Economic Instability and Flexible Exchange Rates 9789814377232

Table of contents :
Opening Address
Economic Instability and Flexible Exchange Rates
APPENDIX
THE AUTHOR

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Economic Instability and Flexible Exchange Rates

This paper was originally prepared for delivery at a seminar sponsored by the Institute of Southeast Asian Studies, in Singapore on 12 April 1982, and revised for publication with data available through October 1982. The author wishes to thank William M. Reichert, who provided valuable assistance throughout the preparation of this revision.

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1983 Institute of Southeast Asian Studies

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Economic Instability and Flexible Exchange Rates

A seminar organized by the Institute of Southeast Asian Studies 12 April 1982 Singapore

Robert V. Roosa

INSTITUTE OF SOUTHEAST ASIAN STUDIES

Opening Address K.S. Sandhu Director Institute of Southeast Asian Studies

Ladies and Gentlemen, Let me first of all welcome you and say how much we look forward to your participating in this afternoon's deliberations. We are also particularly pleased to welcome Mr George Bogaars and Mr Chua Chor Teck of Keppel Shipyard, which has worked closely with us to make Dr Robert Roosa's presence here possible. Of course, in the final analysis it has been Dr Roosa's and your co-operation that has made this afternoon's gathering possible, and we are most grateful to you, Dr Roosa, for taking time off from your busy schedule to be with us this afternoon. Dr Roosa is well known in both banking and economic circles. All of you have his complete curriculum vitae with you. It, therefore, suffices for me to state that as a Former Under-Secretary of the U.S. Treasury and a member of the Federal Reserve Board, and as an adviser or a consultant to a number of organizations, he brings a wealth of experience to today's gathering. In short both his present position and past responsibilities should make for a most interesting discussion this afternoon. The theme of the seminar - Economic Instability and Flexible Exchange Rates - is not only topical but of considerable significance in view of the current monetary disorder and the buffetings that small and developing countries are being subjected to by the unpredictable ups and downs of the major currencies. While it may be too much to expect Dr Roosa to provide answers to all our concerns, nevertheless there will be ample opportunity to explore possibilities. Towards this end, Dr Roosa will deliberately keep his presentation short so as to allow more time for discussion and comments. My role will be merely to facilitate meaningful dialogue. I therefore have great pleasure in calling upon Dr Robert Roosa to make his presentation.

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Economic Instability and Flexible Exchange Rates The causes of instability in the world economy are legion, but the international monetary system has to share some of the blame for the fluctuations that have occurred in recent years. To be sure, that same vibrant and expanding monetary system also deserves some of the credit for making possible the great expansion of production and trade that has occurred around the world since World War II. In supporting that growth, the various institutions engaged in international finance have created truly remarkable innovations throughout a world-girdling array of banking facilities and capital markets. But as the monetary network has proliferated, and promoted world-wide growth, its new characteristics have at times had the perverse effect of aggravating instability and distorting the economic allocation of resources, both within individual countries and in the flows of goods and capital among them. One source of instability or distortion comes, quite simply, from erratic or excessive growth in the money supplies created by the deposit expansion of the various banking systems. Such expansion is no longer only that of individual countries but also that of the extraterritorial ("offshore") markets which have since the sixties generated amounts of bank-deposit money roughly comparable to those of the various national monetary systems. A second unstabilizing influence comes from the piling up of credit risks that banks incur within a given country, or across national frontiers, as they aggressively expand their deposits. For the same expansion of credit which supports real economic growth can also, if provided by means of an excessively rapid expansion of bank-deposit money, become a top-heavy burden for borrowing firms or nations. When borrowers cannot put the proceeds to work producing a large enough income stream to service the debt, retrenchment has to occur - either through deliberate action or the imposed contraction brought on by extreme inflation at home or shrinking markets abroad. Meanwhile, as lenders find themselves with increasing amounts of non-performing loans, they begin to reduce new lending, and thereby accentuate instability. l

