Mr. Chairman, thank you for this opportunity to express my viewson exchange-rate policies. Commentary about exchange-rate policiesoften originates in polemical, and more or less political, attemptsat self-justification. In consequence, the discourse is oftenconfused and confusing. In an attempt to bring some clarity to thetopic, I will begin by presenting some principles andcharacteristics of exchange-rate regimes.
There are three types of exchange-rate regimes: floating, fixed,and pegged rates. Each type has different characteristics andgenerates different results. Although floating and fixed ratesappear to be dissimilar, they are members of the same family. Bothare "automatic" free-market mechanisms for international payments.With a "clean" floating rate, a monetary authority sets a monetarypolicy, but has no exchange-rate policy-the exchange rate is onautopilot. In consequence, the monetary base is determineddomestically by a monetary authority. In other words, when acentral bank purchases bonds or bills and increases its netdomestic assets, the monetary base increases and vice versa.Whereas, with a fixed rate, a monetary authority sets the exchangerate, but has no monetary policy-monetary policy is on autopilot.In consequence, under a fixed-rate regime, the monetary base isdetermined by the balance of payments. In other words, when acountry's official net foreign reserves increase, its monetary baseincreases and vice versa. With both of these free-marketexchange-rate mechanisms, there cannot be conflicts betweenexchange-rate and monetary policies, and balance-of-payments crisescannot rear their ugly heads. Market forces automatically rebalancefinancial flows and avert balance-of-payments crises.
Floating- and fixed-rate regimes are equally desirable inprinciple. However, floating rates, unlike fixed rates, have rarelyperformed well in developing countries because these countries lack(in varying degrees) strong independent institutions, coherent andpredictable systems of governance and the rule of law. Accordingly,they cannot establish confidence in their currencies. Indeed, theyusually lack either a sound past performance or credible guaranteesfor future monetary stability. In consequence, a floating currencyusually becomes a sinking currency in a developing country.
Fixed and pegged rates appear to be the same. However, they arefundamentally different. Pegged rates are not free-marketmechanisms for international payments. Pegged rates (adjustablepegs, bands, crawling pegs, managed floats, etc.), require themonetary authority to manage the exchange rate and monetary policysimultaneously. With a pegged rate, the monetary base contains bothdomestic (domestic assets) and foreign (foreign reserves)components. Unlike floating and fixed rates, pegged rates almostalways result in conflicts between exchange-rate and monetarypolicies. For example, when capital inflows become "excessive"under a pegged system, a monetary authority often attempts tosterilize the ensuing increase in the foreign component of themonetary base by reducing the domestic component of the monetarybase. And when outflows become "excessive," an authority attemptsto offset the decrease in the foreign component of the base with anincrease in the domestic component of the monetary base.Balance-of-payments crises erupt as a monetary authority begins tooffset more and more of the reduction in the foreign component ofthe monetary base with domestically created base money. When thisoccurs in a country with free capital mobility, it is only a matterof time before market participants spot the contradictions betweenexchange-rate and monetary policies and force a devaluation. Table1 summarizes the main characteristics and results anticipated withfloating, fixed, and pegged exchange rates, when free capitalmobility 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 MonetaryPolicy||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 RegimePolicies
If a country adopts a fixed exchange-rate regime (either anorthodox currency board or official"dollarization") and allows free capital mobility, it must give upmonetary autonomy. Alternatively, if a country wants monetaryautonomy and free capital mobility, it must adopt a floatingexchange rate. If a country has a pegged exchange rate, it mustrestrict capital mobility to avoid balance of payments and currencycrises.
Over the past decade, the advantages of free capital mobilityhave become clear, and restrictions of capital mobility have beendramatically reduced. However, most developing countries havecontinued to employ some variant of pegged exchange rates. And notsurprisingly, major balance of payments and currency crises haveoccurred frequently in the 1990s.
In a world of increasing capital mobility, the U.S. governmenthad no coherent policy on exchange rates until the late 1990s.Motivated by criticism from a small group of economists (includingmyself), former Senator Connie Mack's campaign for officialdollarization in countries with low quality currencies, and thefallout from the currency crises that engulfed Mexico, Asia andRussia, the U.S. Treasury finally produced a clear policy statementon exchange-rate regimes. Given that the U.S. embraces free capitalmobility, Treasury Secretary Robert Rubin correctly concluded, in aspeech made at The Johns Hopkins University on April 21, 1999, thateither floating or fixed exchange rates were acceptable, but thatpegged rates were not. And shortly after Lawrence Summers becameTreasury Secretary, he presented the same policy conclusions at anaddress he delivered at Yale University on September 22, 1999.Stanley Fischer, the former deputy managing director of theInternational Monetary Fund, weighed in with the same message, whenhe delivered the Distinguished Lecture on Economics in Governmentat the annual meeting of the American Economic Association in NewOrleans on January 6, 2001.
