Floating vs Fixed Exchange Rates

The arguments in favor of floating vs fixed exchange rates carry more or less weight depending on the circumstances of the day, and the viability of whatever system if fixed rates is under consideration.

Modern history is not exactly bursting at the seams with stories of successful fixed exchange rate systems, but much of the blame for that rests, as usual, with incompetent self-serving governments.

Two of the most recent examples of failed attempts to fix the values of currencies, or 'peg' them within certain bounds, are the:

  • Bretton Woods System that came into effect after the Second World War, with the seeds of its eventual collapse sown in 1971 when Richard Nixon suspended the US Dollar's convertibility to gold.
  • Exchange Rate Mechanism (ERM) of the European Union, which collapsed in the 1990s after East and West German Unification led to a huge increase in spending by the German government, followed by a higher interest rate that led to an appreciation of the Deutsch-Mark against other European currencies.

Both of these failures are typical of the failures that have always plagued fixed exchange rate systems i.e. when it comes down to it, a government's commitment to maintain the system crumbles almost as soon as it threatens their popularity at the ballot box. 

On this page I will take a look into the advantages and disadvantages of floating vs fixed exchange rates.

Freely Floating Exchange Rates

In the purest form of Floating exchange rates the government takes a completely hands-off approach and allows the market to determine the correct rate of exchange at all times. This leads to a system in which the Balance of Payments is always in balance (except for calculation errors) meaning that the central bank never has to intervene to maintain the accounts.

For example, if there is a deficit on the accounts it would simply mean that the domestic currency is priced too highly and needs to depreciate in order that its exports can become relatively more competitive in other countries, and vice-versa for foreign imports. This process of depreciation of the currency will continue until the deficit disappears.

Managed Floating Exchange Rates

Managed Exchange Rates, also known as a 'dirty float', is a system whereby the central bank does not try to maintain any given value of its currency, but it is prepared to intervene in the foreign exchange market during periods of volatility so that any transition phase can run smoothly without the currency appreciation too high or depreciating too low on its path to a new market-clearing valuation.

Floating Rate Advantages & Disadvantages

Advantages:

The advantage of floating exchange rates comes with its in-built automatic stabilizing effects on economic activity. For example, consider an economy that is falling into recession. With declining profits from domestic businesses, stock values will fall and investment will flow out of the economy in search of more profitable opportunities in other countries. As this happens the demand for domestic currency will fall and that of foreign currency will rise.

The inevitable result is that the exchange rate will automatically and immediately start to depreciate as the recession begins. This will make imports more expensive for domestic consumers whilst exports become more competitive on overseas markets. Both of these effects give a helpful boost to the economy precisely when it is most needed.

For an overheating economy, the reverse process will apply which will help to cool down the economy.

Disadvantages:

The main quoted disadvantage of floating vs fixed exchange rates is that governments have extra freedom to manipulate the economy in the short-run because it is free from any monetary policy commitment to maintain the currency at a given exchange rate. This frees the government to, for example, create a short-term boom ahead of an election in order to gain popularity and votes. This is undeniably a concern, but the failing is that of government, not the floating rate system itself.

As I will explain in the summary at the bottom of the page, government self-interest and ambition is not contained by abandoning floating exchange rates, and the eventual consequences of inappropriate policy tend to be worse under alternative systems. 

A second disadvantage with a floating rate is that international traders have to try to hedge against currency movements with contracts in the derivatives markets. The need for these contracts is based on the fact that firms need time to fulfill orders, and orders that come from overseas customers are subject to more exchange rate risk the longer the time period that fulfilling the order requires.

Most international trade contracts are negotiated in terms of US Dollars, even when neither party to the contract is the USA, so an insurance against currency movements in the form of a forward-contract is usually required, and comes at some expense without completely negating all types of risk.