The third potential for instability and maldistribution arises from the volatile performance of exchange rates, particularly as they become influenced by financial forces distinct from the basic balance of trade. It is largely towards this issue, the possible distorting effects of international movements of money and capital on exchange rates in the environment of the 1980s, that the following comments are directed. To be sure, both the first and the second sources of instability - excessive monetary expansion and unsupportable debt burdens - are crucial elements of vulnerability today as well. But not everything can be addressed within the permissible scope of one paper, so they are neglected here in order to focus on exchange rates as potential forces of instability. One of the profound environmental changes of recent years has been that the sheer size of the growth in real production and trade has outrun the capacity of the domestic money and capital markets of the early postwar period. By the mid-sixties, the dollars available from US sources could no longer stretch to meet the payments needs of the international system and the Euro-dollar had to become a major supplement, followed later in the next decade by the Asian dollar, which was literally born here in Singapore. Nor were dollars of either kind, onshore or offshore, enough by the later seventies. Euro-D-Marks, Euro-yen, Euro-francs, and others had to emerge, both as transactions currencies and as capital instruments, to fulfil the needs of the world's potential for real expansion. And through these years new kinds of capital markets were developing, following the model developed initially in London. They provided "offshore" money market facilities, and bond issuance, placement, and trading markets that are semi-detached from the domestic money and capital markets of the domicile, whether in Luxemburg, or Lichtenstein, or Grand Cayman, or Hong Kong, or Singapore, or most recently, New York. My preoccupation in these remarks, without elaborating further on the constructive innovations that have occurred in the financial sector, is to focus on the risks accompanying these great advances. Why, or how, has the evolution of a larger and more diversified financial system, which has done so much to smooth the paths of trade and to cushion severe shocks, also brought with it new potentials for instability in the performance of those real goods economies which provide the livelihood of the world's four billion people? To narrow the question, what has happened to the forces determining rates of exchange among currencies that has made the needed interconvertibility of moneys, which is so essential for the optimum growth of world trade, into a cause at times of aggravated instability - not only in trade among nations but also in the economic performance within individual countries? I ~hould say at the outset that I have no simple diagnosis, and certainly no stmp~e formula to propose. The issues and the problems, though, are appropnately discussed here in Singapore, the newest and most creative 2

of the world's international capital markets. I would like, first, to review in very broad terms an apparent gap in economic analysis, or economic theory, that seems to prevent any simple answer to the paradox that a highly sophisticated payments system, developed to meet modern needs, also seems to generate economic instability. Then second, taking an empirical approach, I will look at the data, examining the rather volatile behaviour of the foreign exchange markets. It is illuminating to consider especially the dramatic oscillations in the relation of the US dollar to the yen and the D-Mark as those two currencies and their capital markets have taken on larger roles over the past few years. Third, although I cannot provide a neatly integrated description, either in economic theory or in practical detail, of the linkages between capital movements and the patterns of world trade, I will mention some operational possibilities for attempting to minimize the often conflicting differences between movements of capital and of trade - possibilities that may have some relevance to the world's need for a lessening of economic instability.

I. A VACUUM IN "ACCEPTED" ECONOMIC DOCTRINE Economic doctrine with respect to the trade in goods and services among nations has, for more than a century, centred on the principle of comparative advantage. The essential proposition is that all countries will achieve an optimum national product, individually and together, by working towards the most efficient international division of labour. That requires, as the ultimate aim, a relatively free movement of goods and services across national frontiers, at prices reflecting the factor costs within each country - costs determined by resource availability and productivity. While economic literature has been filled with all sorts of qualifications relating to the details of this process, the elements of free and open trade have been broadly accepted as the aim towards which marketoriented economies should be directed. These are the aims which you here in Singapore have recognized in shaping the controls which have been essential in your comparatively small and exposed economic situation. This century-old scenario of accepted economic doctrine also had a place for capital movements. They were fitted into trade theory in the form of shifts in the geographic location of various kinds of physical capital. Capital was expected to move in response to changing opportunities among countries for real investment in agriculture or mining or manufacturing or the various service industries. It shifted into uses which promised those cost or productivity advantages that would yield the most attractive return. In this sense, capital movements were viewed in the economics textbooks as simply performing the function of allocating financial resources and savings among real producing assets anywhere;

