Fixed or Floating Jude Wanniski November 6, 2004

Memo To: Supply Side Students
From: Jude Wanniski
Re: Fixed Rates Over Floating

This weekend I’m reaching back to a Wall Street Journal op-ed I wrote 30 years ago, on June 14, 1974, presenting “The Case for Fixed Exchange Rates” as developed by Robert Mundell and Arthur Laffer. This was my first attempt to explain the mechanisms envisioned by the two, only a month after my first meeting with Mundell in May of that year. In reading the op-ed, remember that President Richard Nixon had broken the dollar/gold link only three years earlier, with every intention of restoring it sometime later that year or soon thereafter. For those of you who have been following the lessons this semester, you will note how close the op-ed was to being relevant to the issues of today, with Alan Greenspan telling Congress he has been trying to replicate a gold standard by managing interest rates, an idea which has no modern theoretical foundation at all.

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It was not until the spring of 1973 that Treasury Secretary George Shultz, a disciple of Milton Friedman and floating exchange rates, officially decreed the float to be permanent. But where Friedman had predicted the float would be beneficial to the economy, by June of 1974 the inflation that followed the float was rampant. Please do not read the piece as if it were gospel, however. At the time, the idea of re-fixing the dollar to gold was not on anyone’s political scope, but was opposed by almost all economists. So Mundell and Laffer translated their arguments into a demand-side model, using money-supply arguments in a global framework and never mentioning “gold.”

You will notice they do suggest one country take on the role of providing “asset convertibility,” recommending the United States. What asset? They don’t say, but we know they mean “gold.” Regular students of SSU will notice in reading the op-ed that it not only does not deal with the concept of monetary “deflation,” but it assumes that prices will not fall if a currency appreciates. They were of course in error, as history demonstrated, as they assumed wages were “sticky” in the downward direction, an error made by thinking of the Great Depression as the result of monetary error. It was another three years before I discovered the Crash of 1929 was the result of a fiscal error, the Smoot-Hawley Tariff Act, and another seven years before I discovered the concept of monetary deflation, as distinct from economic contraction. Of course, in the Great Depression, with the price of gold never in decline, wages were sticky downward. In a monetary deflation, with gold in decline, wages will be forced to adjust downward.

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The Case for Fixed Exchange Rates WSJ June 14, 1974

When economic policymakers get together in Washington they fret that the usual economic medicine no longer seems to work -- inflation seems oblivious to fiscal discipline, tighter money, dampened demand or increased supply, or even new proposals to tie the economy to the consumer price index. But at least, the policymakers sigh, our international problems have been solved by floating exchange rates.

There are, though, at least two economists who are prepared to argue that floating exchange rates are precisely the reason the rest of the medicine no longer works. Arthur B. Laffer of the University of Chicago and Robert Mundell of Ontario's University of Waterloo are proponents of an unorthodox view of international economics. They believe that the fundamental cause of the current world inflation is excess growth in the world money supply, but that floating rates are a structural cause that "rachets" the inflation into double-digit figures. And they believe the world cannot solve the inflation until it arranges a system of truly fixed exchange rates.

After all, Professors Mundell and Laffer point out, the moderate inflation of the 1950s ended in 1968, when exchange-rate changes began taking place with some frequency. Inflation speeded further after August 1971, when exchange-rate changes were taking place with rapidity. And when fixity was abandoned and the world began floating in February last year, the world became wildly inflationary.

The Mundell-Laffer Argument

In the Mundell-Laffer view of the world economy, this result is inevitable. Their theoretical model rests on a basic assumption they argue is a close approximation of reality in today's increasingly integrated economic world. This is that an article's real price -- that is, its value relative to other articles rather than to national currencies -- cannot be different in two nations with closely related economies. If it were, supplies of that article would simply flow from one nation to another until the real prices were equal.

If this is true, it follows that when one country devalues its currency in relation to another country, prices as measured by the two currencies will adjust to compensate for the change; the nominal prices will change to maintain equal real prices. And from this seemingly simple proposition flow a number of unorthodox conclusions.

One, for example, is that a nation cannot improve its balance of trade by devaluing; it will achieve no competitive advantage because nominal prices will change and real prices will not. A second is that a nation that does devalue its currency will suffer extraordinary inflation; if real prices remain unchanged, its nominal prices will have to go up faster than the rest of the world's. Professor Laffer has elaborated these arguments in articles on this page on Feb. 5, 1973 and Jan. 10, 1974.

In a world of constantly floating exchange rates one more factor becomes important: Prices are rigid in the downward direction. That is, prices move up more easily than they move down. If there were no rigidities and country A devalued against country B, half of the adjustment would show up as higher nominal prices in Country A, and half as lower nominal prices in country B. But because of the downward rigidity, a disproportionate amount of the adjustment takes the form of inflation in the devaluing country.

So suppose that floating exchange rates prevail between currency A, perhaps the dollar, and currency B, perhaps a bundle of European currencies. And suppose A depreciates by 10% in six months, and appreciates by the same amount in the next six months. Nominal prices in both countries adjust to compensate for these changes in exchange rates. In the first six months a disproportionate share of the adjustment takes place through inflation in nation A, and in the second six months a disproportionate share takes place through inflation in nation B. Thus at the end of the year the exchange rates are unchanged, but nominal prices in both nations are higher. The float has ratcheted world inflation to a higher level.

The view that floating exchange rates foster inflation is only one part of a far larger economic viewpoint Professors Laffer and Mundell have been developing. They argue strongly for fixed exchange rates, as a method of promoting world economic integration. And while most proponents of fixed rates are traditional economists forever constructing elaborate mechanisms trying to approximate the 19th Century gold standard, these two professors argue from a monetarist economic viewpoint, usually associated with floating rates.

