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Exchange Rates, Currency Areas
and the International Financial Architecture

by Dr. Robert A. Mundell, Columbia University
1999 Nobel Laureate Economics

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Remarks delivered at an IMF panel, September 22, 2000, Prague, Czech Republic.

It is important to realize the significance of the change that has come upon the world with the creation of the euro. We no longer think in terms of flexible exchange rates, but rather of currency areas. And increasingly, we will no longer think of a dollar-dominated international monetary arrangement but one in which the power is shared by the dollar, euro and yen areas, with a residual amount of power held by the IMF representing the other countries. This is in my view a great step forward, because it will bring forth new and for once meaningful ideas about reform of the international financial architecture. The euro promises to be a catalyst for international monetary reform.

Alternative Monetary Targets

If international financial architecture has any meaning at all, it applies to the exchange rate arrangements at the core of the world economy, the anchor for achieving and numeraire for measuring global price stability, and management of a world currency, if one exists. In other words there is no financial architecture today, and the problem of reform is to create it.

In my Nobel Memorial lecture, I referred to the first and last decades as "bookends" of the twentieth century because they were each decades of price stability, sandwiching in between mixed decades of stability and instability. But there the similarity ends. Price stability was achieved in the first decade through a highly efficient international monetary system, the international gold standard, a system that also provided the world not only with fixed exchange rates but also the bonus of a world currency. The last decade provided the core regions with price stability achieved through inflation targeting but with extreme volatility of exchange rates, and no trace of a world currency. In that sense we are not as well off as we were a century ago.

A major issue among officials and economists is the choice between fixed and flexible exchange rates. It is a false issue because it is a choice between incomparables. A fixed exchange rate system commits monetary policy and is therefore a monetary rule. It cannot be compared to flexible exchange rates, which is merely the absence of that particular monetary rule, and is indeed consistent with any monetary policy at all, including hyperinflation. A fixed exchange rate system has to be compared with other monetary rules, such as inflation targeting or monetary targeting. Only then can a meaningful comparison between systems be made.

Some countries do not have the option of fixed exchange rates. A fixed exchange rate presupposes a currency to fix to. The United States cannot find a currency to fix to. When, back in 1944, the United States insisted on insertion of the gold clause, Article IV-4-b, to exempt it from the exchange rate requirement, it was reflecting the reality of the dominant currency. Small countries can fix to big countries and import the inflation stability of the latter but not the other way around.

The three major currency areas have each achieved a high degree of price stability, more or less consonant with desired targets of 0-3 per cent inflation. Why between such areas of price stability is it necessary to have exchange rate changes? We have seen the euro drop by almost 30 percent from its starting point against the dollar, and this in less than two years. Can this volatility be expected to continue?

Exchange Rate Volatility

At best only hints can be got by looking at the predecessors of the euro, the ECU and its backbone, the DM. Think of the volatility of the DM-dollar rate over the past 25 years. In 1975, the dollar was about 3.5 DM. Five years later in 1980, it was half that, 1.7 DM. Five years later, it was 3.4 DM, it had doubled. And then in 1992, the dollar had gone down below 1.4 DM in the pit of the ERM crisis in August 1992. And now the dollar is up around 2 or 2.05 DM. These are tremendous fluctuations. If they were to occur in the euro-dollar rate, it would bring great damage to the stability of the euro- zone economies. The danger is not just in the falling euro. When the dollar cycle turns, the euro could soar far beyond what would be viable for European employment.

Nor is a look at the history of the yen-dollar rate comforting. For a quarter century after 1948 the dollar was 360 yen; in 1985, before the Plaza Accord, it was around 240 yen; ten years later it had fallen to 79 yen. And then three years later, in June 1998, it had soared to 148 yen, bringing on the Asian crisis; and then suddenly it came down 105 yen. Volatility of this type destabilizes financial markets, disrupts trade and creates extremely difficult conditions for the rest of Asia.

At the time of the historic Bretton Woods meeting in 1944, the architects of the IMF realized that exchange rates -- and especially the exchange rates of the major countries -- were a matter of multilateral concern and had to be managed for the benefit of all countries, a concept that has been lost in recent years.

The appreciation of the dollar against the yen between 1995 and 1998, following hard on the heels of the devaluation of the renminbi, is to blame for the so-called Asian crisis. I use the term "so- called" because at least five countries escaped it: Singapore, China, Hong-Kong, Taiwan and Japan. These countries had two things in common: a precise target for their monetary policy, and more than ample foreign exchange rate reserves.

Stable Prices and Stable Exchange Rates

I mentioned before that virtually all of the great classical economists believed strongly in fixed exchange rates. It might be thought that Keynes was an exception, but he was not. Keynes, back in 1923, published a little book called "A Tract on Monetary Reform". In it he made the famous distinction between internal and external stability. He argued that countries might have to choose between stabilizing their price level or their exchange rate, when, for example, the price level in the rest of the world is unstable. In that case the country should give priority to stabilizing its internal price level. But if the rest of the world was also stable, then the authorities should have a secondary goal of stabilizing the exchange rates. Keynes was quite insistent on it and I believe he was completely right, as he was when he supported the gold-based fixed exchange rate system at Bretton Woods.

