How The Fed Can Tame The Savage Currency MarketsRudi Dornbusch
In 1944, the financial leadership of the free world met in Bretton Woods, N.H., to map out a postwar financial system. In the 1930s, the world economy had disintegrated, and the postwar world needed a structure to keep trade routes open. The experts sought to create new institutions that would prevent currency instability, competitive devaluations, tariffs, and quotas. They wanted to fix exchange rates and realign them only in case of "fundamental disequilibrium."
In large part, they succeeded. After World War II, international trade expanded faster than world production. Vanquished Germany and Japan made strong economic comebacks. Despite day-to-day trade frictions, the world moved from a closed system to an open one.
Bretton Woods is given much of the credit, but in fact it had little to do with it: Most of the credit goes to the U.S. Starting with the Reciprocal Trade Agreements Act of 1934, the U.S. reversed protectionism at home and fostered free trade abroad.
The Bretton Woods world of fixed rates was never as idyllic as many would have us believe. Many currencies remained inconvertible for years after the war. Exchange-control laws prevailed, and bureaucrats decided on specific currency transactions. In Britain, that awkward state of affairs continued right up till Margaret Thatcher became Prime Minister in 1979. In Japan, it lasted into the 1980s.
Exchange rates were never completely fixed, either. Realignments constantly took place. Currency crises were routine, centering around a strong German mark, an anemic British pound, a shaky French franc, and an overstretched U.S. dollar.
PRAGMATIC POLICY. The system of make-believe fixed rates crashed in the early 1970s, when the U.S. found it inconvenient to run its economy by standards the Bundesbank set for Germany. A major devaluation of the dollar showed the greenback had been overvalued for years, hurting U.S. growth.
The floating-rate world since then has been no Camelot, either. This was especially true in the 1980s, when a misguided U.S. Treasury turned dogmatic, practicing a hands-off approach to the dollar in the currency markets. In the midst of superhigh interest rates during the Volcker recession, the dollar soared, reaching a glorious overvaluation of 30% to 50%.
Compared with the 1980s, we now have a pragmatic policy. There is plenty of "dirty floating," with governments intervening in the markets. Whatever the dreams of the Bretton Woods romanticists, governments are determined not to make the mistake again of locking their currencies in place, only to have them become targets of speculative attacks.
It's true that the volatility of the mark-dollar rate is almost three times as high under current floating rates as in the fixed-rate period. But what are the consequences? One is that flexible rates have given countries the ability to follow an independent policy geared to domestic needs rather than to the demands of the currency markets.
NO RETURN. Yet this pro-growth policy may bring with it an inherent inflationary bias. Those who would return to a fixed-rate system feel that linking a country to more responsible central banks abroad would limit that tendency and reduce instability in the financial markets. Unfortunately, there can be no return to Bretton Woods sytems: The Bundesbank will not accept monetary policy set by the U.S., and the U.S. will not accept a Buba-managed straitjacket on its economy. So, for better or worse, fixed rates are a nonstarter.
Of course, there is the experience of the European Monetary System (EMS). As soon as European countries fixed their currencies to the German mark, they began to let the Buba run their monetary policies. Countries gained on the inflation front, but Britain, Italy, and Spain saw their currencies collapse in a speculative free-for-all. The only nations sticking with fixed rates were the true believers in Buba policy. Even so, exchange-rate margins have since been widened for EMS countries.
Yet the question remains: Why not announce target zones for major-currency relationships--such as dollar-to-mark or dollar-to-yen--to generate more predictability? The answer is that, unless there is tight monetary coordination, such a system is just as prone to attack as a rigidily fixed system.
A better strategy is to let the Federal Reserve publicly announce an inflation target for the coming years--of 1% to 3%. Let Congress monitor it and have the Fed vigorously pursue policies that achieve it. In time, the target will be accepted by markets around the world. Then the chief reason for wild currency swings--worry about inflation and the Fed's ability to stop it--will disappear.
The international monetary system matters. The best combines the advantages of exchange-rate flexibility with firm inflation targeting. There are great benefits to predictably low inflation. Currency stability is one. Purists won't be satisfied because currencies will still move. But large and disruptive swings will mostly be gone. And if, on occasion, governments intervene in foreign exchange markets to help cool them off, so what?