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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 money change hands at a whim. Some people argue that

making realignments less predictable would stalemate destructive speculation

("The Way Ahead" 22), but most people realize that by the time central banks

know to devaluate, the smart speculators--reading the same economic signs as the

bankers--will know the same thing, especially if devaluation continues to be

seen as a fairly drastic undertaking. Spain, for example, tried in 1993 to catch

speculators off guard by realigning in the middle of the trading day, but that

can only be done once before speculators catch on (Eichengreen and Wyplosz 89).

In the case of a completely fixed system, devaluation is necessarily an extreme

measure and thus there is no question: Speculators will have no trouble seeing

it coming and will run from the market.

These situations could hypothetically be avoided if central banks could

intervene to prevent devaluation from ever becoming necessary. Some currencies,

however, probably do not deserve to be propped up even if doing so were possible,

because their real value is so far from their nominal value that it would be

counterproductive to perpetuate the inaccuracy. Second, it can also be argued

that central banks simply do not have the power to control the market, both

because they don't have enough money (Germany spent 44 billion marks to prop up

the pound and the lira in 1993 with very little success) and because their

short-sighted attempts at circumventing the "invisible hand" fail. In the 1980s,

governments joined several times to change the value of the dollar relative to

the yen (the Plaza and Louvre agreements), an undertaking whose long-term

success is dubious. Some people even blame the subsequent volatility in the

market and the severe problems in the Japanese economy on the machinations of

those governments (Friedman, "Anxiety" 34; Wood 8).

There are also other problems with fixed or targeted rates. Even if the system

could be maintained, the economies of the world are probably not integrated

enough to deal with a fixed rate system and to correct imbalances of trade.

Capital is free to flow from country to country, but labor is not and neither

are many businesses. The comparison of the states of the USA to the countries of

the world is specious: Not only do the states share a central government and

have virtually no economic sovereignty or identity, and not only is everybody

certain that the situation will never change and thus there is no speculation,

but, most importantly, everything flows freely over every border ("Interview").

The balance of the free market, of supply and demand, is easily maintained. That

is not the case in the world at large.

Finally, the last problem with fixed or targeted exchange rates is that

confidence in the system has to be absolute or else pessimistic, self-fulfilling

speculation will cause the collapse of the system. Unfortunately, the system

isn't perfect. Again and again people write that as soon as this or that crisis

passes over (Germany's reunification, for example), we will have economic and

political peace and be able to fix exchange rates. But crises in Europe and

elsewhere haven't ceased just because Hitler is no longer alive and the Berlin

Wall has fallen. Overwhelming problems will at some point strike the system--we

haven't advanced beyond war, mayhem and natural disasters--and there will be no

solution but to leave the monetary regime, as has happened before (notably in

World War II). People with money in the currency market know this, and knowing

this, help to make it inevitable.

One misconception about fixed exchange rates ought to be noted here: the

difference between real and nominal values of money. With fixed rates, nominal

exchange rates may be stable but real exchange rates vary. Prices of imports and

exports still change relative to each other; this is how the system balances

itself. As a country's money supply contracts and expands by the actions of

foreigners, the price level within the country changes. (Theoretically, it would

go both up and down, but the tendency of prices to "stick" high hinders the

balancing mechanism by making deflation rare.) As one author put it, the

attractiveness of fixed rates depends partially on the answer to the question,

"How stupid is your labour force?" ("Currency Reform" 18) And how stupid are all

the business people? Is not the fluctuation in the nominal and real values of

the currency under a floating system similar to the fluctuation in the real

value of fixed currency? The changes in floating exchange rates have proved to

be much more volatile than the (real) changes in fixed rates, but it ought to be

noted that real values still change under both systems, in both cases to remedy

balance of payments problems. Since we would have to sacrifice in order to

maintain nominal stability through fixed rates, we ought to remember to ask

exactly how much real stability we would be getting in return.

The third major proposal for a monetary system is that of monetary unification.

This poses some of the same problems as a fixed or targeted rate system. Most

people don't support it because, essentially, it unifies too much. It takes too

much power out of the hands of nations and puts it somewhere else. It would,

like a free market, increase harmonization (competition) in taxation, another

trend which threatens the autonomy of nations (Hornblower 41). Governments would,

as in the other two systems, give up a great deal of control over their domestic

economies, and the problems of individual country's business cycles would be

ignored and unregulated. Even if monetary unification were wanted--and it would

remove the problems currency volatility poses for international trade--its

institution would be virtually impossible in the current political climate.

"Jealousies, allegiances, the bases of political support remain firmly national;

that fact cannot be wished away by a coin" ("To Phrase a Coin" 14). The

governments of countries and their populations are further from integration than

the economies themselves; it would be impossible to achieve the amount of

political coordination--one could even call it union--that would be necessary to

create and sustain complete monetary unification.

So, what is the answer? Obviously, currency volatility is a problem.

