competence and appropriateness of domestic macroeconomic policies in the past ten years was much influenced, positively or negatively, by the exchange rate arrangements that actually existed, or that these policies would have been greatly improved under any other arrangements. (Bryant (1983, pp. 78–79))

  • The extremely turbulent nature of events during the period 1973–78 should make us very cautious about making a general assessment of our recent experience with floating exchange rates. On the one hand, these disturbances occurred in the form of external shocks which profoundly altered the world pattern of current accounts. On the other hand—and more recently—they were caused by disequilibrating capital movements resulting from rapid shifts in the currency composition of liquid portfolios. One has the impression that any exchange rate regime would have had trouble coping with imbalances of these kinds, especially when the world’s dominant reserve centre runs a sizable current-account deficit. After all, the Bretton Woods system broke down in similar circumstances. (Lamfalussy (1979, p. 50))

For the same reasons, even if major changes in the exchange rate system could be brought about, such changes alone would not be likely to significantly reduce unemployment, eliminate pressures for protection, lead to a resurgence in investment or productivity, or make economies immune from future disturbances. The exchange rate system is an important facilitating mechanism for economic interdependence among countries, but it is not a panacea for the world’s current array of economic troubles.

(5) The present exchange rate system has demonstrated some considerable strengths that should not be overlooked. Foremost among them perhaps is that exchange rate changes have made a positive contribution to securing effective external payments adjustment over the medium to long run. Despite some powerful external disturbances, the data as set out in Tables 2 and 3 are not inconsistent with the judgment that the average size and the average persistence of payments imbalances of the larger industrial countries have been smaller during the last decade than during the last ten years of the adjustable peg system. Also, asymmetries in adjustment between surplus and deficit countries, and between the most important reserve center and non-reserve-currency countries have been reduced. Similarly, given the slow adjustment of national price levels, exchange rate changes have made it possible for real exchange rate changes to adjust to, inter alia, permanent changes in the terms of trade, significant natural resource discoveries, continuing differences in trend rates of growth of labor productivity, and evolutionary changes in barriers to trade and capital mobility. The greater flexibility of exchange rates may also have served to increase somewhat the independence of monetary policy and to improve the insulation from general price level disturbances that arise from large intercountry inflation differentials. Also, by funneling more of the short-term disturbances through the exchange market rather than through the goods and labor markets, producers and consumers are better able to reduce the consequences of uncertainty by purchasing insurance against these unforeseen contingencies. Finally, in a world in which effective coordination of policies among the major industrial countries has been the exception rather than the rule, and where there have been serious lapses of discipline in policymaking at the national level, the present system has at least maintained a mechanism of conflict resolution (namely, the foreign exchange market) that has not involved either suspension of currency convertibility or large-scale restrictions on trade and capital flows.

(6) A harsh operating environment and good average performance over the decade do not mean that the operation of the present exchange rate system has been free of serious problems. It certainly has not. The most critical one has been that real exchange rate movements have sometimes gone far beyond those movements suggested by best estimates of “fundamentals,” and have sometimes stayed out of line for periods of up to two to three years. In terms of the concepts used in this paper, this is just another way of saying that there have sometimes been large and persistent departures of actual external payments positions from equilibrium ones. Even if the costs of such maladjustments cannot be estimated with much precision, it is clear that they have created problems in two major areas.

The first is that of efficient resource allocation. The real exchange rate is too important a relative price for it not to affect the pattern of production, employment, investment, and consumption both within and across countries whenever it changes by large amounts (e.g., 30 percent or more) over the medium term. For example, countries with persistent undervalued real exchange rates have tended to overproduce exports, underconsume imports, and overinvest abroad and in tradable goods industries at home. The overvaluation case is symmetrical. Further, when these unsustainable exchange rate and payments positions do unwind (as they eventually must), there are likely to be nontrivial adjustment costs because resources (especially labor) released from the overexpanded sectors do not quickly find employment elsewhere, particularly in the context of sluggish overall economic activity. Thus, even though such resource misallocation and adjustment costs were probably not the primary determinant of inflation, growth, and unemployment performance over the past decade, they made a difficult situation even more troublesome.

The second major concern is in the policy reaction to disequilibrium exchange rates. Although the foreign exchange market does provide a decentralized solution to policy inconsistencies across countries, it has become increasingly evident that countries may resort to other more socially destructive administrative mechanisms if they feel that the verdict of the market is both inequitable and persistent. These administrative mechanisms—most of which involve subsidies (overt or hidden), taxes, or quantitative restrictions on exports or imports—are worrisome because they not only erode the gains from trade but also make cooperation more difficult in other areas of mutual concern. Again, even though exchange rate distortions have probably not been the prime mover of such restrictive measures, they certainly have not helped. In this sense, and contrary to initial expectations, the present system has not yet “depoliticized” the process of exchange rate adjustment. It also highlights why it is so essential in the future to take sufficient preventive measures to keep an adjustment mechanism as imprecise as the exchange rate from having to shoulder so much of the adjustment burden.