Floating all boats
Jan 14th 2010
From The Economist print edition
The link between exchange rates and asset markets
Illustration by S. Kambayashi
FOR 100 years after 1870 governments and central bankers struggled to maintain a system of fixed exchange rates. When the Bretton Woods agreement collapsed in the early 1970s the three leading economies of America, Germany and Japan accepted that their currencies would float against each other. So it has been ever since.
The period since the Bretton Woods system fell apart has also seen enormous bubbles in asset markets, a huge expansion of the financial sector and a rapid rise in consumer debt. These developments are no coincidence. Floating exchange rates and booming asset markets have reinforced each other.
Previous exchange-rate systems had been linked, directly or indirectly, to gold. The aim was to put a constraint on the ability of governments to debase their currencies by printing money. The corollary was that countries found it hard to fund trade deficits for long.
With floating exchange rates, the trade constraint was removed. This allowed America to enjoy its long-running deficit. But as Richard Duncan pointed out in his prescient book “The Dollar Crisis”, published in 2003, it also let other countries run huge surpluses.
This was no longer a zero-sum game. Surplus countries built up their foreign-exchange reserves. These either translated into bubbles at home (for example, Japan in the 1980s) or fuelled them abroad (America in the past decade).
The move to fiat money (paper not backed by gold) created the huge expansion in global money supply that the pessimists had predicted. According to Mr Duncan, under Bretton Woods global foreign-exchange reserves grew by 55% between 1949 and 1969. They then grew by almost 2,000% between 1969 and 2000. This extra money was used to push up asset, rather than consumer, prices.
Freed from the need to defend their currencies, and with consumer inflation a minor problem over the past 20 years, central banks could afford to let interest rates drift steadily lower. Even countries with pegged exchange rates, such as Latvia and China, “imported” the loose monetary conditions of the developed world. This policy put a floor under asset prices and eventually created the conditions for the credit crunch of 2007-08. Only by lowering rates almost to zero have the authorities managed to stabilise matters again.
This process helps explain why equity and house prices reached peaks in recent years that were unknown under fixed exchange-rate systems. It also suggests why floating rates did not deter cross-border investment.
In the first half of the 20th century foreign investment was largely in the form of bank deposits and government bonds. This was partly due to investor caution and partly due to capital controls. The yields on such instruments were fairly low, making investors very sensitive to any exchange-rate changes. A burst of depreciation could wipe out years of profits.
Furthermore, shifts in exchange rates, when they came, tended to be big. Devaluation was seen as a national humiliation, so was resisted until the last minute. By that stage the exchange rate was well out of line with the fundamentals.
Since 1970 exchange-rate moves in developed markets have generally been dwarfed by asset-price shifts. (The exceptions have occurred in countries that have tried to maintain currency pegs.) Currency risk has been of such little concern to institutional investors that many do not bother to hedge it. Indeed a popular tactic has been the “carry trade”, borrowing low-yielding currencies to buy higher-yielding (and higher-risk) currencies.
It is no mystery why developed countries abandoned fixed rates. By anchoring the currency, governments forced the real economy to absorb shocks. This implied wage cuts or higher unemployment, all for the benefit of creditors. But in a democracy the votes of debtors tend to overwhelm the interests of creditors.
This battle is about to be re-enacted in the euro zone, where higher-cost countries have tied themselves to a new gold standard, in the form of the hyper-efficient German export machine. That implies the need to keep the lid on deficits and wage growth.
But a floating-rate system is not a free lunch either. It has been accompanied by a rise in debt burdens that will be a deadweight on economies for many years. The credit crunch has shifted the burden of servicing that debt from the private to the public sector. An era of austerity, which the floating-rate system was designed to avoid, is going to occur after all.
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