FIXED EXCHANGE RATE FOOLISHNESS
(THE FOLLIES OF 1985)

Published in The Wall Street Journal,

April 24, 1986.

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The Merits of Flexible Exchange Rates: An Anthology, published by George Mason University Press in 1987—for which I acted as editor—contained a chapter I wrote on the creation of the International Monetary Market. The chapter began with the following thought: "Few things are more symbolic of flexible exchange rates than the International Monetary Market (IMM) in Chicago. Indeed, the birth of this futures exchange on May 16, 1972 is inextricably intertwined with the death of Bretton Woods, occurring as it did but a few months after President Nixon officially closed the gold window and ended the system of fixed exchange rates."

Consequently, whenever the repudiated specter of fixed exchange rates resurfaces—which happens periodically—it is incumbent upon IMM idealogues, as well as all those who understand this issue, to speak out. Indeed, the Anthology was an outgrowth of an ad-hoc coalition of leaders from academia, business, and commerce who shared the idea that world economic stability and viability is best achieved through adherence to free market principles. That coalition—the American Coalition for Flexible Exchange Rates (ACFX)—was organized in 1986 at our coercion when there was a growing clamor for a return to a more fixed international monetary system.

The ACFX was founded on the following propositions:

That free markets are the best arbiter of supply and demand, providing the most efficient determinant of price;

That the free market exchange system reflects, does not cause, fundamental economic factors at work in various nations;

That the value of a nation's currency depends upon a complicated analysis by the free market of the differences between that nation and others in price levels and inflation rates, interest rates, national money supplies, national incomes, trade and investment flows, government and private debt, and political risk;

That these complex factors are best assessed and balanced through the flexible free market exchange system;

That a stable international monetary system is fostered by market-driven exchange rates.

The ACFX successfully repulsed the anti-free market forces of that day. The following Wall Street Journal op-ed article served as the opening volley of our counter-attack.

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In 1985, we witnessed the final round in an unusual struggle between forces of nature and the wiles of man.  It was a year during which the power of the free market proved as seldom before its unequalled strength in determining fair value.  Alas, it was also the year that man, his eyes tightly shut to the clear evidence about him, schemed once again in a futile quest to overcome the honest evaluations of supply and demand.

On one hand OPEC—the once all-powerful international price-fixing cartel—found it increasingly difficult to maintain its long-standing system of artificial price edicts in the face of unrelenting market forces. Similarly, the London Metals Exchange desperately fought to survive the massive default caused by the artificially-supported tin prices of the International Tin Council (ITC). On the other hand, the U.S. Treasury, in unison with several other ministers of finance—the Group of Five (G-5)—picked up the torch on behalf of artificial price rule by committee.

This time they tell us it will be different; that the universal laws of supply and demand are different for foreign exchange than for oil or tin.  Indeed, they point with pride to the recent instant success of their magic bullet and attempt to assuage our doubts by insisting that the motivation is pure.  Meanwhile, some of our most principled free market advocates shamefully look the other way, mumbling something about the occasional virtues of pragmatism over idealism.

False! The fundamental truths that govern the value of money are no different than those for all commodities.  The market forces that ultimately overpowered a man-made method to artificially ordain the value of oil will similarly undo the manipulations of the G-5 or any artificial system that attempts to dictate the relative value of the dollar.  In today's world, a fixed rate or targeted range for currency in international capital markets can last for only so long as market forces agree with it.

The G-5's September 22, 1985 quick fix was successful simply because the market agreed with the result.  The dollar had already established its top after enduring the blow-off stage of its four-year long bull market.  By early September, it had already fallen 23% against the Deutsche mark, 33% against the British pound and 10% against the Japanese yen.  The dollar was in the final stages of consolidation after this initial down-leg when the G-5 struck.  Their timing was excellent.  With prospects for lower U.S. interest rates in sight, the dollar responded to the added pressure of the moment.  Had the ministers not acted, free market forces would have achieved a similar result.

The danger of believing otherwise is the same as in the case of any false messiah.  We will be forced to appeal to our new intervention god again and again with increasingly negative results.  Greater uncertainty, higher volatility and accentuated price dislocations will be among the predictable achievements.  Eventually, the stark truth will reveal itself when the participating ministers no longer see eye-to-eye, or when the market totally refuses to obey our dictates. This inevitably will happen—witness OPEC and the ITC.  Indeed, in the history of mankind, there are few examples where policy makers have been able to outsmart—or any extended period of time—the collective judgment of buyers and sellers in the marketplace. It will then be of small value to claim that we adopted the new religion only in order to prevent a worse fate; that the prevailing U.S. political climate for protectionism threatened the sanctity of world commerce and that therefore a little intervention was far better than a little trade war. Alas, just as in the case of pregnancy, there is no such thing as only a little fixed.  Intervention, as with every intoxicating elixir, has a certain mass appeal. 

