Testimony

On International Economic and Exchange Rate Policy Hearings

Committee on Banking, Housing and Urban Affairs Committee
United States Senate

Mr. Chairman, thank you for this opportunity to express my views on exchange-rate policies. Commentary about exchange-rate policies often originates in polemical, and more or less political, attempts at self-justification. In consequence, the discourse is often confused and confusing. In an attempt to bring some clarity to the topic, I will begin by presenting some principles and characteristics of exchange-rate regimes.

Exchange-Rate Regimes

There are three types of exchange-rate regimes: floating, fixed, and pegged rates. Each type has different characteristics and generates different results. Although floating and fixed rates appear to be dissimilar, they are members of the same family. Both are “automatic” free-market mechanisms for international payments. With a “clean” floating rate, a monetary authority sets a monetary policy, but has no exchange-rate policy-the exchange rate is on autopilot. In consequence, the monetary base is determined domestically by a monetary authority. In other words, when a central bank purchases bonds or bills and increases its net domestic assets, the monetary base increases and vice versa. Whereas, with a fixed rate, a monetary authority sets the exchange rate, but has no monetary policy-monetary policy is on autopilot. In consequence, under a fixed-rate regime, the monetary base is determined by the balance of payments. In other words, when a country’s official net foreign reserves increase, its monetary base increases and vice versa. With both of these free-market exchange-rate mechanisms, there cannot be conflicts between exchange-rate and monetary policies, and balance-of-payments crises cannot rear their ugly heads. Market forces automatically rebalance financial flows and avert balance-of-payments crises.

Floating- and fixed-rate regimes are equally desirable in principle. However, floating rates, unlike fixed rates, have rarely performed well in developing countries because these countries lack (in varying degrees) strong independent institutions, coherent and predictable systems of governance and the rule of law. Accordingly, they cannot establish confidence in their currencies. Indeed, they usually lack either a sound past performance or credible guarantees for future monetary stability. In consequence, a floating currency usually becomes a sinking currency in a developing country.

Fixed and pegged rates appear to be the same. However, they are fundamentally different. Pegged rates are not free-market mechanisms for international payments. Pegged rates (adjustable pegs, bands, crawling pegs, managed floats, etc.), require the monetary authority to manage the exchange rate and monetary policy simultaneously. With a pegged rate, the monetary base contains both domestic (domestic assets) and foreign (foreign reserves) components. Unlike floating and fixed rates, pegged rates almost always result in conflicts between exchange-rate and monetary policies. For example, when capital inflows become “excessive” under a pegged system, a monetary authority often attempts to sterilize the ensuing increase in the foreign component of the monetary base by reducing the domestic component of the monetary base. And when outflows become “excessive,” an authority attempts to offset the decrease in the foreign component of the base with an increase in the domestic component of the monetary base. Balance-of-payments crises erupt as a monetary authority begins to offset more and more of the reduction in the foreign component of the monetary base with domestically created base money. When this occurs in a country with free capital mobility, it is only a matter of time before market participants spot the contradictions between exchange-rate and monetary policies and force a devaluation. Table 1 summarizes the main characteristics and results anticipated with floating, fixed, and pegged exchange rates, when free capital mobility is allowed.

Table 1: Exchange Rate Regimes

Type of Regime Exchange Rate Policy Monetary Policy Source of Change in Monetary Base Conflicts Between Exchange Rate and Monetary Policy Balance of Payment Adjustments
Floating Rate No Yes Net Domestic Assets (NDA) No Automatic
Fixed Rate Yes No Foreign Reserves (FR) No Automatic
Pegged Rate Yes Yes NDA and FR Yes Crisis Prone

The Evolution of U.S. Exchange-Rate Regime Policies

If a country adopts a fixed exchange-rate regime (either an orthodox currency board[1] or official “dollarization”) and allows free capital mobility, it must give up monetary autonomy. Alternatively, if a country wants monetary autonomy and free capital mobility, it must adopt a floating exchange rate. If a country has a pegged exchange rate, it must restrict capital mobility to avoid balance of payments and currency crises.

Over the past decade, the advantages of free capital mobility have become clear, and restrictions of capital mobility have been dramatically reduced. However, most developing countries have continued to employ some variant of pegged exchange rates. And not surprisingly, major balance of payments and currency crises have occurred frequently in the 1990s.

In a world of increasing capital mobility, the U.S. government had no coherent policy on exchange rates until the late 1990s. Motivated by criticism from a small group of economists (including myself), former Senator Connie Mack’s campaign for official dollarization in countries with low quality currencies, and the fallout from the currency crises that engulfed Mexico, Asia and Russia, the U.S. Treasury finally produced a clear policy statement on exchange-rate regimes. Given that the U.S. embraces free capital mobility, Treasury Secretary Robert Rubin correctly concluded, in a speech made at The Johns Hopkins University on April 21, 1999, that either floating or fixed exchange rates were acceptable, but that pegged rates were not. And shortly after Lawrence Summers became Treasury Secretary, he presented the same policy conclusions at an address he delivered at Yale University on September 22, 1999. Stanley Fischer, the former deputy managing director of the International Monetary Fund, weighed in with the same message, when he delivered the Distinguished Lecture on Economics in Government at the annual meeting of the American Economic Association in New Orleans on January 6, 2001.

