Floating Exchange Rates: The Only Viable Solution

Floating Exchange Rates: The Only Viable Solution

Stentor Smith

For some, the collapse of Mexico\'s economy proves that floating exchange rates
and markets without capital controls are deadly. Others find the crash of the
European exchange-rate mechanism (ERM) in 1993 to be proof that targeted rates
will always be overturned by the free market. Many see the breakup of Bretton
Woods as the failure of fixed rates. Yet others believe monetary unification in
Europe is the only way to achieve economic and political stability. Many others
hold still different beliefs. There are, however, four main proposals for the
management of international currency exchange rates: monetary unification, fixed
rates, floating rates maintained within certain "reasonable" limits of
variability and freely floating rates. Both fixed exchange rates and rates based
on either explicit or unwritten targeting are impossible to maintain, especially
in an era of free trade. Complete monetary unification would be impossible to
bring about without extensive integration and unification of international
governments and economies, a task so vast that it is unlikely ever to be
accomplished. Thus, the only option central banks have is to allow exchange
rates to float freely.

The European Monetary System, which virtually collapsed in 1993, was an attempt
to fix exchange rates within certain tight bands, to coordinate monetary policy
between member nations and to have central banks intervene to keep exchange
rates within the bands when necessary. The reasons for the collapse were myriad,
but, simply put, it happened because Germany, dealing with financial problems in
part arising from its reunification, refused to lower its high interest rates.
This meant other European countries either had to keep their rates equally high
and allow themselves to fall into recession as a result, or devalue their
currency against the mark, a move viewed by many as a political embarrassment.
The possibility of a devaluation caused speculators to bolt from the lira, the
pound, the franc and other currencies, sending the markets into chaos and
destroying all semblance of stability. In the end, the ERM was adjusted to allow
currencies to fluctuate within 15 percent on either side of their assigned level,
up from (in most cases) a limitation of 2.25 percent. The bands became too wide
to be meaningful or stabilizing, and the system remained alive "in name only"
(Whitney 19).

Many saw this collapse as inevitable and say all attempts at government-imposed
stability will fail: Governments both will not and cannot stick to pegged or
fixed rates. First, maintaining targeted or fixed rates requires a consistent
and fairly uniform monetary policy among nations. There are many reasons that
national governments will not consent to this, the foremost being that different
countries want different things, different economies have different needs and
different governments have different policies. For example, it is thought that
Europe and Japan are more willing to tolerate recession than inflation, while
the United States prefers to keep interest rates low and the economy growing,
even if prices do increase (Whitt 11). In addition, many nations are in
different stages of their overall economic cycles ("Gold Standard" 79). Many
countries thus cannot afford to subscribe to uniform monetary policy. For a
country that would otherwise have had low interest rates, for example, raising
them could be both economically counterproductive (what good is exchange rate
stability if recession is its cost?) and politically disastrous (more people
notice high interest rates and unemployment than care about currency stability).
Even if the government were willing to bow to international standards,
nationalism is strong in the world today and most people do not look fondly upon
consolidated global power--witness the problems of the United Nations. People
would not widely support what would effectively be international control of
their country\'s economic policies and money supply.

Speculators, unfortunately, know that governments today are likely to put their
self-interest ahead of the nebulous common good and to eventually choose the
monetary policy that is best for their individual economy (as it could be argued
happened in the collapse of the ERM). Speculators will act on this suspicion,
dumping uncertain currencies and running to the strongest (in the case of the
1993 debacle, the Deutsche mark).

So, that is why governments will not stick to targeted rates and what happens as
a result. There are also reasons they cannot. First, there is the decline of
capital controls and the resulting ease with which speculation occurs. With the
growing popularity and reality of free markets and with the advent of the
"Information Age," control over the international money supply is both unwanted
and impossible. The slightest hint of a devaluation can be self-fulfilling as
uncountable amounts of