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Let us wait and see if the euro area's fixed exchange experiment really works
Let us wait and see if the euro area's fixed exchange experiment really works
Thomas Willett Dunaway, FT 11/1 2007
Horton Professor of Economics, The Claremont Colleges, US
Sir, Benn Steil ("Digital gold and a flawed global order," January 5) rightly points out that it was in the last decades of the 20th century that most of the economics profession favoured flexible exchange rates. But he offers a one-sided view of the debate over fixed versus flexible exchange rates.
Contrary to Mr Steil's assertion, John Maynard Keynes was a noted critic - not a supporter - of permanently fixed rates. Keynes expressed this perhaps most eloquently in his famous essay "The Economic Consequences of Mr Churchill".
However, Keynes was also a critic of floating rates, and favoured the Bretton Woods compromise of adjustably pegged rates. When disequilibrium was fundamental he believed it was the exchange rate, not the domestic economy, that should adjust. When the disequilibrium was judged to be temporary, his policies of choice were financing and capital controls.
As Mr Steil notes, floating rates have hardly been trouble-free. But neither would Mr Stiel's preferred solution of widespread dollarisation. Modern international monetary theory shows it is fruitless to debate fixed versus flexible rates in the abstract. Their relative costs and benefits vary systematically depending on a number of factors.
To Keynes it was the inflexibilities he perceived in domestic economies that made him a critic of domestic adjustment to preserve fixed exchange rates. For small flexible economies, permanently fixed rates may be desirable; but given how many countries have neither small nor flexible economies, a general system of fixed rates is no safe foundation for a stable global economic order.
The main challenge to this conclusion is the optimistic view that by permanently locking in exchange rates, substantially greater flexibility will be generated in domestic economies. While economic efficiency incentives do run in this direction, they are often countered by the same special interest groups that helped to create rigidities in the first place.
The euro area is in the middle of a major experiment to see if the endogenous flexibility theory will work better in Europe. Let us wait for more evidence for the success of fixed exchange rates in Europe, before advocating their adoption globally.