The Issue of the Flexible Exchange Rate Stability

One of the main arguments advanced in favor of fixed exchange rates has been that allowing floating rates would weaken official price discipline.

The argument runs as follows: the fixed-exchange-rate system puts more pressure on governments with international payments deficits than on governments with surpluses--- it follows that allowing governments to switch to floating rates gives more new freedom to deficit countries than it gives to surplus countries; since classical medicine prescribes deflation for deficit countries and inflation for surplus countries, avoiding this medicine with floating rates, permits policy to be more inflationary on the average; this greater inflation with the float is a bad thing, since individual governments are biased toward excessive inflation if they are not disciplined by the need to defend a fixed exchange rate.

The first two parts to the price discipline argument seem roughly to fit the facts. The third requires a personal value judgment.

It does seem to be the case that the fixed exchange rate system constrains deficit countries more than supplies countries. Deficit countries must face an obvious limit to their ability to sustain deficits: they will soon run out of reserves and creditworthiness.

Surplus countries, by contrast, face only more distant and manageable inconveniences from perennial surpluses. After a while, constantly accumulating foreign exchange and gold reserves becomes inconvenient. The central bank or treasury has to swallow these assets as private individuals turn them in for domestic currency.

When the foreign reserve assets rise to some high levels, it becomes technically impossible for the officials to keep further payments surpluses from raising the money supply, because the officials no longer have any ability to cut their domestic lending once it has hit zero.

Experience seems to confirm this asymmetry. In the postwar period it has been possible for surplus countries, such as West Germany and Japan, to continue accumulating reserves for a considerable time without major inconvenience. It has been harder for deficit countries, such as Britain, to hold out so long.

The main exception of a deficit country able to hold out is that of the United States. The United States was able to sustain deficits longer than were most countries because the reserve-currency status of the dollar made a growing world economy willing to accumulate dollars in large amounts for over a decade. The pre-1914 experience with fixed exchange rates looks much the same.

Those countries for which classical medicine proved too much to take were deficit countries. The system of exchange rates fixed to gold was abandoned not by countries whose reserve inflows proved embarrassing but by countries which could not stem reserve outflows at fixed exchange rates.

Countries running surpluses were in a comfortable position and saw no reason to let their exchange rates change. The main exception to this pattern, as in the postwar period, was that of the reserve-center country. Britain was able to run 'large balance-of payments deficits before 1914 because a growing world economy was willing to accumulate greater sterling balances.

With this exception, the asymmetry was clear: the fixed-exchange-rate system pressured deficit countries to deflate more than it pressured surplus countries to inflate.

Given this asymmetry in the burdens of adjusting to a set of fixed exchange rates in a changing world, it follows that allowing countries to begin floating their currencies will on balance release 'more inflationary policies.

This conclusion is supported by the observation that world inflation of money supplies and prices seemed to pick up a bit after the generalized float of August 1971, in the first twelve months, though this occurrence can have other explanations as well.

Whether or not flexible exchange rates lead to too much inflation is an open question. Somebody who cares very much about full employment and is not much bothered about price inflation might prefer flexible rates because they enhance the ability of deficit countries to create jobs with expansionary policies.