Instantly, it became fashionable to call for a return to the Bretton Woods system of fixed exchange rates that was adopted by the Western World directly after World War II.  Instantly, a parade of experts extolled the virtues of that old order.  Leading that parade for the U.S. were two very able and well-intentioned elected luminaries—Senator Bill Bradley (D-NJ) and Congressman Jack Kemp (R-NY).  While each approached the issue from different philosophical viewpoints, both proclaimed the high dollar value was evidence of a failure of flexible exchange rates.  Consequently, they called for a new international Bretton Woods conference in order to re-establish rigidity in foreign exchange.

The world of 1985 does not in any way, shape or form resemble the world of 1944.  The war had then completely ravaged every aspect of international commerce and trade.  The U.S. financial system and its dollar were the sole survivors of the free world's economic fabric.  The agreements achieved at Bretton Woods—at a time when the U.S. could virtually dictate any economic resolve—could no longer be duplicated today.

Both Senator Bradley and Congressman Kemp have the best of intentions in calling for a return to a more fixed monetary order.  Both are highly dedicated to global prosperity, modification of a tax code that penalizes savings and investment, reduction of the budget and trade deficits, and the removal of global trade barriers.  Unfortunately, both are misguided in believing that those worthy goals can be advanced by revisiting the Bretton Woods system of fixed exchange rates. Bradley and Kemp should carefully examine what brought down that world arrangement in the first place.  Though free market economists such as Milton Friedman advocated flexible exchange rates as early as 1950, a consensus in the banking world against fixed rates did not evolve until twenty years later.  By then the Bretton Woods system could no longer cope with the intrinsic value changes responding to daily supply/demand statistics. 

Since the abandonment of fixed exchange rates, free market forces have correctly reflected economic realities.  Our dollar's value declined sharply during the 1973 to 1980 period when the U.S. experienced high inflation and weakened economic conditions.  The dollar rose in value beginning in 1981 when our policies dramatically changed under the leadership of the Federal Reserve Board.  Certainly, this record does not bespeak of a failure on the part of flexible exchange rates.

The issue fueling a desire for fixed rates stems from our current massive trade deficit.  It is argued that the main culprit of the trade imbalance is the high price of the dollar which makes it cheaper to import than to export. While that is obviously true, it is not the complete picture.  The price of the dollar is not a cause but, rather, a symptom of the problem.  Price is but a reflection of a fundamental value in the market.  To argue that the high dollar impacts adversely on our economy does not explain how or why the price got there, nor does it prove that the flexible exchange rate system has failed.  Rather, the opposite is true.

Our extraordinary federal budget deficit could only be funded in one of three ways: restricting investment, increasing savings, or exporting our debt.  We rejected the first alternative, were insufficient in the second, and relied heavily on the third.  Accordingly, rather than being the cause of our trade deficit, the strong dollar resulted from the fact it was the main equilibrating factor which enabled trade exports and imports to make the adjustment necessary to satisfy our extra large debt appetite. 

It is imperative to understand and correctly evaluate the actual role of floating exchange rates in the present situation.  Given the need for foreign capital and the inevitable trade deficit it entails, permitting the price mechanism of floating exchange rates to determine how that trade deficit is to be achieved is the most equitable, and certainly the most efficient, means of getting a very difficult job done.  Surely, such an appraisal of the facts is not meant to deny that there are substantial economic costs resulting from the high dollar.  Such consequences should not be allowed to panic us into unsound or unwarranted actions.  Floating exchange rates, while far from perfect, are the best system man can offer in order to sort out the complexities that comprise the relative value of currency. 

As economist Gottfried Haberler's proclaimed, "The politicalization of exchange rates is a dangerous game. It has caused much turbulence in the foreign exchange markets. Free markets do a better job of setting exchange rates than governments do." Or as E. Gerald Corrigan, President of the New York Fed, said recently in a speech before the Japan Society "...the widespread sense of frustration with the current system of floating exchange rates is understandable and we certainly should be sensitive to opportunities to strengthen the system, but to think that a return to fixed exchange rates or to something like a gold or commodity standard is going to provide magical and painless solutions to our problems is sheer folly."

In 1985 we dramatically learned the futility and folly of interfering with free market values. How odd that, in the same instant, we are urged to repeat our mistakes.  Is this not Santayana's warning? Or was it his curse?

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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