Era May End for Floating Currencies

By JOSEPH KAHN

New York Times
January 2, 1999

Last year's dominant economic story might be summed up this way: When currencies float, economies sink.

From Thailand to Russia, many nations' currencies floated when their exchange rates against the U.S. dollar collapsed, often under pressure from speculators. Then, without exception, those nations' economies sank. The failure of links, or pegs, to the dollar, the world's benchmark currency, made it harder for Russia and many Asian countries to repay foreign loans and contributed to severe recessions.

The currency-induced turmoil has shaken some core assumptions of modern economics. For decades, the prevailing orthodoxy in monetary policy has favored floating exchange rates. Financial markets, not governments, should dictate the value of a currency, the thinking goes. Central banks should achieve policy objectives by raising or lowering interest rates to influence the market. Most major Western economies manage their currencies this way.

But one outcome of the global financial turmoil is that some economists are challenging that way of thinking, at least as it applies to smaller and less-developed countries. The debate seems likely to heat up this year and could well lead to the most radical shifts in the way economies interact with one another since the system of fixed exchange rates broke down in the early 1970s.

In Latin America, Eastern Europe and parts of Asia, leading economists, businessmen and government officials are pondering the idea of effectively abandoning their independent currencies, strictly curtailing the powers of central banks and linking themselves to one or another of the world's major currencies, especially the dollar or the euro, as the modern equivalent of gold.

"I sense a growing feeling in Asia and Latin America, particularly, that floating rates are fine for the United States but not so good for small countries," said Merton Miller, a Nobel prize-winning economist at the University of Chicago. "For many years, everybody in America thought floating exchange rates were the answer, but now there's a sense that this exacerbates the problem."

Miller has recently won converts to his long-held view that smaller countries should replace the central bank with a currency board, which in its pure form has none of the market-intervening powers of today's central banks. In this system, the country still issues currency, but the central bank by law agrees to exchange the currency at a preset rate for dollars or some other strong foreign currency. Money supply is dictated by the central bank's reserve of hard currency, meaning that the quantity of local currency fluctuates depending on how much foreign currency the country gathers through trade or investment.

A leading benefit of currency boards, proponents say, is to remove the power of central bankers who use money supply to manipulate their economies, often for political purposes.

"Currency sovereignty is the right to have stagnant growth because the central banks screw up all the time," said Rudiger Dornbusch, an economist at the Massachusetts Institute of Technology. "In this environment it is increasingly ridiculous to argue that every country must have its own central bank."

Today, only a handful of governments, including those of Hong Kong, Argentina and Bulgaria, have currency boards, which were a common management tool for colonies in the British empire. Hong Kong and Argentina back their local currencies with U.S. dollars, while Bulgaria guarantees convertibility with the German mark at a fixed rate.

Though countries with currency boards have been affected by the same global turmoil that struck their neighbors -- Hong Kong's economy is in a deep recession -- the currency boards have so far survived. They have given the developing world a rare example of monetary stability. Hong Kong, Argentina and Bulgaria are widely seen as better positioned than their neighbors to rebound quickly, in part because outside investors have faith that if they invest in those nations they won't face the risk of devaluation before they get their money back.

Making money stable has been the greatest monetary challenge of the ages. Stable currencies promote trade and investment, which have become increasingly important drivers of economic growth in recent years. Historically, countries sought to make their currencies solid by stocking treasuries with gold, which prevailed as the monetary standard in the United States from the late 19th century until the Great Depression.

With the decline of classical economics in the 1930s and '40s, economists turned against the gold standard and promoted the creation of bigger and much more powerful central banks. Now the tide appears to be shifting again, in favor of smaller central banks and more rigid currency regimes.

One of the biggest contributors to that shift, of course, is European monetary union, which took effect Friday. The 11 participating nations are replacing their currencies with a single currency, the euro, and a single central bank, a once unthinkable sacrifice of national monetary sovereignty in favor of a high-minded economic ideal.

"The euro is a great example of how the world is going to look," said Sebastian Edwards, a professor of international economics at the University of California at Los Angeles. "The euro itself will float against the dollar and other currencies, but member countries will have rigid exchange rates among themselves."

Indeed, many economists see the world eventually dividing into two or three currency zones, one ruled by the euro, one by the dollar and perhaps a third, farther in the future, that uses the Japanese yen or Chinese yuan as an anchor. Each smaller country in a region would either simply accept the benchmark currency as legal tender at home or adopt a currency board.

No one expects the transition, if it happens at all, to come overnight. The International Monetary Fund has favored the use of currency boards in some cases but discouraged them in others. Some leading economists argue strongly that free-floating currencies are still the best system. And many analysts agree that the leading enemy of monetary stability is not a genuine free float but currency alchemy, the kind of monetary distortion that may occur, for example, when a country tries to have the fixed exchange rates of a currency board but still gives its central bank power to manipulate exchange rates and money supply.

Alan Greenspan, the Federal Reserve chairman, has warned against quick-fix solutions to fundamental problems in emerging markets, arguing that tinkering with currency regimes is no substitute for sound macroeconomic management.

"Many emerging-market economies have tried a number of technical devices: the fixed rate peg, varieties of crawling peg, currency boards and even dollarization," Greenspan said in a recent speech. "The success has been mixed. Where successful, they have been backed by sound policies."

Still, some economists say they would not be surprised if the move toward currency boards gathers momentum in coming months or years. Among the countries most likely to adopt them are Brazil, Mexico, Russia and Indonesia. The issue is being debated in all those countries.

Brazilian economists and politicians are considering whether to follow Argentina's lead by linking the real to the dollar, creating the core of a currency alliance that would tie those two countries together with Uruguay and Paraguay. A vocal group of Mexican economists and businessmen are pushing for the dollarization of the economy -- abandonment of the national currency altogether in favor of reliance on the American dollar -- though few see that outcome as imminent.

Indonesia explored setting up a currency board last year, before the Suharto government collapsed, and the idea may be revived as the nation struggles to restore order to its economy. Russia is under pressure to take radical steps, including establishment of a currency board, to restore some credibility to the battered ruble.

Those nations would have to sacrifice sovereignty over areas of monetary management that were once considered purely national. But the lesson of the recent world turmoil may be that currency management is fundamentally international anyway.

"Remember that Germany and France had deep enmity extending back many years," Miller said. "They came together to form the core of the euro countries. Who's to say that Brazil and Argentina, or China and Japan, cannot resolve their grievances? I think that sooner or later they will realize that this is the way to go."