Arthur J. Rolnick - Senior Vice President and Director of Research, 1985-2010
Warren E. Weber - Retired Economist
Published June 1, 1990 | June 1990 issue
The following essay is a synopsis of the Minneapolis Fed's 1989 Annual Report, authored by Warren E. Weber, manager of the Research Department's monetary studies section, and Arthur J. Rolnick, director of research. The views expressed in this synopsis, which appeared in The Wall Street Journal (April 26, 1990), are those of the authors, and not of the Federal Reserve System.
When the major industrialized countries ended the fixed exchange-rate system 16 years ago, they saw their decision as a triumph for the free market: No longer would exchange rates be set by governments and be subject to the vagaries of political developments. No longer could speculators get rich by anticipating, or even precipitating, exchange-rate adjustments. No longer could fiscally irresponsible economies export their inflation.
But the costs of floating exchange rates have been far greater than expected. Trade imbalances have generally widened since 1974. The advantage of independent monetary policy to countries has been small; there is a growing consensus that stable and predictable policy rules are best. For example, the G-7, the group of the West's and Asia's seven most industrialized countries, has met several times over the past five years to coordinate policy. Exchange-rate volatility has been large and costly to international trade. It is time to consider the return to a fixed exchange-rate system. There is even a model for such a systemthe monetary coordination of the various districts of the Federal Reserve in the United States today.
Those who argue that fixed exchange rates cannot work assume, at least implicitly, that currency is essentially no different from other goods. Since exchange rates are the relative prices of currencies and since standard price theory demonstrates that it is impossible to fix the relative prices of goods in the long run, skeptics argue that a fixed exchange rate system is not feasible.
But the conventional argument does not apply to exchange rates because today's currencies are fiat currencies: They are intrinsically worthless pieces of paper that are virtually costless to produce. This means that a government can always avoid depleting the buffer stock of its currency simply by printing more. Therefore, fixing exchange rates is feasible, and any rate will work. That fixed exchange rates are theoretically feasible, however, does not mean they are politically acceptable. Under fixed rates, the country with the fastest growing money supply gets the most seigniorage (revenue) from money creation. More important, some of this seigniorage is collected from residents of other countries because, with exchange rates, the inflation caused by one country's money growth is experienced by all countries. This outcome is bound to be politically unacceptable to other countries. A country can prevent another from exporting inflation by letting its own exchange rate appreciate. As a result, countries will not adhere to fixed rates unless they are willing to coordinate their monetary policies.
The policy coordination necessary for fixed exchange rates, however, is not that all countries agree to have their money supplies grow at roughly the same rate. Even if these money growth rates were the same and other economic fundamentals unchanged, recent research shows that exchange rates can fluctuate simply because people think they will.
The policy coordination required to fix exchange rates has two components:
Central banks would have no problem meeting the first component. If a central bank temporarily ran out of a foreign currency, it could always swap its own currency for the other with the appropriate foreign central bank. This arrangement prevents exchange rates from fluctuating because of speculation, since it guarantees that any amount of a currency demanded will always be supplied at the fixed price. And if countries meet the second component, they will have no incentive to overissue their moneys.
The Bretton Woods system is usually cited as evidence of the fragility of fixed exchange-rate systems. But Bretton Woods is not really a test of whether a fixed exchange-rate system will work. A fixed-rate system requires that policy coordination include an agreement among countries about the amount of seigniorage and its distribution. This component of policy coordination was missing from the Bretton Woods system, which attempted to fix exchange rates while allowing each country some control of its own seigniorage.
A proper test of whether fixed exchange rates are feasible needs evidence from a system with the two required components of policy coordination in place. Such a system exists, and it is running smoothlythe monetary system of the United States.
To many, the notion that the United States has a fixed exchange-rate system may come as a surprise. The notes issued by the Federal Reserve System look like and are used as a single currency. Each note is printed in black and green ink, each has "The United States of America" inscribed on front and back, and each says it is a "Federal Reserve Note" and "legal tender for all debts, public and private." Furthermore, the notes exchange at par: a $20 bill swaps one-for-one with any other $20 bill, one-for-two with any $10 bills, and so forth.
In what sense, then, does the United States have something other than a single currency? A closer look reveals that, in fact, each of the 12 district banks in the Federal Reserve System issues its own notes. Each note is identified by its district bank in four ways: First, on the front left is a circle with the district bank's name written around the inside. Second, in the middle of that circle is a bold, black letter representing the Federal Reserve district of originA for the first district, B for the second and so forth. Third, the letter symbol is the first character of the serial number. Fourth, the district's number is printed on the front four times.
Granted, these differences among Federal Reserve notes are much less distinct than those between, say, U.S. and Italian currencies. Nevertheless, in a physical sense, U.S. currency is not strictly uniform. The importance of these physical differences is that they represent the possibility that the United States could choose to have a floating exchange-rate system among the currencies of the 12 Federal Reserve districts. Instead, the United States has chosen a system of fixed exchange rates.
That the United States has had no trouble maintaining its fixed exchange-rate system demonstrates that such a system is feasible. Despite changes in economic fundamentals among Federal Reserve districts, the United States has not been forced to adjust the exchange rates between district currencies. This is not what the skeptics of fixed rates claim would happen. What if the Ninth District economy were declining while the other district economies were expanding? Or what if the Ninth District were running a trade deficit with the rest of the country? Then, skeptics claim, there should be some downward pressure on Ninth District currency. This, of course has never happened, nor is it likely.
The reason the U.S. system of fixed exchange rates works is that it has the two required components of monetary policy coordination: First, the district Federal Reserve banks have an agreement to swap their currencies for any other district's at the fixed rate in any amount and at any time. Because of this agreement, it's unlikely that many people have ever lost sleep over the exchange value of their district's notes relative to another's.
Second, district Fed banks also have an agreement on how to set the rate of money growth and how to distribute the resulting seigniorage. Each district bank participates in the policy process (at Federal Open Market Committee meetings), and a unified policy action is carried out for all 12 districts. No individual district bank can pursue its own monetary policy. Furthermore, all seigniorage is pooled and disbursed by the U.S. Treasury. By design, no district bank can gain by issuing more of its notes than another. Even if all notes were issued by, say, the Ninth District, the revenue would still be pooled and disbursed by the Treasury.
This example of the U.S. monetary system shows that when the two required components of policy coordination are met, a fixed exchange-rate system is feasible.