Differing With Mr. Friedman

Professor Mundell, a 41-year-old Canadian renowned in the profession for his brilliance -- he picked up his Ph.D. in six months residency at MIT 18 years ago -- was the prime mover in conceptualizing the theory. Professor Laffer, 33 -- on the faculty of Chicago's Graduate School of Business at 27 -- has been the more flamboyant and aggressive of the two, both in working through the rigorous underpinnings of the theory and in presenting it. They were drawn together at Chicago six years ago and began applying the Friedman monetarist model of the U.S. economy to the world. Their sharp differences with Professor Friedman on the exchange-rate issue is the result of this difference in perspective.

The typical monetarist argument for floating exchange rates holds that only through pure floating can a country gain independence over its monetary policy. When central banks are not required by agreement to intervene in order to support a "weak" currency, the country whose currency is weak is forced to accept the consequences of the easy-money policies that made the currency weak. It will no longer be able to "export" inflation, and by the same token it will not have to import the inflation caused by excess money creation outside its borders. Floating advocates say this is desirable, that it exerts an internal discipline on each monetary authority to act responsibly.

Professors Laffer and Mundell agree that floating rates give each nation independence in monetary policy, but they believe such independence is undesirable. It interferes with maximum economic efficiency, in effect serving as an economic barrier such as tariffs or quotas. In viewing the world itself as a closed economic system, they say it is recognized as being desirable that there be one price for wheat and zero barriers to trade, thereby assuring that wheat will be produced by the most efficient. So too, in a closed national economy, or in an ideal integrated world economy, there would be one money, a common currency in which all prices are measured and all transactions take place. In a less than ideal world, this condition can be approximated by truly and absolutely fixed exchange rates. If rates are fixed, devaluation and revaluations of money no longer interfere with the efficiencies of a free market.

The idea that a fixed system is a market system and a floating system a controlled one is the most difficult Mundell-Laffer concept to see. Its essence is that when rates float, the central bank of each country has a monopoly over its money supply; when rates are fixed, the citizens of the participant countries share in a common money pool with no interference by their respective governments.

Under a float, the citizens of the United States, in order to satisfy their money demands, have to rely exclusively on the individuals who run the Federal Reserve to produce the precise money supply to meet demand. Because the individuals at the Fed can never know precisely what the demand is, they can only make rough guesses, and are always wrong in one direction or the other. If an excess is produced at a given instant in time, it cannot be exported for use by other countries. If a shortfall is produced, U.S. citizens cannot make up the difference by borrowing foreign currency and converting it to dollars.

Under a fixed-rate system, by contrast, the central banks of the system do not have to be precise in their production of money. If they produce too much, foreigners will borrow it, take it to their central banks, and convert it to local currencies. If the Fed produces too little at a given instant, money demanders here will borrow abroad and convert those foreign currencies to dollars by presenting them at a central bank.

Under fixed rates, inflation will still result if the world money supply -- the aggregate of the money created by all the central banks -- grows faster than productive resources. But because the money is shared, the inflation rate will be similar in all countries. And of course, the inflation caused to excessive money growth will not be intensified by the ratcheting effect of floating rates with downward price rigidity.

Beyond that, because the integrating effect of a common money promotes total economic efficiency, there are conditions in which it can combat both inflation and unemployment simultaneously. To explain this, Professors Laffer and Mundell use a simplified two-country model. Consider Country A, which uses dollars and has 10% inflation rate and 0% unemployment. Country B uses francs, has a 0% inflation rate and 10% unemployment. Country A clearly has too few goods and no more workers; Country B has all the goods it needs and too many workers. Given independent money systems, Country A can't make use of the surplus workers in Country B; Country B can't make use of the surplus money of Country A to employ its workers. Given a common currency or a fixed exchange-rate system, the transfer is made and both countries have no inflation and no unemployment.

Fixing exchange rates, in the Mundell-Laffer view, would not cure inflation. But it would reduce it by removing the ratcheting effect, and would provide a structure under which the central banks could coordinate their money-creation policies in a way that would control the remaining inflation.

Their proposals for how to fix rates are simple in the economic sense. At least one major country, the U.S. being the best candidate, would have to accept the discipline of primary reserve or asset convertibility, while other currencies were kept convertible into that major intervention currency at fixed rates. Governments would be obligated to sell unlimited quantities of their currency at the floor price, and would borrow whatever reserves would be needed to fight speculative runs.

Multinational Policy Review

The U.S. would manage its money supply using world money growth as a target, keeping this at an appropriate level by compensating for money creation of other central banks. The Mundell-Laffer model assumes that any such system would involve multinational policy review. Governments that needed to borrow foreign exchange from other governments would pay market rates of interest, which would be an important element of discipline in the system.

This system would break down, as other fixed-rate systems have in the past, if one of the governments inflated its money supply to the point where it runs out of reserve assets and cannot borrow more. At that point, a government will devalue its currency, hoping to improve its competitiveness vis-a-vis its trading partners. The payment of market interest rates on borrowed reserves is intended to persuade governments that are inflating faster than others that it would be cheaper to get their money growth in line.

The political problem, of course, is to persuade governments to give up the option of inflating their currencies and devaluing. Professors Laffer and Mundell are more optimistic on this score than most observers, simply because their economic view tells them this option does not work anyway, and because governments seem to be learning the same thing through experience.

The experience of recent years, after all, has been that inflating currencies does not cure unemployment. Since the days of the Smithsonian agreement, governments seem to be learning that devaluation doesn't help a country's trade position and revaluation doesn't hurt it. Floating exchange rates have certainly coincided with abnormally high inflation.

None of this experience conforms to usual economic models, but it conforms perfectly with the Mundell-Laffer one. And if governments came to believe that the latter model describes their economic problems, their political problems would no longer look so insurmountable.