Originally published August 18, 2011 on the New Economic Perspectives blog.
Thanks for comments. Let me stick to the topic: MMT and alternative exchange rate regimes. At one end we have fixed exchange rates—with the currency pegged to gold or to a foreign currency. At the other we have floating rates. No one seemed to question my (obvious) claim that floating rates provide more domestic policy space, in general. Other than that, what are the advantages and disadvantages?
Well the belief is that fixed rates provide more certainty—you know what the dollar will be worth relative to the pound. That makes it easier to write (nonhedged) contracts. However, the uncertainty is shifted to the ability of government to maintain the peg. That is especially problematic in the post-Bretton Woods era in which countries that peg are essentially “going it alone”.
Many also (paradoxically) believe that fixed exchange rates reduce the chance of speculative attacks. That is counterfactual as well as counterintuitive. Remember the pound? George Soros brought it down and supposedly made a billion dollars in a day betting the UK could not defend the fix. Would you rather short a currency that is fixed, or one that floats minute by minute? In which of those two cases could you make a billion a day? Would you rather try to hit a moving target, or one that is stationary?
Now it is true that daily fluctuation of pegged rates might be nil for long periods of time, in contrast to floating rates that might vary all the time. But when pegged rates do move, they can generate currency crises because when the peg is broken, that is equivalent to a default. If I promise to you to convert my dollar IOUs to a foreign currency (or gold) at a fixed rate, and then I tell you that I’ll only give you half the promised amount of foreign currency, I have just defaulted. That causes havoc in markets.So, yes, fixed rates can in some cases provide greater certainty—until they are abandoned. To ensure the fixed rate will be maintained, the country will need access to substantial foreign currency reserves. A country like China or Taiwan today can provide a believable promise of conversion at fixed exchange rates. Most nations cannot.
How do these countries obtain the foreign exchange reserves? For the most part, they run current account surpluses (selling goods and services abroad, or earning factor incomes in foreign currency) or they borrow them. How do those reserves end up at government? Because the exporters who earn—let us say—US Dollars need to cover their own domestic expenses in the domestic currency. The central bank offers exchange services to its banks—they need domestic currency reserves. The central bank creates domestic currency reserves and buys the foreign currency reserves. The central bank then typically exchanges Dollar reserves at the Fed for Treasuries. It wants to earn interest. That is why there is a very close link between US current account deficits and foreign accumulation of Treasuries. It is not that foreigners are “lending” to the US government so that it can deficit spend. Rather, the US current account allows foreigners to earn Dollars, and they want to earn interest on safe Treasuries.
What about the IMF articles mentioned that require a country to accept its own currency in exchange for Special Drawing Rights or the seller’s own currency? Does that mean that all signatories have abandoned their floating rate currency? Have they lost domestic policy space? Are they then open to speculative attacks, as if they were on a fixed exchange rate system?First it is important to note that this is a self-imposed constraint. Governments have adopted a wide variety of these. The US government for example has a self-imposed debt limit. We just went through a huge debate about raising it. Clearly, markets did not force that on the US. Similarly, the IMF Articles of Agreement were adopted—not forced by any kind of market forces or logic.
And in practice, they have no material impact on domestic policy space. Let us say the Chinese decide to submit Dollars to the US to demand payment in RMB. Has the US pegged to RMB? No. It will provide RMB at the current exchange rate. Will this pose an affordability problem? No. Assume the US runs out of RMB. It then goes to foreign exchange markets and uses Dollars to buy RMB at the current exchange rate. Will it run out of Dollars? No. It creates as many Dollars as necessary to buy as many RMBs as it needs. It can meet all demands as they come due.
Now, the great fear is that this will cause the Dollar to depreciate (the RMB to appreciate). So here’s the fear of our deficit hysterians: China might submit $2 trillion in US currency (reserves and Treasuries), demanding RMB, causing the Dollar to collapse. Really? That is what China wants? What happens to Chinese sales to the US? What happens to the value of Dollar assets held by China? Do you really believe China would do this?
China wants to sell some of its output to the US; if the Dollar collapses, it says “bye bye” to sales. It already holds substantial Dollar reserves. If the Dollar collapses, it is stuck holding an asset that falls in value. Now, in truth, no central bank needs to worry about that. So what if it holds worthless assets. (Just ask the Fed—it bought up toxic waste assets that really have no value at all, in order to save the banksters on Wall Street. That is a topic for another day.) But the Chinese do seem to worry about that—indeed, that is why they keep telling the US to maintain the dollar’s value, or else! (Or else what? Well, nothing. It is a lot like holding a gun to your head and demanding ransom before you blow your brains out. Again, a topic for another time.) The point is that the hyperventilator’s scenario is just not plausible. Current external holders of the Dollar have no interest in seeing it collapse.
Further, so far as I can tell, the Articles are designed to allow countries facing their own payment problems to submit their foreign currency holdings to obtain SDRs (or to drain their own currency out of foreign exchange markets—to stabilize the value of their own currency). The purpose of the Articles is NOT to support speculative attacks—but to protect countries from speculative attacks. If China ever did attempt to crash the dollar in the manner imagined by some hysterians, I suspect the Articles would be set aside until the attack ended. In other words, the Articles were adopted to help stabilize international financial markets, not to enhance destabilizing forces.
If you think about the Bretton Woods standard, the Articles imposed discipline. The Dollar was pegged to gold, and all other nations pegged to the Dollar. The Articles forced each nation to carefully manage foreign currency reserves (meaning Dollars) to ensure they could convert on a fixed exchange rate to Dollars. If too much of a country’s domestic currency was held externally, a fear would grow that it could not maintain the peg to the Dollar; foreign holders could present the currency and demand Dollars. With the Dollar and most other important currencies floating, the Articles do not impose discipline on them. But foreign holders can use the Articles to stabilize their own currencies.
There was a question about Russia’s default that Scott Fullwiler answered (directing readers to Warren Mosler’s piece). But then the question was “why” did Russia choose to default. As best I can determine (and I am no expert although I happened to be in the room when Warren was on the phone during the crisis) it was a political decision. We cannot completely ignore politics. Yes, Congress could have decided not to raise the debt limit. We appeared to be quite close. There was no good economic reason to do it—but politics can lead to some crazy results.
We will deal later with the question asking why money MUST be an IOU.