The Exchange Rate Issue

Aram Klijn
Aram Klijn is currently a first year Bsc Economics student. He is especially interested in macroeconomics, international trade and anything related to music.

The past century has seen drastic shifts in the international financial balances, each requiring its own tailored policy response. However, with an ever-increasing number of economically relevant countries, monetary systems and financial products, finding proper responses to any shift of economic power or economic downturn has become a lengthy and complicated ordeal; so complicated that devising an appropriate and timely policy response is hardly possible anymore. This exacerbates the negative effects of any crises and heightens the risk of an unwanted procyclical policy response. What were our past alternatives, and where should we look for the future?

Back to The Future

As economies in the late 19th century became increasingly globalized due to the invention of mass communication, mass transport and international civil travel, a proper international financial exchange market had to be created. Whereas both silver and gold had been used as standards from the fall of the Byzantine Empire until the 19th century, the relative price between silver and gold began to fluctuate in the later half of the 19th century, mainly due to Germany’s decision to stop minting silver ‘thalers’, a widespread form of currency throughout Europe, with a set value throughout the continent. The reparation payments payable to Germany after the Franco-Prussian war were also specified to be delivered in gold – further reducing the worth of silver relative to gold. Soon, most major economic players had pegged a specific amount of currency to an ounce of gold – the differing prices being their international exchange rates. This de facto gold standard was written into American law by the Gold Standard Act of 1900. This proved a relatively stable system, albeit it for only 14 years. As the First World War rolled around, many countries were forced to suspend the gold-for-currency convertibility due to (too) large military government expenditures. The system was proven inherently flawed. The Great Depression was the final nail in the coffin, proving that a Gold Standard was not set up to handle the economic turmoil of the 1930’s. In 1944, the Bretton Woods system was devised, essentially fixing all exchange rate to the USA’s designated dollar per ounce of gold ratio. This system too failed, leading to the system that we have now: A mix of both fixed and floating exchange rates.

To peg or not to peg?

Pegging your exchange rate to an arbitrary other exchange rate holds certain benefits: Your exchange rate vis-à-vis the currency that you are pegged to is fixed completely. This can be beneficial for a country that trades heavily with the  country that it is pegged to, or countries that are financially dependent on another nation. One such example is the West-African Economic and Monetary union (UEMOA), that, in previous years, was pegged to the French Franc and is now pegged to the Euro. This was done because West Africa has always had close ties to France and conducts most of its trade with France. Another reason to peg a currency is that price levels are less volatile and trade is therefore more predictable. However, it leaves you utterly at the mercy of another country’s monetary policy. If they go down, you go down. There is also an increased risk of excessive trade deficits (or surpluses), possibly leading to capital flight. To counterbalance this, a government would have to devalue its currency if the trade deficit (and subsequent debt accumulation) reaches levels too high to be credibly considered repayable. A free-floating exchange rate has some notable benefits over a pegged currency, however; Monetary policy is effective and can be used to make sure a country is able to stay relevant in international financial markets. It also allows governments to use the exchange rate as a tool to keep the trade deficit below a certain threshold. However, it does not incentivise cooperation between countries. There is hardly any organisation, aside from the World Trade Organisation, barring a country from sailing a trade policy beneficial to itself, but detrimental to others. Sadly, the WTO’s decisions are not binding.

The World Economy and the Holy Grail

What measures could realistically be taken to reduce the main bottlenecks of the current free-choice exchange rate regime? How can we both realize accountability for trade policies and an adequately quick policy response? The WTO attempts to make countries accountable for their trade policies, both by way of agreements ‘forcing’ member states to declare that they will not unilaterally declare economic sanctions or tariffs without appealing to the WTO first. However, as stated before, the WTO’s decisions are only as binding as each member state feels they are. Trump has not batted an eye at the WTO’s agreements and has unilaterally declared trade tariffs on Chinese goods, laying the groundwork for a smouldering trade war. It is yet to be seen whether Trump’s decision to put America first will be the first step to making a country accountable for the exchange rate regime they choose. A quick policy response to such complicated economic decisions is yet still a dream of the future, for bureaucratic reasons as well as the pure policies themselves. Every economic event needs its own, tailor-made policy response and sadly, today’s computing power is not yet sufficiently advanced to be able to run macroeconomic simulations so complicated that they reflect reality. Possibly, when quantum computers become a efficient reality, this too will change. Our financial products have become increasingly digitalized, but macroeconomic policy advice and analysis has not kept up.


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