Using National Currencies in International Transactions: The Case for Flexible Exchange Rates

Abstract

After the demise of Bretton Woods the world trading system has been characterized by lower growth, higher inflation, gyrating exchange rates, recurring international liquidity crises and secularly rising rates of unemployment. In the process a variety of flexible exchange rate regimes have evolved. These have created perverse incentives to compete for limited reserves, set trading partner against trading partner and perpetuated the stagnant world economy that Keynes had so presciently anticipated. The resulting degree of exchange rate volatility has been greater than ever previously experienced. Economic performance, whether measured in terms of growth rates or unemployment rates was dramatically below the exceptionally strong experience of the Bretton Woods period under fixed exchange rates.

To suppose that there exists some smoothly functioning automatic mechanism of adjustment which preserves equilibrium if only we trust to methods of laisser-faire is a doctrinaire delusion which disregards the lessons of historical experience without having behind it the support of sound theory.

Keynes, 1941, CW XXV: 21–2

There is no doubt that contractionary monetary and fiscal policies implemented in defence of the fixed parity put a serious drag on real economic performance

Buiter et al., 1998: 37

It is characteristic of a freely convertible international standard that it throws the main burden of adjustment on the country which is in the debtor position on the international balance of payments. … that is, onthe country which is (in this context) by hypothesis the weaker and above all the smaller in comparison with the other side of the scales which (for this purpose) is the rest of the world. … The contribution in terms of the resulting social strains which the debtor country has to make to the restoration of equilibrium by changing its prices and wages is altogether out of proportion to the contribution asked of its creditors … the process of adjustment is compulsory for the debtor and voluntary for the creditor. If the creditor does not choose to make, or allow, his share of the adjustment, he suffers no inconvenience. For whilst a country’s reserve cannot fall below zero, there is no ceiling which sets an upper limit. The same is true if international loans are to be the means of adjustment. The debtor must borrow; the creditor is under no such compulsion.

Keynes, 1941, CW XXV: 27–8