With these policy pronouncements, the U.S. Treasury's (and theIMF's) position on exchange rates became clear. In principle, theposition was correct. In practice, it was (and continues to be)applied correctly in the case of the U.S. dollar, where a floatingexchange-rate regime continues to be embraced. In developingcountries, however, the United States and the IMF have not adheredto the position with any rigor. For example, Brazil and Turkey wereboth given the green light to continue or establish peggedexchange-rate regimes shortly after U.S. officials indicated thatthese set-ups were, in principle, unacceptable.
The Bush administration has not yet articulated a clear policyon exchange-rate regimes. Secretary O'Neil would do well to clearthe air and make a statement along the same lines as Messrs. Rubinand Summers. Indeed, since the United States espouses free capitalmobility, the only logical course is for U.S. policy to embracefloating rates or fixed rates (orthodox currency boards or officialdollarization), and to reject pegged rates. With the departure ofStanley Fischer, the IMF's position on exchange-rate regimes hasbecome fuzzy. Anne Krueger, Fischer's successor, would do well tofollow his lead and reaffirm Fischer's conclusions.
The "Strong" Dollar Mantra
The exchange rate-the nominal exchange rate quoted in themarket-is a price. With a floating exchange-rate policy, the pricefreely adjusts to changes in individuals' and business'expectations about conditions here and abroad. The dollar broadlystrengthened against other currencies after the mid-1990s becausemarket participants expected to receive higher rates of return ontheir investments in the U.S. than abroad. For example, considerfor a moment the fate of the euro versus the dollar since theeuro's launch on January 1, 1999. Then, the exchange rate was 1.17dollars per euro; today it's about 0.90. The dollar strengthened by30% against the euro primarily because market participantsanticipated brighter prospects and higher rates of return in theU.S. than in Euroland, and capital flowed out of euro-denominatedassets into equities, bonds and other U.S. investments.
This brings me to the "strong dollar" mantra. This rhetoricalphrase, which was prompted by the dollar's broad strength in themarkets, is unfortunate and confusing, at best. The combination ofa floating exchange rate and the pursuit of low inflation, whichthe United States has had for many years now, is a policy. The"strong dollar" is not. Indeed, given a floating exchange rateregime, it's impossible to know what a so-called strong dollarpolicy is because the price of the dollar on foreign-exchangemarkets is on autopilot. The price is (or should be) determined bybuyers and sellers, and U.S. government officials should refrainfrom trying to influence it by "open-mouth operations." As long asthe U.S. embraces a floating exchange rate policy, the TreasurySecretary should strike the term "strong dollar" from his lexiconwhen engaging in discourses about exchange-rate policies. Thephrase "strong dollar" is meaningless and leads to no end ofconfusion.
The Dollar's Dominance
So, under a floating-rate policy, one in which the dollar'sprice is on autopilot, what can be said about the dollar? We cansay that the dollar is the world's dominant currency, more so witheach passing year.
Consider some facts about the U.S. dollar and its role in theworld's monetary affairs. Thanks to its stability, liquidity andlow transactions costs, the dollar occupies a commanding role. Itis the world's dominant international currency, a unique featurethat gives the U.S. an edge in attracting capital inflows tofinance current account deficits at a relatively low cost. Thisprompted Charles de Gaulle, when he was President of France, tocharacterize the benefits derived from the dollar's dominantposition as an "exorbitant privilege."
- Ninety percent of all internationally traded commodities areinvoiced and priced in dollars.
- The invoicing and pricing of manufactured goods ininternational trade presents a much more complicated picture. Thedollar, however, dominates. For example, 37% of the UnitedKingdom's exports to Germany are invoiced in dollars, not euros orSterling.
- The dollar is employed on one side of 90% of all foreignexchange transactions.
- Over 66% of all central bank reserves are denominated indollars, and that percentage has been steadily increasing since1990.
- The second most popular hand-to-hand currency used byforeigners is the dollar, with their own domestic currencies infirst place. That explains why an estimated 50-70% of all dollarnotes circulate overseas.
- The dollar is the second most popular denomination used byforeigners for on-shore bank accounts, with their domestic unit ofaccount usually in first place. According to the IMF, the averageratio of dollar-denominated bank accounts to broad money in highlydollarized countries is 0.59, and for moderated dollarizedcountries, the ratio is 0.18. Not surprisingly, the dollar is theking of off-shore bank accounts.
- Fifty percent of the international-traded bonds are denominatedin U.S. dollars.