I believe that philosophy is just as true today as it was in Keynes' day. We need to move towards a system that would try to stabilize not just the world price level but the exchange rates among the major currency areas, i.e., the dollar-yen and dollar-euro rate. A monetary economist knows that, when a central bank wants to expand, ease monetary conditions, it has to expand its balance sheet, which it can do in one or both of two ways: buy domestic assets or buy foreign assets. Alternatively, to tighten up, it has to contract its balance sheet, and sell either domestic or foreign assets. The European Central Bank -- and I also have to say the Federal Reserve Bank -- has this strange notion that it should restrict its intervention to changing its domestic assets, while not touching -- heaven forbid! -- its foreign assets. Why have foreign assets? "Domestic assets only" is just the wrong principle. It is pretty obvious that when the euro overshoots in one direction -- say the downward direction which is the current situtation -- it is preferable to sell foreign assets rather than domestic bonds. It may not even be desirable at all to sell bonds and raise interest rates.

I wrote about this issue in some detail in the Wall Street Journal in March and I can't labour it now. But let me say that I believe that exchange rate volatility is a major threat to prosperity in the world today. It is volatility of exchange rates that causes unnecessary volatility in capital markets. Whenever the exchange rate overshoots it affects the real value of taxes, the value of all financial assets, the domestic price level and eventually wage rates. An unstable exchange rate means unstable financial markets, and a stable exchange rate means more stable financial markets.

But how do we go about getting more exchange rate stability? One problem is that there is no general acknowledgement that it is a good idea. Both the European Central Bank and the Federal Reserve System have been trumpeting inflation targeting and benign neglect of the exchange rates. But you have to realize that these institutions change their mind frequently. In 1981 the Federal Reserve finally reversed the depreciation of the dollar of the late 1970s, and then, when the dollar soared far above its equilibrium, the Treasury called in help from the G-5 at the Plaza meeting in 1985 to manage the dollar down. Again, at the Louvre meeting in 1987, monetary officials were worried that the dollar was going down too much and too rapidly! What is pablum one day is castor oil the next. What is clear is that free market exchange rates do not guarantee equilibrium exchange rates.

At long last, Europeans have begun to worry that the depreciation of the euro may build up inflation in the monetary pipeline, and someone may get the idea in the United States that a high dollar coupled with a 4.2 per cent current account deficit and (a change from the 1980s) a large net debtor position, is dangerous for the United States.

A Digression on the Euro

My main concern today is with a permanent improvement in the international monetary system. But I cannot refrain from making a digression to speak about the sagging euro. I do believe that two measures would be of great help. The first would be for the European Central Bank to put a floor to the euro against the dollar. And because the future may bring the other problem of a too rapid fall of the dollar, I would put a ceiling on it as well. I would start today with a floor at 85 cents and a ceiling at 115 cents, but over time it would be possible and desirable to narrow these levels substantially. Of course I am aware that such bands will require that monetary policy take account somewhat of the balance of payments and the exchange rate. Optimally, intervention should: (1) have a clearly-stated objective (e.g., support the floor or ceiling); (2) take place in the forward as well as the spot market; (3) not be sterilized; and (4) be concerted with partners.

The second measure I would suggest would be to utilize some of the vast gold reserves of the EU to produce a gold coin, a europa equal to 100 euros, that would be an overvalued legal-tender coin. It was a mistake to delay for three years the introduction of the paper currency and coins and the production of a gold currency would heighten general interest in the euro at the same time put the EU's excess gold reserves to good use.

A G-2 Monetary Union?

I want to emphasize, however, that achieving price stability and fixed exchange rates among the G-3 is much easier to achieve -- from at least a technical point of view -- than people generally think. It might be hard to think of a currency union of the three currency areas at the same time. But in fact a union of any two would be sufficient to set the trend. The three currency areas have monetary masses more or less corresponding to their respective GDPs, the ratio of about $9.5 trillion, $7.0 trillion, and $5 trillion respectively, together making up perhaps 60 per cent of world GDP. A monetary union of any two of the areas would make it the dominant currency area and thus make it very attractive for the third area to join because the alternatives would be worse. Any one of the three could opt out and accept the number two position.

How would monetary union between two of the G-3 countries come about? The clue is provided by what the EU-11 did. To do that, they had to have a common agreement on (1) the targeted inflation rate; (2) a common way of measuring the inflation rate (Eurostat's harmonized index of consumer prices, HICP); (3) redistribution of the seigniorage (in proportion to equity in the ECB); (4) locked exchange rates; and (5) a centralized monetary policy. Europe did that. Why would it be more difficult to do it between, say, the dollar and the euro, or the dollar and the yen, or the yen and the euro? The rate of inflation is close enough, the inflation target is about the same, why not just lock exchange rates and organize a common monetary policy? It would be administratively and institutionally easy and the politics would not be more difficult than, say, the organization of D-Day.