With these policy pronouncements, the U.S. Treasury’s (and the IMF’s) position on exchange rates became clear. In principle, the position was correct. In practice, it was (and continues to be) applied correctly in the case of the U.S. dollar, where a floating exchange-rate regime continues to be embraced. In developing countries, however, the United States and the IMF have not adhered to the position with any rigor. For example, Brazil and Turkey were both given the green light to continue or establish pegged exchange-rate regimes shortly after U.S. officials indicated that these set-ups were, in principle, unacceptable.

The Bush administration has not yet articulated a clear policy on exchange-rate regimes. Secretary O’Neil would do well to clear the air and make a statement along the same lines as Messrs. Rubin and Summers. Indeed, since the United States espouses free capital mobility, the only logical course is for U.S. policy to embrace floating rates or fixed rates (orthodox currency boards or official dollarization), and to reject pegged rates. With the departure of Stanley Fischer, the IMF’s position on exchange-rate regimes has become fuzzy. Anne Krueger, Fischer’s successor, would do well to follow his lead and reaffirm Fischer’s conclusions.

The “Strong” Dollar Mantra

The exchange rate-the nominal exchange rate quoted in the market-is a price. With a floating exchange-rate policy, the price freely adjusts to changes in individuals’ and business’ expectations about conditions here and abroad. The dollar broadly strengthened against other currencies after the mid-1990s because market participants expected to receive higher rates of return on their investments in the U.S. than abroad. For example, consider for a moment the fate of the euro versus the dollar since the euro’s launch on January 1, 1999. Then, the exchange rate was 1.17 dollars per euro; today it’s about 0.90. The dollar strengthened by 30% against the euro primarily because market participants anticipated brighter prospects and higher rates of return in the U.S. than in Euroland, and capital flowed out of euro-denominated assets into equities, bonds and other U.S. investments.

This brings me to the “strong dollar” mantra. This rhetorical phrase, which was prompted by the dollar’s broad strength in the markets, is unfortunate and confusing, at best. The combination of a floating exchange rate and the pursuit of low inflation, which the United States has had for many years now, is a policy. The “strong dollar” is not. Indeed, given a floating exchange rate regime, it’s impossible to know what a so-called strong dollar policy is because the price of the dollar on foreign-exchange markets is on autopilot. The price is (or should be) determined by buyers and sellers, and U.S. government officials should refrain from trying to influence it by “open-mouth operations.” As long as the U.S. embraces a floating exchange rate policy, the Treasury Secretary should strike the term “strong dollar” from his lexicon when engaging in discourses about exchange-rate policies. The phrase “strong dollar” is meaningless and leads to no end of confusion.

The Dollar’s Dominance

So, under a floating-rate policy, one in which the dollar’s price is on autopilot, what can be said about the dollar? We can say that the dollar is the world’s dominant currency, more so with each passing year.

Consider some facts about the U.S. dollar and its role in the world’s monetary affairs. Thanks to its stability, liquidity and low transactions costs, the dollar occupies a commanding role. It is the world’s dominant international currency, a unique feature that gives the U.S. an edge in attracting capital inflows to finance current account deficits at a relatively low cost. This prompted Charles de Gaulle, when he was President of France, to characterize the benefits derived from the dollar’s dominant position as an “exorbitant privilege.”[2]

  • Ninety percent of all internationally traded commodities are invoiced and priced in dollars.
  • The invoicing and pricing of manufactured goods in international trade presents a much more complicated picture. The dollar, however, dominates. For example, 37% of the United Kingdom’s exports to Germany are invoiced in dollars, not euros or Sterling.
  • The dollar is employed on one side of 90% of all foreign exchange transactions.
  • Over 66% of all central bank reserves are denominated in dollars, and that percentage has been steadily increasing since 1990.
  • The second most popular hand-to-hand currency used by foreigners is the dollar, with their own domestic currencies in first place. That explains why an estimated 50-70% of all dollar notes circulate overseas.
  • The dollar is the second most popular denomination used by foreigners for on-shore bank accounts, with their domestic unit of account usually in first place. According to the IMF, the average ratio of dollar-denominated bank accounts to broad money in highly dollarized countries is 0.59, and for moderated dollarized countries, the ratio is 0.18. Not surprisingly, the dollar is the king of off-shore bank accounts.
  • Fifty percent of the international-traded bonds are denominated in U.S. dollars.
  • The dollar also dominates the world’s equity markets, with 60% of the capitalized value of all traded companies in the world denominated in dollars. And that is not all. Capital markets throughout the world are rapidly shifting into dollars. To lower their cost of capital, foreign companies are beating a path to the New York Stock Exchange and NASDAQ, which of course both trade in dollars. Many traditional foreign companies now issue American Depositary Receipts in New York. These ADRs, representing claims on shares in foreign companies, are traded in dollars, and dividends are paid in dollars. For example, 58.7% of the total capitalization of all traded Latin American companies is denominated in dollars, and for the two largest Latin economies, Brazil and Mexico, the dollarized percentages are 69.9% and 42%, respectively.