Fixed Exchange Rates i.e Pegged Rates

In order to maintain a fixed exchange rate, the central bank intervenes in the foreign exchange market by agreeing to buy and sell its currency at a given price. That price will depend upon what exactly the domestic currency is being fixed against. If the UK pound, for example, were to be fixed against the US dollar at 0.7 GBP per USD, then the Bank of England will buy and sell US dollars for 70 pence.

Since the Bank of England guarantees this price, no one will give up a US dollar for less than 70 pence, and no one will pay more than 70 pence to gain a dollar - so the exchange rate is fixed.

I should point out here that the exchange rate can be fixed against commodities as well as other currencies. The Gold Standard was a system in which national currencies were fixed against the price of gold, and central banks would convert their currencies into gold at a fixed price. The Bretton Woods system was a de-facto gold standard whereby the US pegged the dollar to gold, and other member countries pegged their currencies to the dollar.

Fixed Exchange Rates, Advantages & Disadvantages

Advantages:

The implications of fixing the exchange rate require that a country's money-supply cannot be allowed to fluctuate, because just as altering the supply of a good/service would cause a change in its market selling price, so too would the the relative price of the currency on the foreign exchange markets. The primary benefits of this are twofold:

  1. Proponents argue that fixed exchange rates should deliver lower inflation rates because the government is unable to boost their economies via loose monetary policy (because that would influence the currency's value).  However, fiscal policy is actually more powerful under this system, so the ability to generate a boom with resulting inflation remains.
  2. The main benefit of a stable monetary system and fixed exchange rate is that it will make foreign trade less risky, and that should lead to greater economic benefits through increased trade with other countries. 

For a better understanding of how monetary policy and fiscal policy would function with floating vs fixed exchange rates, have a look at my page about:

Disadvantages:

  1. If, for whatever reason, domestic inflation runs at a different rate to that experienced in other member countries of the fixed rate system, there will be gradually increasing pressure for a devaluation (or revaluation) which would undermine the whole point of fixed rates. Pressure would grow because inflation erodes the real value of a currency i.e. it reduces its purchasing power compared to other currencies. When this happens the foreign exchange markets will quickly start to speculate against that currency, and as these speculators start to short-sell, things can quickly escalate out of control and force a devaluation.
  2. There is also a problem in that it is quite difficult to know the correct rate at which to fix rates in the first place. For example, the ERM had economic convergence criteria built into the 'Maastricht Treaty' as a prerequisite of membership, but it said nothing about whether economies should be heading in the same direction at the point of convergence, and if one country is tending towards growth when another is slowing down then the growing country will tend to have a stronger currency in subsequent years. Fixing at the point of convergence doesn't achieve much in these circumstances.

Floating vs Fixed Exchange Rate Summary

On balance it is very difficult to argue in favor of fixed exchange rates. Floating exchange rates have prevailed for most countries in modern times precisely because of the severity of failed fixed rate systems, and why would we expect anything else? A fixed exchange rate is basically a government interference in the workings of a free-market price system, and I am unaware of a single success story relating to price-controls.

You might have thought that the costs of the failed ERM would have deterred the European Union countries from any further integration of their economies, but the precise opposite occurred. When economic facts get in the way of political ambitions you can be sure that politicians will serve their own interests ahead of any concern for the people they purport to serve...

The response to the ERM collapse was to march on regardless and enter a sort of fixed rate system that cannot be broken by international flows of money i.e. a currency union. The Euro was born out of failure, and now, when member countries suffer recession and need to depreciate their currencies to boost their economies, they find that they are powerless to do so.

Many of the southern European countries in the Eurozone, most notable Greece, Italy and Spain, have been economically devastated since the 2008 financial meltdown, and crippled with falling GDP, sky-high unemployment rates, and mounting debt levels that they are powerless to repay.

This is the true economic cost of a fixed exchange rate system that cannot be broken - an inability to react and adjust in a way that can improve competitiveness and stimulate recovery. Far from promoting stability, fixed exchange rates have a long track record of severely exacerbating instability.

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