When assessing the performance of the international monetary system, one is tempted to paraphrase Winston Churchill on democracy: The system of flexible exchange rates is the worst possible one, except for all the others.
Critics of the current system correctly point out the costs imposed on the economy by the swings that have occurred in the value of the dollar. For instance, U.S. exporters made painful adjustments when the dollar strengthened between 1997 and 2002, resulting in considerable economic distress for stockholders, workers, and communities across the country.
The subsequent weakening of the dollar eased much of that pain. But the recent uptick in the greenback's value has once again brought complaints about the "strong dollar."
Many exchange-rate changes can be hedged. But such financial engineering consumes resources that could be put to alternative uses were the international financial system not subject to exchange-rate gyrations.
Critics of flexible rates tend to overlook or minimize, however, the costs of alternative systems. Were the dollar, yen, and euro fixed to each other, the costs of adjustment to economic change would be born by prices, wages, and employment. To maintain the external value of the dollar, the Fed would need to raise interest rates more aggressively. Instead of a weakening dollar, Americans would be confronted by deflation. Growth would slow or even turn negative in such a scenario.
Large movements in exchange rates, such as we have experienced in recent years, reflect profound shifts in global economic forces. Changes in competitiveness, national taxation of investment, and perceived risk generate economic tsunamis in the form of shifting capital flows. These upheavals occur under any system of exchange rates, fixed or floating.
The post-1997 rise in the dollar was partly a consequence of the Asian financial crisis, as global capital migrated to American shores. Lucky that it did, boosting the dollar's value, for otherwise there would have been no recovery in Asia or the rest of the world.
American consumers underwrote the global recovery with their voracious appetite for the very products made in Asia. A capital-driven rise in the dollar financed that spending and the resultant global recovery.
Now there has been a shift at the margin in the attractiveness of investment in Asia. Not U.S. weakness, but China's impressive strength is driving that shift.
The pre-World War I classical gold standard operated with fixed exchange rates and economies experienced large capital flows. The international economy also saw relatively free movement of people across borders. War and the rise of totalitarian nation-states put a damper on both.
The development of the modern welfare state now makes immigration costly to the recipient countries. Likewise, generous unemployment payments have raised the costs of adjustment to capital flows under fixed exchange rates. Developed countries experiencing outflows can no longer permit deflation to run its course, because of the unemployment costs.
A return to a world of peace, free trade, and prosperity would be the best of all worlds. A system of fixed exchange rates might be a byproduct of a return to a liberal international economic order. In the meantime, flexible rates facilitate the adjustment to the global economic changes we confront.