1995-1996 Essay Contest

Second Place Essay

A Modified Float: The Clear Choice

Michael C. Smith
Memorial High School
Eau Claire, Wisconsin


It is quite difficult to make it through a conversation with an economist without running into the issue of fixed versus floating currency exchange rates. Few other topics in economics have brought on such heated debate. By weighing the pros and cons of both systems, it becomes evident that floating rates simply offer more benefits to society. Floating rates by themselves, however, are not the answer. A system of modified floating rates would offer the discipline and greater stability of fixed rates, while at the same time offering the freedom and increased trade of floating rates.

Fixed rates have been used extensively throughout history. Probably the best examples of fixed rates are the gold standard and the Bretton Woods system. It should also be noted that fixed rates do have their advantages. Ideally, in a true fixed rate system, businesses have certainties in making buying decisions and there is a large degree of market discipline (Interview, Kolb). Through discipline, economic actions would be for the benefit of all economies and not for one country's special interests. Neither of these ideals, however, have been effectively shown in past fixed rate systems (Interview, Kolb). As pointed out in The Economist, "For a generation the world's main currencies have been tied together. [This] arrangement has been given a fair run, and has fallen apart with a memorable crunch" (The Economist, 21). Fixed rates simply have not been able to handle the economic problems of the world, and as a direct result, the world has turned largely to floating exchange rates.

Perhaps no other benefit of floating rates is greater than the fact that they are self-adjusting. As economists Campbell R. McConnell and Stanley L. Brue point out, "Floating rates have a compelling virtue: they automatically adjust so as eventually to eliminate balance of payment deficits or surpluses" (770). Due to the fact that floating rates are based on supply and demand, they have the unique ability to adjust along with changes in taste, relative incomes, relative prices, relative real interest rates, and speculation. Fixed rates, on the other hand, must be set—disallowing for inevitable changes in the supply and demand of currencies. In order to stabilize their exchange rates, governments are forced to intervene directly or indirectly in the foreign exchange market. In effect, they are tampering with what the world has deemed as the equilibrium price. Fixed rates must also deal with the question of who is going to initially set the exchange rates for the world. Problems also arise for fixed rates with an increase in the volume of trade in the world. When trade increases, fixed rates are not able to efficiently handle the necessary increase in the money supply (McConnell and Brue, 777).

The biggest criticism of floating rates has been their instability over the past 23 years. Exchange rate volatility has been significantly higher since around 1973, leading to instability in trading. As economist Dr. Fred Kolb points out, however, "There are problems with variability in exchange rates, but the markets have come up with instruments to deal with these variabilities" (Interview, Kolb). Currency options and futures markets on exchange rates are a few of the instruments that help add stability to trade. Currency options can be thought of as the "invisible hand" of exchange rates. Through the use of hedging, speculators have been able to provide a short term security for businesses. In effect, by using puts and calls, businesses are able to buy insurance on their transactions with other countries. Through the futures market, speculation is able to help promote international trade (McConnell and Brue, 785).

The argument has also been made that, because of these instabilities, floating rates ultimately lower world trade and overall efficiency. As compared to fixed rates, this is simply not true. Floating rates, it is claimed, lower world trade because of instability. Yet, trade policies under a fixed system to directly affect supply and demand reduce the volume of potential world trade through their inefficient use of tariffs and quotas. "The fundamental problem with these policies is [that] they reduce the volume of world trade and distort its composition or pattern away from that which is economically desirable" (McConnell and Brue, 772). This, in effect, makes the world's economies less efficient due to the fact that countries are not able to take full advantage of their comparative advantages in the production of goods and services. These policies also lead to negative feelings between nations, causing their trading partners to retaliate with their own tariffs and quotas further reducing the volume of world trade (Interview, Kolb).

Using exchange controls has been another method used by fixed rate nations that hampers trade. Using exchange controls not only limits potential trade, but also leads to limited choices and the creation of black markets (McConnell and Brue, 773). This effectively lowers the level of overall freedom, efficiency, and trade—all goals that most economists would agree are desirable. Even using reserves to combat fixed rate fluctuations has its limitations. Once the reserves are gone, loans must be made or assets sold. These are still only temporary solutions. With extended periods of deficits, a country is forced to abandon its fixed rate system or use less desirable means of tariffs, quotas, and controls to meet its pegged fixed rate (McConnell and Brue, 771-773).