Unfortunately, all other alternatives seem worse. There are, at least, some

advantages to freely floating rates aside from their existence as the only

viable system. First, they can act as "shock absorbers" and moderate the

exportation of one country's problems (inflation, for example) to its neighbors

("Fixed and Floating Voters" 64; Friedman, "Introduction" xxiii). Second, the

free market punishes incompetent governments for bad fiscal policies. Mexico's

monetary policy was woefully irresponsible; thus, it's hardly a surprise its

entire economy collapsed. Competition in the currency market, as in all other

things, drives people and governments to be responsible (Becker 34).

The system is also, in some ways, fair. As Paul Magnusson posits, it "arguably

reflects the fair value of nations' legal tender based on the fundamentals of

growth, inflation, and interest rates." He goes on to add that "currency

volatility is the price of a free market, not a condition to be cured" (108).

Just as, for example, it's widely believed that price and rent controls hurt

more than they help, so too do government interventions in the currency market.

As mentioned above, many even blame government intervention for volatility in

the first place, as in the case of the Plaza and Louvre agreements. Some people

also argue that volatility may be temporary until the system settles down

(Friedman, "Introduction" xxiii), but this bears some of the marks of the

unrealistic optimism of people who seem to believe Europe and the world will be

(after we resolve just one more crisis) forever peaceful and ready for


The biggest advantage of floating exchange rates is that they give each country

control over its domestic affairs. Presumably, it knows best how to handle them,

and it is to be hoped that knowledge of the workings of the free market will

keep it from doing so irresponsibly. Speculation can be a stabilizing force that

demands responsible fiscal policy and money management. The cost of economic

stability and prosperity may in fact be exchange rate instability: $6.5 billion

to $39 billion was estimated to have been spent on hedging in 1989 (Rolnick and

Weber 33), but how much money would be lost each year by sacrificing individual

economies to the international "good" (as in the case of the European nations

that fell into recession during the ERM crisis)? Besides, as the president of

the New York Federal Reserve Bank said, "low inflation is the best assurance of

exchange rate stability" (Lewis A24). Theoretically, intelligent domestic

control of national economies will dampen currency volatility as well as

improving the health of the economy itself.

For all these reasons, floating exchange rates are the best system available to

central banks at this time. The mechanism is certainly not without flaws, but it

is the only truly feasible choice. Governments will always desert a fixed or

targeted rate system, either when their reserves run out or when domestic

inflation or recession becomes too severe. The real values of currencies do

fluctuate--that is the problem. Sooner or later a gross imbalance will arise and

it will be fixed either by the nation voluntarily leaving the system or by

speculators foreseeing its demise and forcing it out. The solution to that

problem, monetary union--fixed rates with no devaluation or "leaving the system"

allowed--would be impossible to institute and maintain even if it were

economically advantageous to all involved. The only realistic and economically

sound solution, problematic though it may be, is to have exchange rates float

freely and without restriction.


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Business Week 13 November 1995: 34.

Brooks, David. "A First Class Eurocrat." The American Spectator March 1992: 46-


"Currency Reform: A Brief History of Funny Money." The Economist 6 January 1990:


Dowd, Kevin. "European Monetary Reform: Pitfalls of Central Planning." USA Today

March 1995: 70-73.

Eichengreen, Barry and Charles Wyplosz. "Mending Europe's Currency System." The

Economist 5 June 1993: 89.

"Europe's Currency Tangle." The Economist 30 January 1993: 21-23.

"Europe's Totem Pole." The Economist 23 September 1995: 14-15.

"Fixed and Floating Voters." The Economist 1 April 1995: 64.

Frenkel, Jacob A. and Morris Goldstein. "Europe's Emerging Economic and Monetary

Union." Finance & Development March 1991: 2-5.

Friedman, Milton. "Free-Floating Anxiety." National Review 12 September 1994:


_________,"Introduction." The Merits Of Flexible Exchange Rates. Ed. Leo Melamed.

Fairfax, Virginia: George Mason University Press, 1988. xix-xxv.

Habermeier, Karl and Horst & Ungerer. "A Single Currency for the European

Community." Finance & Development September 1992: 26-29.

Hoffman, Ellen. "One World, One Currency?" Omni June 1991: 51+.

Hornblower, Margot. "No One Ever Said It Would Be Easy." Time 1 March 1993: 32+.

"Interview with Alan S. Blinder." The Region December 1994. Online. Kimberely.

Javetski, Bill and Patrick Oster. "Europe: Unification for the Favored Few."

Business Week 19 September 1994: 54.

Krugman, Paul R. "Europe's Fatal Monetary Vision." U.S. News And World Report 16

August 1993: 45.

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Report 16 August 1993: 43-45.

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Quarterly Winter 1993: 26-38.

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1994: D1.

Magnusson, Paul. "The IMF Should Look Forward, Not Back." Business Week 3

October 1994: 108.

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