We Can’t Fix Money Rates Among Equals

After World War II, officials in Washington endowed West Germany and Japan with undervalued currencies. Cheap marks and yen would revive stricken enemies by fueling export industries.

The policy succeeded beyond anyone’s dreams, and both nations have now more or less reached American standards of technology and consumption.

So when the former enemies clearly were threatening to reach economic equality with the United States in 1971, the balance was altered. Pushing an open door, the principal U.S. trade partners compelled a willing Administration to devalue the dollar and tear up the postwar system of fixed or stabilized exchange rates. President Richard M. Nixon billed all this as the greatest monetary event since the money changers were driven from the Temple. Currency rates have been moving uneasily against each other ever since.

There are some simple lessons in this for Federal Reserve Chairman Paul A. Volcker and Treasury Secretary James A. Baker III. Exchange rates can be fixed or stabilized only when the world is blessed with a dominant economy. Great Britain could enforce a gold standard after a fashion in the 19th Century; the United States could run a dollar exchange standard, with thehelp of the International Monetary Fund, for the first quarter-century after World War II. But once other economies catch up to the leader they will no longer surrender their exports at cut-rate prices--one way of defining an undervalued currency--and insist on a full measure of goods and services in return. Once shortages and backwardness ended, the West Europeans and the Japanese would no longer stuff national piggy banks with unlimited quantities of dollars purchased with too many European and Japanese products. Businessmen have been forced to get used to the forward buying and selling of currencies that float; they can no longer be fixed against the dollar.

This is a pity, no doubt, but not nearly as bad as the stabilized exchange-rate system that Baker claims he seeks on alternate days of the week. In the present circumstances, fixed or stabilized exchange rates mean quite simply that the United States must adapt its domestic economic policy to its most austere partner, West Germany. To keep the dollar and the mark together, Washington must tailor American living standards to the peculiar notions of Bonn. West Germany now enjoys high unemployment and falling prices, a deflation crying out for expansion. But West Germans are flagellants, and want more of what they have. That is their privilege. But how grim, how unnecessary to impose on us.

In a stabilized system we, too, must deflate, or the mark will, as it has, rise against the dollar. Similarly, to keep the dollar in step with the yen, the United States must cut back on living standards to stay even with an economy in which prices fall and unemployment rises. Baker argues plausibly that there is an alternative to U.S. deflation--that the West Germans and the Japanese should reflate, expand. Japanese Prime Minister Yasuhiro Nakasone seems to have partly agreed with this view, promising to lower interest rates by some infinitesimal amount. But, for the most part, Japan and Germany do not reflate, and the conventions of international banking bless them for not doing so. Under the unwritten rules, a positive trade balance and a rising currency are virtuous; a trade deficit and a falling currency are sinful. This is a piece of neo-mercantilist nonsense that guides all central banks and treasuries. It demonstrates the absurdity of Baker’s attempt to stabilize currencies.

Happily, finance ministers and central bankers are too feeble to enforce any stabilizing impulse. The puny attempts of central banks to influence exchange rates by intervening with $10 billion or so daily are swamped by the capital flowing across unregulated exchanges. Large banks, corporate treasuries and other big-time money operators shift more than $100 billion in an ordinary day. Baker and the others should stop pretending to power that they do not have, cannot have and should not have.

But in a wicked world won’t a falling dollar inevitably mean costlier imports, higher prices, a Federal Reserve money squeeze, rising interest rates and the very austerity that fixed rates threaten?

This is a scenario that many business economists almost welcome. But things need not happen this way. Any rise in foreign prices comes against a slack U.S. economy with official unemployment near 7% and unused plants at 20% or higher.

If classical competition existed among autos, electrical machinery, newspapers and the rest, these firms, not consumers, would have to absorb the increased foreign costs. But in fact there almost certainly would be some inflation, because classical competition exists in so few industries.

This is inflation flowing from oligopoly or monopoly power, and should not be treated by broad-brush remedies of tighter money and higher interest rates. The Federal Reserve is unlikely to be impressed by this advice. Essentially it knows one thing: When prices rise, turn the screw, regardless of what forces drove the prices higher. The behavior of central banks should not alter the critical point: It is a gross error to attempt to stabilize exchange rates, fix the unfixable, in a world of economic equals.