Another important advantage to using floating rates is a country's ability to use its own monetary and fiscal policy. By controlling their own policies, countries are able to have better control over their business cycles (Interview, Kolb). When currencies are all tied together, as in a fixed rate system, nations are forced to "bear with" the economic conditions of other countries. Beliefs on inflation also vary widely around the world. The United States, for example, will not tolerate a recession or depression to keep inflation low. On the other hand, Europe and Japan are strongly opposed to high inflation and are willing to take drastic action to fight it. In using a fixed rate system between the two, their beliefs would clash causing undesirable unemployment in one and higher inflation in the other (Whitt, 7). In this sense, it becomes crucial that each country have control over its own monetary and fiscal policy. Perhaps economists McConnell and Brue sum it up the best by saying, "achieving a balance of payments equilibrium and realizing domestic stability are both important national economic objectives; but to sacrifice the latter for the former is to let the tail wag the dog" (773). In other words, it seems foolish to incur inflation or a recession just to maintain an exchange rate. Floating rates possess another unique trait as pointed out by Milton Friedman: "Flexibility in exchange rates has provided a useful, indeed indispensable, shock absorber for monetary and other disturbances, and will continue to do so for the foreseeable future" (Friedman, xxiii). Flexible exchange rates help to "insulate" each national economy from shocks originating elsewhere (Whitt, 6).

Future stability of floating rates has become a major concern of economists around the world. Much of the instability has been credited to a lack of government intervention or a poor use of it. Economists Malcolm Edey and Ketil Hviding agree saying, "much of the financial instability in recent decades [can] be laid at the door of macroeconomic mismanagement, microeconomic distortion in the financial sector, and inadequate government supervision of the financial system" (Economist Newspaper, 7933). This is where the term, "modified floating rates" comes in. Essentially, it is a floating exchange rate system with a central power to control large exchange rate fluctuations. Any large fluctuations that would hurt the economy as a whole would be controlled by buying or selling currencies. This is largely what the world uses now, only this system would use more intervention from central banks and require better arguments on whether intervention is necessary or not. In this way, political decision making would be by the collective, not the individual nations. To some degree, this was created with the formation of the G7 nations (Interview, Kolb). It should also be noted that when Canada moved temporarily to floating rates in l950 to l962, that its rates never moved dramatically, showing the potential of stable floating exchange rates (Whitt, 7). Also, even though there has been some instability with exchange rates since the move to floating rates, substantial growth is still occurring (McConnell and Brue, 778-9). In 1988, Milton Friedman pointed out that, "Exchange rates have become less variable in the past several years, I believe that [this] tendency will continue" (Friedman, xxiv). This prediction has, in fact, come true. By viewing the volatility of exchange rates over the past 23 years, it becomes evident that over the past eight or nine years the volatility has decreased, perhaps directly as a result of the G7 intervention (Whitt, 8). The German mark, notably, has had a fairly stable trend versus the United States dollar since 1987—directly after the G7 meeting (various New York Times). All of this points to the fact that floating exchange rates are becoming more stable, most likely due to the intervention of governments to oversee floating exchange rates.

In viewing the pros and cons of both floating and fixed rates, floating rates clearly win out. There is a catch, however. Floating rates must be managed responsibly under a modified floating system. Using a modified floating system allows the large industrialized countries to collaborate efforts and help control worldwide trade, economic freedom, efficiency, and stability in a positive manner. It is because of this that a modified floating exchange rate system becomes the clear choice for the world to adopt.

Bibliography

Friedman, Milton. Introduction. The Merits Of Flexible Exchange Rates. Ed. Melamed, Leo. Fairfax, Virginia: George Mason University Press, 1988: xix-xxv.

Kolb, Dr. Fred: Personal Interview. 5 Mar. 1996.

McConnell, Campbell R., and Brue, Stanley L. Economics: Principles, Problems, And Policies. New York: McGraw-Hill, Inc., 1996.

Rolnick, Arthur J. and Weber, Warren E. "A Case for Fixing Exchange Rates" Federal Reserve Bank of Minneapolis Annual Report. 1989 ed.

Whitt, Joseph A. Jr. "Flexible Exchange Rates: An Idea Whose Time Has Passed?" Economic Review. New York: Sept./Oct. 1990.

"A Walk on the Wild Side." The Economist Newspaper. EBSCO-CD: Oct. 7, 1995 Vol. 337 Issue 7935.

"A Brief History of Funny Money." The Economist. Jan. 6, 1990: 21-24.

"To Fix or Float Exchange Rates?" Source Unknown.

Various New York Times Editions. New York.

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