The Strange Politics of Fixed Exchange Rate Systems

Next to North Korea’s 5 year plans, fixed exchange rates must be the worst economic policy ever devised by man:

1. The fixed exchange rate regime of the interwar period was a complete disaster, arguably causing WWII.
2. The Chilean peg of the early 198os led to a massive recession, before they switched to inflation targeting.
3. The 1994 Mexican crisis.
4. The 1997-98 East Asian crisis.

Then people said the regimes had to be more impregnable, so that even a speculative attack wouldn’t undermine the peg.  This led to:

5.  The Argentine depression of 1998-2001

Then people said even the currency board wasn’t enough,  As long as you still had a currency, there was always the possibility of devaluation.  This led to the idea of the single currency, the ultimate doomsday device:

6.  The eurozone crisis of 2008–2018

When you talk to proponents of a single currency, they talk of the huge efficiency gains, as if the Swiss and Swedes and Norwegians and Danes are disadvantaged by holding on to their old currencies.  (Actually they are slightly disadvantaged, as the euro is such a monumental failure that desperate Europeans are buying Swiss and Danish bonds with negative nominal yields, even more negative than Germany.)

In the comment section people sometimes ask me what it is that conservatives like so much about fixed rates.  But what’s really weird is that this isn’t even true:

1. In the early 1930s many US unions and the socialists were opposed to dollar devaluation.  Fisher was a more aggressive proponent than Keynes (who favored just a small devaluation and then a return to the gold standard.)
2. Under Bretton Woods (the one semi-successful fixed rate regime) Milton Friedman was the most famous opponent of fixed rates.
3. The radical left in Greece wants to stay in the euro, and Berlusconi suggests Italy should consider leaving.
4. The socialist Mitterrand pressured the Germans into supporting the euro project.
5. Here’s Margaret Thatcher’s view:

Next week it will be 20 years since Margaret Thatcher fell. Pressure had been building on a number of fronts, but the issue which finally destroyed her was the yet-to-be-born euro. In the last weekend of October 1990, she travelled to a European summit in Rome, where Jacques Delors’ dream of European Monetary Union was high on the agenda. But while Mrs Thatcher was fighting her lone battle against the prospective single currency abroad, she was being fatally undermined at home. Geoffrey Howe, her bitterest cabinet critic, went on television to tell the interviewer Brian Walden that in principle Britain did not oppose the euro.

In her Commons statement after returning home, she was forced to slap Howe down: “this government believes in the pound sterling.” Howe resigned, and days later delivered the famous speech from the back benches that set in motion a leadership contest.

Today, Margaret Thatcher’s autobiography, first published in 1993, reads like a prophecy. It shows how deeply and with what extraordinary wisdom she had examined Delors’ proposals for the single currency. Her overriding objection was not ill-considered or xenophobic, as subsequent critics have repeatedly claimed.

They were economic. Right back in 1990, Mrs Thatcher foresaw with painful clarity the devastation it was bound to cause. Her autobiography records how she warned John Major, her euro-friendly chancellor of the exchequer, that the single currency could not accommodate both industrial powerhouses such as Germany and smaller countries such as Greece. Germany, forecast Thatcher, would be phobic about inflation, while the euro would prove fatal to the poorer countries because it would “devastate their inefficient economies”.

It is as if, all those years ago, the British prime minister possessed a crystal ball that enabled her to foresee the catastrophic events of the past year or so in Ireland, Greece and Portugal. Indeed, it is one of the tragedies of European history that the world chose not to believe her. President Mitterrand of France and Chancellor Kohl of Germany dismissed her words of caution. And when Mrs Thatcher was driven from office in 1990, a crucial voice was lost, and a new consensus started to form in Britain in favour of the euro.

This consensus stretched across the entire spectrum of the British establishment. It took in Tony Blair’s New Labour and all of Paddy Ashdown’s Liberal Democrats. The CBI came out for the euro, and so did the trades unions. The Foreign Office was doctrinally pro-single currency. Leading businessmen, such as Peter Sutherland (chairman of BP and Goldman Sachs International) and the fashion-conscious Richard Branson were strongly in favour. The Financial Times, a newspaper whose judgment has been wrong on every great economic issue of the last 40 years, was another supporter.

Ah, the good old days when the right was right.

Yes, smart liberals like Paul Krugman were also opposed.  Many conservatives favored the euro.  But nonetheless it’s undoubtedly true that fixed exchange rates appeal to both sides of the political spectrum.  But why?

This is just a guess, but for the right it might represent “hard money” and a lack of discretion for monetary policymakers.  For the left it might represent a distrust of market prices, which fluctuate wildly in response to the whims of speculators.  Whatever the reason, this unholy alliance of the left and right has produced one policy fiasco after another.

In fairness to the other side, Bretton Woods worked pretty well in the 1950s and 1960s.  In my view that reflected rapid growth in European countries like Italy, which benefited from the Balassa-Samuelson effect.  Fixed rates may be OK for small open economies like Hong Kong or Dubai (but Singapore suggests they aren’t essential).  They might be the lesser of evils for countries prone to hyperinflation like Zimbabwe.  They might work in small homogeneous areas like Austria/Germany/Benelux.  But in the modern world the presumption should be flexible exchange rates with NGDP targeting.  The burden of proof should be on those advocating fixed rates.

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