Reasons behind the popularity of floating exchange rate policy

Exchange rates have been at the heart of numerous economic crashes, highlighted by the example of Argentina in the late ‘90s and the UK in 1992. In both cases, fixed exchange rates that were pegged at unsustainable levels caused speculators to take advantage of the country’s central bank policies, causing a massive and abrupt currency devaluation. In fact, history is replete with the adverse consequences of fixed exchange rate policies that do not allow for accommodation of changing economic circumstances and outlooks between countries. As such, there is no mystery why the dominant currency policy is one of flexible exchange rates that allow for changes in economic climate and internal economic growth. This trend is perhaps exemplified by developing economies like China progressively floating their exchange rate to capture the benefits of policy and free international capital flows.

The virtues of a flexible exchange rate cannot be appreciated without understanding the lesser alternative: a fixed exchange rate. Put simply, a fixed exchange rate represents a policy where a central bank assigns, or “pegs” a value to its own currency in terms of a foreign currency, often the United States Dollar. The benefits of this policy are clear and simple to understand to even the most casual of armchair economists. Fixed exchange rates can bolster confidence that investments made in that foreign market will not lose value as a result of fluctuating currency values. For example, if the Bank of Canada were to peg the Canadian Dollar at $0.75 USD, investors would know that $100 CAD held in an RBC bank account would be worth the same $75 USD tomorrow as it is today. Furthermore, the entailed currency value stability eliminates the possibility of massive value fluctuations and the resultant economic swings.

The near-term virtues of a fixed exchange rate, however, are grossly outweighed by the long-term downsides. In the case of emerging economies, which constitute the majority of countries with fixed exchange rates, a pegged currency value is based on existing market conditions. In the case that the currency is pegged above the value that financial speculators believe the currency is worth, financial capital steadily flows into the country, and the central bank must do nothing more than accept the foreign-denominated currency and print domestic money for the exchange. However, as the economy of that country grows, and as funds pour steadily into that country, the value of the currency tends to fall. This is thanks to the eventual exhaustion of investment opportunities that makes the currency less desirable. This is precisely the reason behind the 1990s currency crisis in Argentina. Originally fixed at a rate well below its perceived value, the Argentinian Peso was seen as a bargain for investors, encouraging foreign investment in the Argentinian economy and robust economic growth. However, as the currency value fell, Argentina was left with no choice but to try to hold out as long as possible. When eventually the Argentinian Central Bank announced a devaluation of its currency, the value of the money Argentinians held was drastically reduced, and foreign investors lost all faith in the currency’s value. This, ultimately, led to an immense loss of investor confidence and an economic downturn that spread throughout Latin America and crippled dozens of surrounding economies. One cannot help but observe that this sort of crash would have been entirely avoided were the Argentinian Peso a free-floating currency.

But how about in the case of a developed, stable economy? Surely an economy with much more sustainable growth might be able to reap the benefits of a fixed exchange rate without the risk? The answer, unfortunately, is no. The example of the English pound, a member of a fixed exchange rate agreement with Europe, came under speculative “attack” in 1992 when investors deliberately flooded the market for the currency, consequently driving the perceived currency value below the fixed rate. As the value fell, speculators dumped their holdings of the British Pound and any Pound-denominated debt holdings, further reducing the market value of the currency. Soon, British companies and investors were unable to gain access to financial credit and the economy slowed to a crawl. Even though the Pound Sterling had a highly advanced, stable, and well-managed economy to call home, unavoidable economic cycles and a few opportunistic speculators crippled the oldest central bank in the world. Once again, the superior option, a flexible exchange rate, would have absorbed the currency fluctuation. Perhaps the mild value fluctuations would have caused a mild economic downturn, but this would have replaced the reality of a momentous currency crash with global implications.

In short, the adoption of a fixed exchange rate can act as a salve for the short-term troubles of a flexible exchange rate and the inevitable fluctuations it entails. However, opting for a fixed exchange rate ignores the long-term need for a flexible currency that can absorb economic shocks and allow for an evolving local and global economic environment. Thus, the long-term trend of countries toward floating exchange rates is driven by a growth of economic education in developing economies, and the method’s clear superiority in providing a central bank with options to take policy stances and allow capital flows.

By,

Gordon Milne

Picture titled, "The Bank of England", taken by John Mitchell on July 6, 2011, obtained through Creative Commons (https://flic.kr/p/a1bySk).