Floating Exchange Rates: The Only Viable Solution

Floating Exchange Rates: The Only Viable Solution


Stentor Smith


For some, the collapse of Mexico's economy proves that floating exchange rates

and markets without capital controls are deadly. Others find the crash of the

European exchange-rate mechanism (ERM) in 1993 to be proof that targeted rates

will always be overturned by the free market. Many see the breakup of Bretton

Woods as the failure of fixed rates. Yet others believe monetary unification in

Europe is the only way to achieve economic and political stability. Many others

hold still different beliefs. There are, however, four main proposals for the

management of international currency exchange rates: monetary unification, fixed

rates, floating rates maintained within certain "reasonable" limits of

variability and freely floating rates. Both fixed exchange rates and rates based

on either explicit or unwritten targeting are impossible to maintain, especially

in an era of free trade. Complete monetary unification would be impossible to

bring about without extensive integration and unification of international

governments and economies, a task so vast that it is unlikely ever to be

accomplished. Thus, the only option central banks have is to allow exchange

rates to float freely.


The European Monetary System, which virtually collapsed in 1993, was an attempt

to fix exchange rates within certain tight bands, to coordinate monetary policy

between member nations and to have central banks intervene to keep exchange

rates within the bands when necessary. The reasons for the collapse were myriad,

but, simply put, it happened because Germany, dealing with financial problems in

part arising from its reunification, refused to lower its high interest rates.

This meant other European countries either had to keep their rates equally high

and allow themselves to fall into recession as a result, or devalue their

currency against the mark, a move viewed by many as a political embarrassment.

The possibility of a devaluation caused speculators to bolt from the lira, the

pound, the franc and other currencies, sending the markets into chaos and

destroying all semblance of stability. In the end, the ERM was adjusted to allow

currencies to fluctuate within 15 percent on either side of their assigned level,

up from (in most cases) a limitation of 2.25 percent. The bands became too wide

to be meaningful or stabilizing, and the system remained alive "in name only"

(Whitney 19).


Many saw this collapse as inevitable and say all attempts at government-imposed

stability will fail: Governments both will not and cannot stick to pegged or

fixed rates. First, maintaining targeted or fixed rates requires a consistent

and fairly uniform monetary policy among nations. There are many reasons that

national governments will not consent to this, the foremost being that different

countries want different things, different economies have different needs and

different governments have different policies. For example, it is thought that

Europe and Japan are more willing to tolerate recession than inflation, while

the United States prefers to keep interest rates low and the economy growing,

even if prices do increase (Whitt 11). In addition, many nations are in

different stages of their overall economic cycles ("Gold Standard" 79). Many

countries thus cannot afford to subscribe to uniform monetary policy. For a

country that would otherwise have had low interest rates, for example, raising

them could be both economically counterproductive (what good is exchange rate

stability if recession is its cost?) and politically disastrous (more people

notice high interest rates and unemployment than care about currency stability).

Even if the government were willing to bow to international standards,

nationalism is strong in the world today and most people do not look fondly upon

consolidated global power--witness the problems of the United Nations. People

would not widely support what would effectively be international control of

their
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