All this boils down to a simple fact: the world is already highly and unofficially dollarized. And unless the quality of the dollar deteriorates, that is the way things will stay. If more countries with low-quality currencies would officially replace their domestic currencies with the dollar, the competitive devaluations that so many fret about would come to an abrupt halt. And exchange-rate crises that frequently engulf countries with half-baked currencies would be a thing of the past. After all, countries that are officially dollarized don’t have an exchange rate vis-à-vis the dollar.

The Dollar’s Price

The dollar’s strength against major currencies since 1995 and particularly since the start of 2000 has persuaded many, particularly the dollar bears, that the dollar’s price is too “high” and unsustainable. The dollar’s “high” price has also generated predictable howls from those who assert that the “strong dollar” has made their businesses uncompetitive and squeezed their margins.

Just how “high” is the dollar’s price? It depends on how you measure it. If we use the Federal Reserve’s broad dollar index or the IMF’s dollar index, it appears that the dollar is at a “high” level and perhaps not sustainable (see Chart 1). However, if we use ABN-AMRO’s trade-weighted dollar index, the dollar doesn’t appear to be as “strong” as many believe. The weighting used by ABN-AMRO is more representative of the realities (see Table 2). Indeed, ABN-AMRO’s dollar index more accurately reflects the dollar’s trade weighted price than do either the IMF’s or the Fed’s dollar indexes.[3] Perhaps that explains why the dollar bears have been disappointed so often in the past few years: they have been looking at the wrong indexes.

Table 2: Weightings Used in US Dollar Indices

ABN AMRO IMF Fed Broad
Japan (JPY) 31.6 30.3 13.3
Europe (EUR) 21.0 29.9 16.3
Canada (CAD) 17.2 25.0 17.0
Mexico (MXN) 13.3 0.0 10.4
UK (GBP) 4.6 9.0 4.3
China (CNY) 7.4 0.0 8.0
Hong Kong (HKD) 2.6 0.0 2.6
Malaysia (MYR) 2.3 0.0 2.4
Other 0.0 0.0 25.8
Total 100.0 100.0 100.0

Chart 1

Yet another way to look at the dollar indexes, which are constructed by a few experts, is through the lens of the Austrian School of economics. As Friedrich von Hayek, a leader of the Austrian School, observed, the most important function of a market is to process widely dispersed bits of information from many market participants to generate an easily understood metric-a price. Not surprisingly, the judgments of many market participants, who are putting real money at risk, are deemed to be more important, as they should be, than artificial constructs produced by a small group of experts. Accordingly, the dollar’s price is where buyers and sellers agree it should be. To the extent that the dollar’s price is too “high” simply means that the consensus of the many market participants differs from the few who are in the business of constructing artificial indexes.

Under a floating exchange-rate regime, the future course of the dollar will be determined by expectations about prospective rates of return in the U.S. and overseas, as well as the risks involved. Judgments about future returns and risks are, of course, difficult and highly dependent on, as Lord Keynes put it, the state of confidence. In this respect, all we know is that the U.S. is engaged in a new, long war against an elusive enemy which will consume meaningful real resources, eventually becoming a drag on productivity. This suggests that capital flows to the US (as evidenced by recent data), might not be as forthcoming in the future as they were during the past few years. If that’s the case, the floating dollar will weaken in the markets and market forces will automatically cause those “troubling” U.S. current account deficits to shrink.

In closing, under floating rates, the less said in Washington, DC about the level and course of the dollar’s price, the better. After all, under floating, the dollar’s exchange rate is on autopilot. Alas, this is probably asking for too much. When it comes to exchange rates and adjustments in the balance of payments, many of the cognoscenti in Washington have a distaste for automaticity. For them, the consequences of a country’s balance of payments should not spread themselves out inconspicuously in time and scope. Instead, they should remain concentrated and visible as a signal for policy changes and as a pivot for expert consultations.

Notes

1. Contrary to the popular impression, Argentina’s convertibility system was not an orthodox currency board. Some students of currency board systems pointed this out almost a decade ago. They anticipated that Argentina’s convertibility system would eventually degenerate into a pegged exchange-rate system and that it would blow up. See Steve H. Hanke, Lars Jonung and Kurt Schuler, Russian Currency and Finance: A Currency Board Approach to Reform. London: Routledge, 1993, pp. 72-77.

2. I thank Fred Bergsten for reminding me of de Gaulle’s astute observation.

3. The ABN AMRO index is based on the Fed ‘broad’ index weighting system. To avoid creating an unwieldy index and to reduce susceptibility to potential distortions from sharp fluctuations in nominal values in developing economies, the ABN AMRO index does not explicitly include weights for minor US trading partners. It does, however, include weights for medium-sized trading partners such as the UK, Mexico, China, Hong Kong and Malaysia.