It is very convenient to have a division of responsibilities. Suppose the ECB -- the new boy on the bloc -- were given the task of fixing the euro to the dollar and does nothing else; in other words purchases and sales of foreign exchange determine monetary expansion or contraction as in a currency board system. If then a committee of both the Federal Reserve and the European Central Bank made decisions about expansion and contraction (or raising or lowering interest rates), by buying or selling either European or American bonds, the monetary union would be in full swing. Adding the third member would not be any more difficult. It makes things easier to choose one of the three currencies as the leading currency, while the other two currencies would be locked to that leading currency, and monetary policy would be based on a decision to expand or contract according to the decision the joint G-3 open market committee judged was needed to fulfil their planned inflation target.

If a G-3 fix and union could be achieved, it would be a comparatively simple matter to expand it to take into account the rest of the world or at least the other members of the IMF. A common unit of account could be established that could have a fixed and stable relationship to the G-3 currencies, and which could become the official unit of account -- an intor -- for the IMF and World Bank. At long last, an international financial architecture would come into being.

A World Currency

It looks as if we are a long way from that position now. Yet it is surprising how quickly moods can change and producers of statecraft can escape the old modes of thought. The idea of a world currency is much older than most people think. Julius Caesar set Rome and for many purposes most of the world on the track of a universal union of account which flourished in the days of Caesar Augustus and its currency descendants lasted until the breakdown of the gold standard. The Italian Gasparo Scaruffi (1519-1584), a merchant and banker from Reggio Emilia, published in 1582 an impressive work on money that contained a viable proposal for the establishment of a universal mint, the adoption of one uniform coinage throughout Europe, with the same shape, weight and name in every country, "as if the world were one city and one monarchy." His work was called Alitinonfo, a name derived from the Greek meaning "true light," and taken from his desire to spread true light on the subject of money.

Back in the nineteenth century, at the Paris conference of 1867, a plan for a world currency linked to gold coins in multiples of 5 gold French francs was widely discussed but never achieved the agreement of Britain, the world's leading financial power. Less than a century later, by the time of Bretton Woods, a world currency figured in both the major plans for the post-war world monetary order. The British plan -- essentially Keynes' plan for a World Clearing Union -- envisaged a world currency called "bancor." The official American plan -- essentially Harry Dexter White's plan for a "fund" -- also contained a plan for a world currency called "unitas." In the negotiations leading up to the charter itself, however, the Americans backed away from the idea of a world currency and insisted on an international monetary system based on gold and the dollar. When gold became undervalued by post-war inflation, the dollar reigned supreme.

Each time the idea of a world currency comes up, it runs afoul of the ambitions of the dominant power, which is content to see its own currency elevated to monarchical status. It was Britain in the nineteenth and America in the twentieth century that rejected the idea of world currency.

For those who like numbers, we are now in a millennium. One millennium ago, we had the gold besant, a universal unit of account. Earlier, it had been called the solidus by Constantine the Great. In the age of Caesar Augustus, the Roman aureus was the universal unit of account. We had those expressions of world currency in the past and I think we can recover them again under our new political trappings. Searching in that direction for a universal unit of account will have to take account of present realities, which means the dollar, euro and yen. There is no point talking about international financial architecture unless we are talking about the exchange rates of major currencies and "world money."

In an article in the New York Times in February of this year Paul Volcker said: "A global economy requires a global currency". I heartily endorse that statement. So I close my remarks by saying not just international monetary reform is not impossible, but that it is quite possible and I think that there is a chance that it might come about in the next decade. All it takes is monetary will.

Thank you.

For the past twenty five years, Robert Mundell has been Professor of Economics at Columbia University in New York . He studied at the University of British Columbia and the London School of Economics before receiving his Ph.D. from MIT. He taught at Stanford University and the Bologna (Italy) Center of the School of Advanced International Studies of the Johns Hopkins University before joining, in 1961, the staff of the International Monetary Fund. From 1966 to 1971 he was a Professor of Economics at the University of Chicago and Editor of the Journal of Political Economy; he was also summer Professor of International Economics at the Graduate Institute of International Studies in Geneva, Switzerland. In 1974 he came to Columbia University. He has written extensively on the history of the international monetary system and played a significant role in the founding of the euro. In 1983 he received the Jacques Rueff Medal and Prize in the French Senate; in 1997 he became a Distinguished Fellow of the American Economic Association; in 1998, he was made a fellow of the American Academy of Arts and Science; and in 1999, he received the Nobel Memorial Prize in Economic Science.

Dr. Robert A. Mundell
Dept. of Economics
Columbia University
New York, NY 10027
U.S.A.
Tel: (212) 854-3669
Fax: (212) 854-8059
ram15@columbia.edu

Copyright © 2000 by Dr. Robert Mundell. All Rights Reserved.

This article reprinted at USAGOLD with permission.

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