Forbes, November 2, 1998
Wild currency fluctuations are destabilizing the world economy and our own stock market. A great economist explains the play.
A primer on exchange rates
By Milton Friedman
Three types of exchange rate regimes are possible and have existed at various times in various countries.
Fixed rate or unified currency
The clearest example is a common currency: the dollar in the U.S.; the euro that will shortly reign in the common market. Almost identical is the balboa in Panama, which is interchangeable with the dollar one-to-one, and the currency boards in Argentina and Hong Kong, which are committed to creating currency only in exchange for a specified amount of U.S. dollars (one peso to $1 in Argentina, 7.8 Hong Kong dollars to $1) and to keeping dollar reserves equal to the dollar value of all currency outstanding. A pure gold standard is a variant of this type of regime.
The key feature of the currency board is that there is only one central bank with the power to create money—in the examples cited, it's the U.S. Federal Reserve System. Hong Kong has no central bank; Argentina does—but without the power to create money.
Hong Kong and Argentina have retained the option of terminating their currency boards, changing the exchange rate, or introducing central bank features, as the Hong Kong Monetary Authority has done in a limited way. As a result, they are not immune to infection from foreign exchange crises originating elsewhere. Nonetheless, currency boards have a good record of surviving such crises intact. Those options are not retained by California or Panama, and will not be retained by the countries that adopt the euro as their sole currency.
Pegged exchange rate
This prevailed in the East Asian countries other than Japan. All had national central banks with the power to create money and committed themselves to maintain the price of their domestic currency in terms of the U.S. dollar at a fixed level, or within narrow bounds—a policy they had been encouraged to adopt by the IMF.
Such a peg is fundamentally different from a unified currency. If Argentina has a current account deficit; i.e., the dollar receipts from abroad are less than the payments due abroad, the quantity of currency (high-powered or base money) automatically goes down. That brings pressure on the economy to reduce foreign payments and increase foreign receipts. The economy cannot evade the discipline of external transactions.
But under the pegged system, when Thailand had a current account deficit, the Bank of Thailand did not have to reduce the quantity of high-powered money. It could draw on its dollar reserves or borrow dollars from abroad to finance the deficit. It could, at least for a time, evade the discipline of external transactions.
In a world of free capital flows, such a regime is a ticking bomb. It is never easy to know whether a deficit is transitory and will soon be reversed or is the precursor to further deficits. The temptation is always to hope for the best, and avoid any action that would tend to depress the domestic economy. Such a policy can be effective in smoothing over minor and temporary problems, but it lets minor problems that are not transitory accumulate until they become major problems. Moreover, at this stage, the direction of any likely change is clear to everyone—in the Thailand case, a devaluation. A speculator who sold the Thai baht short could at worst lose commissions and interest on his capital, since if the baht were not devalued, the peg meant that he could cover his short at the same price at which he sold it. On the other hand, a devaluation would bring him large profits.
The resulting collapse in the dollar value of the currencies of the four East Asian countries is an oft-told tale that has been experienced even by large and highly developed countries. The United Kingdom, which had a central bank and at the same time pegged its currency, experienced a foreign exchange crisis in late 1967, when the pound was pegged to the U.S. dollar, and again, this time along with France, Italy and other members of the European Monetary Union, in 1992 and 1993, when the peg was not to the dollar but to exchange rates agreed to under the European Monetary Union.
Floating rates
The third type of exchange rate regime is one under which rates of exchange are determined in the market on the basis of predominantly private transactions. In a pure form, clean floating, the central bank does not intervene in the market to affect the exchange rate though it or the government may engage in exchange transactions in the course of its other activities. In practice, dirty floating is more common: The central bank intervenes from time to time to affect the exchange rate but does not announce in advance any specific value that it will seek to maintain. That is the regime currently followed by the U.S., Britain, Japan and many other countries.
Under a clean floating rate, there cannot be and never has been a foreign exchange crisis. There may be internal crises, as in Japan, but not accompanied by a foreign exchange crisis. The reason is simple: changes in exchange rates absorb the pressures that in a pegged regime lead to crises. The foreign exchange crisis that affected Korea, Thailand, Malaysia, and Indonesia did not spill over to New Zealand or Australia because those countries had floating exchange rates.
The IMF muddies the water
The Mexican crisis of 1995 is the most recent example of a major currency crisis in a country with a central bank and pegged exchange rates. Mexico, it is said, was bailed out by a $50 billion financial aid package from a consortium including the International Monetary Fund, the U.S., other countries and other international agencies. The reality is that "Mexico" was not bailed out. Foreign entities—banks and other financial institutions that had made dollar loans to Mexico—were bailed out. The internal recession that followed the bailout left the ordinary Mexican citizen with a sharply reduced income, facing higher prices for goods and services. That remains true today.
The Mexican bailout helped fuel the East Asian crisis that erupted two years later. It encouraged individuals and financial institutions to make loans to and invest in the East Asian countries, reassured about currency risk by the belief that the IMF would bail them out if the exchange pegs broke.
"Businessmen should not have a free insurance policy every time they take a risk in global markets."
-Milton Friedman
I do not blame the lenders for accepting the gift of insurance. I blame the IMF for offering the gift by the way it handled the Mexican and other crises.
The Mexican bailout was on a much larger scale than earlier ventures. It led to the IMF being viewed as a lender of last resort, a function it was not equipped to perform. When the Asian crisis broke, the IMF quickly committed itself to more than $100 billion in loans to the four countries involved, subject to conditions on government budgets, monetary policies, banking regulations and the like. In retrospect, many observers, myself included, believe that much of the advice was based on the IMF's experience with countries whose problems derived from excessive government spending and budgets. The advice was not appropriate to East Asia, where the problem was not a fiscal crisis but a banking crisis—in Japan as well as in the pegged-rate countries.
What should we do?
Of the three possible exchange rate regimes for a developing country, either a truly fixed rate with no national central bank or a floating rate plus a national central bank is preferable to a pegged exchange rate. That lesson emerges clearly from East Asia but is also supported by much earlier experience.