Forget Bretton Woods
Will Hutton has a wonderfully silly idea:
Brown should also go back to Bretton Woods basics. He should propose the end of floating exchange rates and argue for a system of managed exchange rates between the euro, dollar and yen to bring back more predictability into the system.
Tim’s reaction to this is right. To see just how silly it is, let’s assume - heroically - that such a system could work and that the UK had been pegging sterling in recent months.
If this had happened, the Bank of England could not have cut interest rates, because it would instead have had to set them higher to stop sterling falling. Insofar as lower official rates have worked at all, this would have exacerbated our downturn.
How might this have been avoided?
One possibility would be for sterling to have been pegged at a low rate. But this would have exacerbated the earlier inflationary boom, as the Bank would have had to keep rates low to keep sterling down.
Another, contrary, possibility is that a sterling peg would have stopped the boom in the first place. This is because policy-makers would have feared that a current account deficit would have put pressure on sterling, and so set monetary and fiscal policy tighter a few years ago to stop it emerging. But this would have choked off not just the housing boom, but also investment in productive capital goods.
But would even this have been feasible at all? Maybe not. Imagine that a big country saves more than it invests, runs a current account surplus. It must then buy overseas assets. If it buys UK ones there’ll be incipient upward pressure on sterling. Under floating exchange rates, sterling merely drifts upwards. Depending upon how much this depresses inflation, domestic interest rates may or may not come down.
Under fixed exchange rates, however, interest rates must fall to stop sterling rising. And this threatens to cause an even bigger boom in house prices, and hence - eventually - a bigger bust.
Such a scenario is no mere theoretical possibility. It is, roughly, what happened to the Spanish property market after the country joined the euro, with results that are now being felt.
And the big country is, of course, China. The question of how the global economy could cope with its current account surplus would have been a much bigger headache under fixed exchange rates than it has been under floating ones.
Trying to peg exchange rates would be like squeezing on a balloon. You’d reduce volatility in one place, but merely increase it in others.
This would be worse than pointless. The great thing about exchange rate volatility is that it’s relatively harmless. One of Paul Krugman’s smartest sayings (of many) is that “the exchange rate has so little effect in part because it fluctuates so much.”
So, why not leave volatility in the place where it does least damage?
If this had happened, the Bank of England could not have cut interest rates, because it would instead have had to set them higher to stop sterling falling. Insofar as lower official rates have worked at all, this would have exacerbated our downturn.
How might this have been avoided?
One possibility would be for sterling to have been pegged at a low rate. But this would have exacerbated the earlier inflationary boom, as the Bank would have had to keep rates low to keep sterling down.
Another, contrary, possibility is that a sterling peg would have stopped the boom in the first place. This is because policy-makers would have feared that a current account deficit would have put pressure on sterling, and so set monetary and fiscal policy tighter a few years ago to stop it emerging. But this would have choked off not just the housing boom, but also investment in productive capital goods.
But would even this have been feasible at all? Maybe not. Imagine that a big country saves more than it invests, runs a current account surplus. It must then buy overseas assets. If it buys UK ones there’ll be incipient upward pressure on sterling. Under floating exchange rates, sterling merely drifts upwards. Depending upon how much this depresses inflation, domestic interest rates may or may not come down.
Under fixed exchange rates, however, interest rates must fall to stop sterling rising. And this threatens to cause an even bigger boom in house prices, and hence - eventually - a bigger bust.
Such a scenario is no mere theoretical possibility. It is, roughly, what happened to the Spanish property market after the country joined the euro, with results that are now being felt.
And the big country is, of course, China. The question of how the global economy could cope with its current account surplus would have been a much bigger headache under fixed exchange rates than it has been under floating ones.
Trying to peg exchange rates would be like squeezing on a balloon. You’d reduce volatility in one place, but merely increase it in others.
This would be worse than pointless. The great thing about exchange rate volatility is that it’s relatively harmless. One of Paul Krugman’s smartest sayings (of many) is that “the exchange rate has so little effect in part because it fluctuates so much.”
So, why not leave volatility in the place where it does least damage?
I don't disagree particularly, but is it not possible that China wouldn't have had a huge current account surplus if there had been a Bretton Woods II, as the yuan would have been valued higher (as the dollar wouldn't have depreciated) and indeed if a part of the system it would have probably revalued more?
Posted by: Matthew | November 10, 2008 at 06:38 PM
Much as I revel in the pain of English owners of holiday homes in Tuscany, the volatility in the euro-sterling exchange rate is for many individuals and businesses a very bad thing.
I defer to your vastly greater knowledge of the dismal science, but I have to ask about the case of Denmark. The Danish kroner is, for want of a better term, semi-pegged to the euro. That is, the currency is allowed a small amount of leeway within set boundaries. Yet, as long as I can remember, the Danish economy has done its own thing, with the government retaining a fair amount of control over economic policy. This affected me badly, as the mortgage interest rate on my one-bedroom apartment in Frederiksberg was much greater than the rate in Germany, from whence I moved in late 2000.
Posted by: Francis Sedgemore | November 10, 2008 at 08:07 PM
Out of historic interest, I post this link to a BBC news report from January 1999 relating to proposals of the then German finance minister, Oscar Lafontaine, for an international framework to fix the exchange rates of leading global currencies within target ranges - a return to the notions of the Bretton Woods structure which progressively collapsed during 1972/3:
http://news.bbc.co.uk/1/hi/events/the_launch_of_emu/inside_emu/225434.stm
See also the preceding reflections of Dominique Strauss-Kahn on these themes in November 1998 - which I mention here since he is now the present MD of the IMF:
http://www10.finances.gouv.fr/fonds_documentaire/archives/discours/dk981109.htm
Btw as I recall, Keynes was opposed to flexible exchange rates because he believed that exchange rate volatility would inhibit the growth of world trade post WW2. In that context, he may have been right but Sterling was floated in June 1972 and has floated ever since apart from the misguided entry into European Exchange Rate Mechansim (ERM) in October 1990 through to its forced exit in September 1992 due to mounting speculative pressures.
As best I can tell, there is now little enthusiasm around for Britain to join the Eurozone and irrevocably peg the exchange rate of Sterling to the Euro for ever more.
Posted by: Bob B | November 10, 2008 at 09:51 PM
Yes,
but we DO need some international financial reform of some sort. Speculative international financial flows are disfunctional and destabilising. I sort of wonder if all that is needed is a Tobin tax. But it is certainly true that neo-mercantilism (Japan and China) is a big problem and chronic surplus countries need to pay a higher price than they do today (the price today is of course higher import prices - but it doesn't seem to worry them - they regard exporting their unemployment worth it).
Posted by: reason | November 11, 2008 at 09:07 AM
Isn't this essentially the problem? That floating rates sound great, and might be best in practice, but they do run up against the difficulty that not everyone allows their currency to float. You can say 'well great, cheap imports' but there are secondary consequences.
Posted by: Matthew | November 11, 2008 at 10:37 AM
I agree completely with Chris. John Major, black wednesday...
Posted by: georges | November 11, 2008 at 07:09 PM