- The dollar also dominates the world's equity markets, with 60%of the capitalized value of all traded companies in the worlddenominated in dollars. And that is not all. Capital marketsthroughout the world are rapidly shifting into dollars. To lowertheir cost of capital, foreign companies are beating a path to theNew York Stock Exchange and NASDAQ, which of course both trade indollars. Many traditional foreign companies now issue AmericanDepositary Receipts in New York. These ADRs, representing claims onshares in foreign companies, are traded in dollars, and dividendsare paid in dollars. For example, 58.7% of the total capitalizationof all traded Latin American companies is denominated in dollars,and for the two largest Latin economies, Brazil and Mexico, thedollarized percentages are 69.9% and 42%, respectively.
All this boils down to a simple fact: the world is alreadyhighly and unofficially dollarized. And unless the quality of thedollar deteriorates, that is the way things will stay. If morecountries with low-quality currencies would officially replacetheir domestic currencies with the dollar, the competitivedevaluations that so many fret about would come to an abrupt halt.And exchange-rate crises that frequently engulf countries withhalf-baked currencies would be a thing of the past. After all,countries that are officially dollarized don't have an exchangerate vis-à-vis the dollar.
The Dollar's Price
The dollar's strength against major currencies since 1995 andparticularly 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 alsogenerated predictable howls from those who assert that the "strongdollar" has made their businesses uncompetitive and squeezed theirmargins.
Just how "high" is the dollar's price? It depends on how youmeasure it. If we use the Federal Reserve's broad dollar index orthe IMF's dollar index, it appears that the dollar is at a "high"level and perhaps not sustainable (see Chart 1). However, if we useABN-AMRO's trade-weighted dollar index, the dollar doesn't appearto be as "strong" as many believe. The weighting used by ABN-AMROis more representative of the realities (see Table 2). Indeed,ABN-AMRO's dollar index more accurately reflects the dollar's tradeweighted price than do either the IMF's or the Fed's dollarindexes. Perhaps that explains why the dollarbears have been disappointed so often in the past few years: theyhave been looking at the wrong indexes.
Table 2: Weightings Used in US DollarIndices
|ABN AMRO||IMF||Fed Broad|
|Hong Kong (HKD)||2.6||0.0||2.6|
Yet another way to look at the dollar indexes, which areconstructed by a few experts, is through the lens of the AustrianSchool of economics. As Friedrich von Hayek, a leader of theAustrian School, observed, the most important function of a marketis to process widely dispersed bits of information from many marketparticipants to generate an easily understood metric-a price. Notsurprisingly, the judgments of many market participants, who areputting real money at risk, are deemed to be more important, asthey should be, than artificial constructs produced by a smallgroup of experts. Accordingly, the dollar's price is where buyersand sellers agree it should be. To the extent that the dollar'sprice is too "high" simply means that the consensus of the manymarket participants differs from the few who are in the business ofconstructing artificial indexes.
Under a floating exchange-rate regime, the future course of thedollar will be determined by expectations about prospective ratesof return in the U.S. and overseas, as well as the risks involved.Judgments about future returns and risks are, of course, difficultand highly dependent on, as Lord Keynes put it, the state ofconfidence. In this respect, all we know is that the U.S. isengaged in a new, long war against an elusive enemy which willconsume meaningful real resources, eventually becoming a drag onproductivity. This suggests that capital flows to the US (asevidenced by recent data), might not be as forthcoming in thefuture as they were during the past few years. If that's the case,the floating dollar will weaken in the markets and market forceswill automatically cause those "troubling" U.S. current accountdeficits 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 onautopilot. Alas, this is probably asking for too much. When itcomes to exchange rates and adjustments in the balance of payments,many of the cognoscenti in Washington have a distaste forautomaticity. For them, the consequences of a country's balance ofpayments should not spread themselves out inconspicuously in timeand scope. Instead, they should remain concentrated and visible asa signal for policy changes and as a pivot for expertconsultations.
1. Contrary to the popular impression,Argentina's convertibility system was not an orthodox currencyboard. Some students of currency board systems pointed this outalmost a decade ago. They anticipated that Argentina'sconvertibility system would eventually degenerate into a peggedexchange-rate system and that it would blow up. See Steve H. Hanke,Lars Jonung and Kurt Schuler, Russian Currency and Finance: ACurrency Board Approach to Reform. London: Routledge, 1993, pp.72-77.
3. The ABN AMRO index is based on the Fed'broad' index weighting system. To avoid creating an unwieldy indexand to reduce susceptibility to potential distortions from sharpfluctuations in nominal values in developing economies, the ABNAMRO index does not explicitly include weights for minor US tradingpartners. It does, however, include weights for medium-sizedtrading partners such as the UK, Mexico, China, Hong Kong andMalaysia.