Fixed or floating exchange rates?

[Geoffrey Howe]

Fixed or floating exchange rates? I can't say I really understand much about the issue, but my usernamesake, despite his free-market inclinations, was a strong supporter of fixed rates. I can go and find some of his reasoning, but I'd be interested to see what some of the more knowledgeable here have to add.

Perhaps this is too simplistic a question.

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Well, the British pound had semi fixed rates until George Soros exploited that.

[Geoffrey Howe]

Well, the British pound had semi fixed rates until George Soros exploited that.

We were in the ERM; that's what Geoffrey Howe wanted to join earlier than we did.

[Karpatsky]

What a fixed rate functionally means is that the central bank is selling or buying the home currency in theoretically infinite amounts at the given rate, keeping the market at that price. This makes things easier for international capital flows and so makes the country a safer bet for import, export, and investment for the country which is being pegged to.

There are two major downsides: first, the country's ability to maintain the peg is dependent on its forex reserves (or, in the olden days, gold reserves). This means a crisis either in the country or the country being pegged to could require the government to spend down its reserves very very quickly to maintain the peg. You can see how even the whisper of it failing to be able to do so could become a self-fulfilling prophecy. The only way to prevent this would be to temporarily suspend convertibility (and so free flow of capital), which of course kills investors' and importers' interest in doing business with your country.

Second, a peg functionally removes the country's monetary policy autonomy. If the CB is using its ability to inflate or deflate to maintain the peg, it can't use it to fight inflation or stimulate growth. This was once called the 'golden straightjacket', and is one of the key reasons for the long duration of the Eurozone crisis - Germany and other countries which were doing relatively well were unwilling to inflate the Euro, forcing countries like Greece onto austerity which slowed their recovery.

These three potential desirable policies (fixed exchange rates, monetary policy autonomy, free capital flows) are sometimes called the 'impossible trinity'. You can have two, but it's impossible to have three in the long run.

[Cassius]

Whilst fixed rates can seem superficially attractive, in practice they’re extremely difficult to maintain. It’s instructive to read up on Britain’s economic history in the 20th century, as an example, and see just how much blood, sweat and tears went into trying to fix the pound at one rate or another (whether that was on the Gold Standard, Bretton Woods, or the ERM), something that ultimately proved to be futile.

[Geoffrey Howe]

Whilst fixed rates can seem superficially attractive, in practice they’re extremely difficult to maintain. It’s instructive to read up on Britain’s economic history in the 20th century, as an example, and see just how much blood, sweat and tears went into trying to fix the pound at one rate or another (whether that was on the Gold Standard, Bretton Woods, or the ERM), something that ultimately proved to be futile.

Geoffrey Howe's support for fixed rates, specifically the ERM was I think largely derived from his time as Chancellor in the still extremely volatile early 1980s; particularly bad for Britain given our petrocurrency status at the time. He wanted a return to the 'stability' of the Bretton Woods system.

Interestingly, he and Nigel Lawson say that things would have turned out much better if we had joined when was initially hoped in 1985; gaining a foothold and avoiding teething problems. Clearly German reunification made the system very difficult.

I believe that, by joining the fixed but adjustable system that the ERM then was, we should have achieved more stability not only with the exchange rate but with monetary and, quite probably, fiscal policy too. For membership of the Mechanism would have enabled us to avoid the unsatisfactory halfway-house of 'shadowing the Deutschmark'...this would have delivered a more restrained monetary policy and quite probably steered us away from the Lawson Boom - and consequent inflation and inevitable recession. Finally, as more mature, streetwise members of the system to play a much more credible and thus fuller part in shaping the Delors Report and managing the (invariably different) response to the shock of German unification...we joined in September 1990 when the pound-Deutschmark exchange rate was unsustainably high. The task of making the policy sufficiently credible to the markets was thus much harder than it need have been.

Interestingly, in 1985 the Treasury, the Chancellor and the Governor of the Bank of England all supported entry.

I'll follow up with some of Nigel Lawson's analysis.

[Cassius]

My understanding of the ERM debacle was that there was a rather political motivation to it - inflation was still relatively high in the late 80s and so high interest rates could be framed as a political necessity to maintain our place in the ERM as opposed to a strategy for containing inflation (thus outsourcing the blame for this from the government and to ‘Europe’).

I’d also query Howe’s assertion about the stability of Bretton Woods - once the world was awash with dollars again, the system as a whole was virtually impossible for the Americans to maintain, which was why Nixon jacked it in in 1971. Meanwhile, our own government’s efforts to prevent the pound from becoming over or undervalued is what led to the ‘stop-go’ policies of the postwar period, which weren’t particularly conducive to stability or long term economic growth.

[Geoffrey Howe]

OK, it seems Nigel Lawson supported EMS as a way to control inflation, especially when domestic pressures made tight monetary policy difficult.

First of all, though, when Geoffrey Howe was Chancellor (1979-1983) he opposed a fixed exchange rate, for the following reasons

• The pound as a petrocurrency was too volatile
• We were already pursuing a strict monetary policy
• The rate proposed in 1982 was too high
• People might blame high interest rates (the government's choice) on EMS and turn them off the whole European idea

He only came to support it by 1984, one year into his Foreign Secretaryship.

Nigel Lawson supported fixed exchange rates as a way to stabilise prices and avoid excessive inflation.

Under the Bretton Woods system governments had the illusion they were pursuing domestic full employment policies, whereas in fact they were following some form of international monetarism.

In effect he saw it as an alternative to monetarism - controlling the 'money supply' - which was becoming very difficult with deregulation and the abolition of exchange controls; sources of credit were too diverse to control. His solution was fixing the pound to the stronger and more stable Deutschmark, making devaluation very difficult - and so incentivising companies and people to restrain costs.

The point is, first, that, for a mixture of historical, cultural and institutional reasons, Germany is able to maintain a reasonable degree of price stability; second, that recognising this, the financial markets attach greater credibility to a monetary policy based on adherence to the Deutschmark; and third that, within the ERM, companies know that if they fail to control costs they are unlikely to be saved from bankruptcy by devaluation.

In effect, he viewed the high pound as a positive because it 'squeezed inflation' out of the system.

[Geoffrey Howe]

My understanding of the ERM debacle was that there was a rather political motivation to it - inflation was still relatively high in the late 80s and so high interest rates could be framed as a political necessity to maintain our place in the ERM as opposed to a strategy for containing inflation (thus outsourcing the blame for this from the government and to ‘Europe’).

Well that was one of the reasons Howe opposed joining it as Chancellor when interest rates were at 17%. (See above)
I should note that as Chancellor he wasn't opposed in principle, he just thought it was the wrong time to join.

[Torie]

If they don't float at some point a currency will crash, absent coordinated economic policies. That is what I learned way back when as I recall, which means in the new paradigm on the other side of the looking glass, that I am probably wrong.

[Geoffrey Howe]

If they don't float at some point a currency will crash, absent coordinated economic policies. That is what I learned way back when as I recall, which means in the new paradigm on the other side of the looking glass, that I am probably wrong.

In 1985 here, the Chancellor of the Exchequer, the Treasury and the Bank of England all supported fixed exchange rates in the form of the ERM; so maybe the new idea is floating...

[Senator-elect Spark]

While Fixed exchanges rates are more desirable to promote stability, it causes less of an ability to adjust during a crisis. Tying one currency to another could tank that currency with one being pegged to the other. Of course, the central bank needs to intervene to stabilize the currency.

I don't think floating exchange rates should be used in developing economies because the market can be too volatile.