recent experience in the UK and US indicates that a floating exchange rate does not automatically cure a balance of payments deficit, or at best the correction process is glacial. This is because the competitiveness of a country’s economy is not just about the currency. Ultimately, the trade adjustment will have to go hand in hand with an adjustment in savings and consumption in each economy.
The adjustment mechanisms associated with fixed exchange rates versus floating exchange rates tend to produce different economic costs. Under a fixed rate system, curing a deficit is likely to involve a general deflationary policy (higher taxes, cuts in expenditures) resulting in increased unemployment and lower economic growth. The floating rate system tends to be inflationary as the exchange rate depreciates following current account deficits. This has usually been the case for countries such as the UK, which is dependent on imports of food and raw materials. It has become an issue for a number of countries which are pegged to the dollar, notably in the Middle East.
A rise in interest rates as part of an anti-inflation package may encourage an inflow of funds. This will increase the price of the currency and will make the economy less internationally competitive. Floating can therefore raise concerns over discipline in economic management. The presence of an inflation target though should help overcome this. When using a fixed rate system, governments have a built-in incentive not to follow inflationary policies. If they do, then unemployment and balance of payments problems are certain to result as the economy becomes uncompetitive.
For this reason, under the Bretton Woods Agreement governments could not allow their inflation rates to differ greatly. The initial policy response was normally to deflate; under the gold standard, deflation would have occurred automatically. Unemployment would rise in both cases. As Galbraith put it, those who express a preference between inflation and depression are “making a fool’s choice – you deal with what you have”. Deflation and depression in the 1930s and inflation in the 1970s were both destructive to the world order.
Those who prefer the floating system will claim that under fixed exchange rates there is loss of freedom in internal policy. This is clearly the case for those who joined the euro in January 1999. Some commentators in the UK regularly quote this as a good reason not to enter and cite the positive effects of devaluation post-1992 and the ability to devalue after the financial shocks of 2008. However, it begs the question of whether if there had been financial discipline prior to these events then devaluation would not have been an issue. In both cases the inflationary impact was muted as fortunately global deflationary pressures dominated.
Looking at the euro in more detail provides some interesting insights.
The euro experience
The euro experience has been broadly positive and the euro now ranks as the second reserve currency behind the dollar. The major criticism of it has been the one size-fits-all monetary policy, but this has also crucially been allied to failures to adjust fiscal policy. This was clearly evident in 2010 in Ireland, Greece and Portugal, which prompted a sell off in the euro and speculation of a break up of the entire union.
The need for fiscal convergence was recognised at the outset of the European Monetary Union but subsequently ignored or manipulated by politicians. The Maastricht Treaty signed in 1992 said that governments had to have budget deficits of no more than 3% of Gross Domestic Product (GDP) and a national debt of less than 60% of GDP (it was known as a stability pact). The importance of balance between monetary and fiscal policy has never been more clearly evident. Unfortunately, the euro-zone countries have behaved as if they were each managing their own currencies.
Each country appears to go its own way in raising taxes or borrowing money. In the past, imbalances would be adjusted over time through an appreciation or devaluation of the currency. This option is no longer available and in the case of Greece the only option was severe austerity measures, including cuts in wages and pensions.
Since the introduction of the Maastricht Treaty the deficit rules have been violated over 40 times. Greece tops the list in this respect. It has only once managed to push its deficit below 3% and this was through creative accounting in 2006. Also, Greece has raised debt through complex structures which have not been included in official statistics.
Ironically, it was Germany that was the second member state, after Portugal, to be subjected to an excessive deficit procedure by the European Union. It was also the German government who steered an “improvement in the implementation of the Stability and Growth Pact” at a special meeting of the Ecofin Council on 20 March 2005. This improvement could only be seen from a political viewpoint as it allowed more frequent exceptional and temporary violations of the deficit rules.
The Bundesbank declared that the changes would “decisively weaken the rules of sound financial policy” and the “goal of achieving sustainable public finances in all member states of the monetary union is being jeopardised”. This judgement has been borne out by recent events in Greece and other periphery countries, notably Ireland and Portugal. It has highlighted that while there is a common monetary policy the members of the euro lack a coherent and credible shared economic policy. It has shown that even small countries can jeopardise the entire currency project. Politically, it has prompted a change in awareness that its members are dependent on one other.
Conclusion
Fixed exchange rates are not just about numbers. They signal intent for co-ordinating economic behaviour and financial discipline. At best they unite the economic performance and policies of nations. In the case of Europe and the USA they represent political integration. Floating is more a statement of self interest which of late has become polarised between the West and Asia. When the industrialised nations went over to floating in 1973 it was not because flexible exchange rates were regarded as a better system but simply because the system of fixed rates had temporarily collapsed.
Floating certainly has its advocates who would argue that it has coped well with oil crises and recession, and provided a more benign adjustment mechanism. This is important when set against the backdrop of the electorate holding governments increasingly accountable for economic performance. It has, however, seen the demise of financial discipline and has led to overshooting and undershooting of exchange prices, which is its major flaw. This has prompted active government intervention, although the primary stated ambition has been to stabilise disorderly markets rather than to create artificial exchange rates. The effectiveness of this intervention has not been firmly established.
During the period in question foreign exchange dealing has seen enormous changes. The rapid changes in communications and computing power has forged the 24-hour dealing market and the speculator; this pair is often blamed for chaotic markets. In reality 24-hour dealing and speculators are the symptom of the problem not the problem itself.
Increasingly wild fluctuations in the exchange rates, which is the situation in the 21st century, have little attraction in the medium term, both in terms of trade and asset allocation. The recent lessons from Europe, discussed in this chapter, are that to achieve stability the politicians will have to learn to live with financial discipline and take responsibility for managing electoral expectations.
Foreign exchange and the UK – 1960 to the 2000s
1960s
By the 1960s the deterioration in the UK’s competitive position was becoming increasingly evident. This was partly a legacy of the war and partly due to an economy heavily dependent on trade, but it was also caused by an inability to change working practices and restructure industry to the new world order.
In 1964 the Labour Prime Minister Harold Wilson made the famous declaration that he would defend the sterling
