Monetary sovereignty as globalization's Achilles' heel.

AuthorSteil, Benn

It is remarkable how the world's short recent history of floating exchange rates among flat currencies has affected popular thinking about what is eternally normal and proper in the economic system. Recently, Senators Charles Schumer and Lindsey Graham (2006) wrote matter of factly in the Wall Street Journal that "One of the fundamental tenets of free trade is that currencies should float." Such a "tenet," if it were such, could only have emerged since the 1970s. Of course, exchange rates had fluctuated widely in previous centuries, but it has been only since the 1970s that such fluctuations have been taken as connatural with the international monetary regime. Even John Maynard Keynes, the arch slayer of the last remnants of commodity money, was an adamant supporter of fixed exchange rates. (1)

Before the 1970s, it was generally taken for granted that international transactions would be best served by a system of fixed exchange rates relative to the international standard of value, which was a commodity or a claim on a commodity. Money accepted across borders had generally been gold, or claims on gold, for about 2,500 years. The post-1971 international monetary "system," certainly a misnomer, is comprised of 150-some-odd currencies, primarily national, all circulating in the form of irredeemable IOUs, or IOUs redeemable only in other IOUs. Some trade freely against others, some trade freely but with governments buying and selling so as to maintain a desired price, and some are subject to exchange restrictions by their government issuers. This would appear a recipe for continual global chaos, but it functions with far more stability than one might expect, given the complete absence of agreed rules or an agreed international money. This is because one currency, the U.S. dollar, is widely accepted voluntarily as money for the purposes of international transactions.

Nonetheless, it is a source of tremendous periodic instability, manifesting itself in currency crises afflicting countries whose currencies are not acceptable for international transactions, but which build up currency imbalances in their national balance sheets through their imports of dollar capital. Over the past two decades, devastating currency crises have hit such countries across Latin America and Asia, as well as countries just beyond the borders of western Europe; in particular, Russia and Turkey. This has led to international capital flows becoming far and away the most widely condemned flaw in globalization.

That the destabilizing effects of today's cross-border capital flows should be considered, however, even by economists who should know better, a manifestation of "market imperfection" or "irrationality" is to my mind astounding. The fundamental difference between capital flows under indelibly fixed and non-fixed exchange rates was well known generations ago, decades before the modern era of globalization. Consider this excerpt from a lecture by Friedrich Hayek in 1937:

Where the possible fluctuations of exchange rates are confined to narrow limits above and below a fixed point, as between the two gold points, the effect of short-term capital movements will be on the whole to reduce the amplitude of the actual fluctuations, since every movement away from the fixed point will as a rule create the expectation that it will soon be reversed. That is, short-term capital movements will on the whole tend to relieve the strain set up by the original cause of a temporarily adverse balance of payments. If exchanges, however, are variable, the capital movements will tend to work in the same direction as the original cause and thereby to intensify it [Hayek 1937: 64]. This was because

Every suspicion that exchange rates were likely to change in the near future would create an additional powerful motive for shifting funds from the country whose currency was likely to fall or to the country whose currency was likely to rise. I should have thought that the experience of the whole post-[first world] war period and particularly of the last few years had so amply confirmed what one might expect a priori that there could be no reasonable doubt about this [Hayek 1937: 63-64]. Hayek's logic was mirrored precisely by the radical change in capital flow behavior that accompanied the crumbling of a credible international monetary anchor, gold, between the first and second world wars. In the words of Ragnar Nurkse (1944: 29),

After the monetary upheavals of the [first world] war and early post-war years, private short-term capital movements tended frequently to be disequilibrating rather than equilibrating: a depreciation of the exchange or a rise in discount rates, for example, instead of attracting short-term balances from abroad, tended sometimes to affect people's anticipation in such a way as to produce the opposite result. In these circumstances the provision of the equilibrating capital movements required for the maintenance of exchange stability devolved more largely on the central banks and necessitated a larger volume of official foreign exchange holdings. This is not simply a matter of whether exchange rates are "fixed" or floating. Exchange rates were "fixed" within the European Monetary System in the late 20th century, but capital flows served to destabilize rather than stabilize it. Interest rate increases will not automatically attract capital flows where the credibility of the fixed parity is inherently weak. This goes to the heart of the difference between the classical gold standard and fixed exchange rates among flat currencies: the former was based on a highly credible commodity standard in which the market, rather than government, determined the money stock, whereas the latter is based on an agreement between flat money issuers, each of which faces incentives to manipulate the money stock in a way which undermines the exchange rate commitment (see Cesarano 2006). The presence of active monetary policymakers will invariably undermine the stabilizing tendency of capital flows.

Yet, perversely as a matter of both monetary logic and history, the most notable economist critic of globalization, Joseph Stiglitz, has argued passionately for monetary nationalism as the remedy for the economic chaos of currency crises (see Stiglitz 2002, 2005). When millions of people, locals and foreigners, are selling a national currency in fear of impending default, the Stiglitz solution is for the issuing government simply to decouple from the world: lower interest rates, devalue, close off financial flows, and stiff the lenders. It is precisely this thinking, a throwback to the disastrous 1930s, which is at the root of the cycle of crisis that has infected modern globalization. Again, Hayek foresaw it in 1937:

The modern idea apparently is that never under any circumstance must an outflow of capital be allowed to raise interest rates at home, and the advocates of this view seem to be satisfied that if the central banks are not committed to maintain a particular parity they will have no difficulty either in preventing an outflow of capital altogether or in offsetting its effect by substituting additional bank credit for the funds which have left the country. It is not easy to see on what this confidence is founded. So long as the outward flow of capital is not effectively prevented by other means, a persistent effort to keep interest rates low can only have the effect of prolonging this tendency indefinitely and of bringing about a continuous and progressive fall of the exchanges. Whether the outward flow of capital starts with a withdrawal of balances held in the country by foreigners, or with an attempt on the parts of nationals of the country to acquire assets abroad, it will deprive banking institutions at home of funds which they were able to lend, and at the same time lower the exchanges. If the central bank succeeds in keeping interest rates low in the first instance by substituting new credits for the capital which has left the country, it will...

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