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exchange rates, if noticed at all, were merely accommodating residuals, determined by the aggregate flows of all forms of trade, including physical capital. But the profound lesson of the past two decades is that the classical conception of the role of international capital movements is no longer adequate to explain the movements of capital in today's world. As national capital markets have expanded, and as "offshore" money and capital markets have developed, a larger and larger proportion of financial flows has reflected shifts among holdings of various kinds of intangible assets. These range from interest-bearing bank deposits and short-term money market instruments to longer-term bonds or marketable equities. Underneath, these flows are still ostensibly serving the classical purpose - getting savings from everywhere into the most productive physical investment anywhere. But because the superstructure of investments and currencies has become enormous and complex, as the world's needs have become differentiated into many new forms, the result has been that many of the gross flows through the capital markets of the world now reflect financial decisions that are not directly tied to (nor do they necessarily lead to) physical capital formation. Indeed, a surprisingly large proportion of the flows to sovereign borrowers, including even many industrialized countries, is devoted to consumption. And only rarely is it a form of consumption that could be identified with the classical "wages fund" (a form of working capital). By contrast, earlier in this century, the preponderance of international capital flows broadly conformed to the theory; they reflected business decisions to finance trade or to establish producing facilities in foreign countries. Now, although data for the flows through the "offshore" markets are very difficult to gather, it seems apparent that the dominant proportion of the investment funds actually in movement internationally today reflects instead decisions concerning portfolio holdings (both short term and long term), as financial or business concerns attempt to diversify their risks and improve their financial returns. Often now it is the large overlay of portfolio capital movements, superimposed on the more routine money flows in payment for goods and services, that exerts the determining influence at the margin on changes in exchange rates. The motivating impetus for shifts of investible funds among markets and currencies now frequently reflects fluctuations in interest rates on financial instruments or altered appraisals of the exchange rate attractions of different currencies, rather than the attraction of new opportunities for real investment. That process still results, in the end, in an efficient distribution of capital resources through today's more specialized and responsive markets, but activities in those same markets can now also set off cross-currents that create new problems. The consequence can be the release of forces that sometimes aggravate those tendencies towards economic instability that develop within individual countries when major domestic adjustments are underway. The more 4

sensitive, potentially volatile, and highly integrated capital markets of today can, in addition to nourishing a more diversified world-wide growth, also transmit an initial condition of instability in one major country into amplified instability throughout most of the world. The great need now is for a unifying theory of all capital movements that can, in conformity with the classical theory of international trade, provide principles that would attract the same consensus as to guiding aims that the theory of trade has provided. For there is today no accepted body of economic doctrine that can bring together in a comprehensive systematic way the host of forces - including actual and expected foreign exchange rates and interest rate differentials - that now affect capital movements alongside the more traditional influences affecting the movement of real goods among countries. In the absence of such an integrated body of guiding doctrine, the officials and institutions concerned with the problems of imbalance in international economic relations have continued to focus attention on the balance of trade and the current account balance of individual countries - looking towards correction in those real accounts as the needed pathway towards stability. What they find increasingly baffling is that such corrective action is often not enough to restore a degree of stability in a country's exchange rate. Indeed, as will appear in Section II, the traditional remedies to restore balance can in some circumstances have precisely the opposite effect. And yet some stability is clearly desirable to help provide a corresponding degree of reasonable confidence in the parameters which domestic businesses, consumers, and investors take into account in making their own decisions. The first major indication of the vacuum that exists in the economic theory of adjustment among nations was the breakdown of the par value system of exchange rates under the Bretton Woods system in 1971. Initially the hope was widely held that order could soon be restored by allowing all exchange rates to float freely. 1 Borrowing from the abstract analysis previously developed by academic economists, many financial officials thought that the prices of the goods that move in trade among countries would coalesce into a form of purchasing power parity, resulting in reasonably stable exchange rates. That initial presumption or hope ignored the great force now embodied in the enormous financial flows among currencies that respond to other causes - beyond the trade balances that are primarily responsive to the price comparisons embodied in purchasing power parities.

1

A thorough statement of the theoretical case for floating is presented by Milton Friedman in The Balance of Payments: Free Versus Fixed Exchange Rates, a debate between Milton Friedman and Robert V. Roosa, published by the American Enterprise Institute for Public Policy Research, Washington D.C., 1967.

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Removal or modification of governmental restrictions on capital or currency movements from the mid-fifties onwards, and the subsequent emergence of the "offshore" markets, opened wide new opportunities for businesses or governments to borrow, and for savers or financial institutions to invest. While those facilities certainly added to the growth potential of the real world economy, and provided a new resiliency for firms or nations in meeting unusual needs, they also offered new scope for rapid and cumulative shifts among currencies by investors (or debtors) whenever the freely moving exchange rates pointed towards opportunities for gain, or for avoiding losses, by shifting funds from one currency to another. During the one initial experiment with completely free movements of exchange rates among the leading currencies of the world in 1973, the rapidity and size of shifts among liquid instruments became so overwhelming that the experiment lasted less than four months, from March to July of that year. 2 The failure of that experiment in uninhibited floating demonstrated a source of instability in the foreign exchange markets that continues today. The reaction to that experience by responsible officials, followed eventually by most of the earlier academic proponents of free floating, has been to jettison the pure theory of floating as unacceptable. Yet there is also a continued rejection of the previous par value system of the Bretton Woods arrangements, on the grounds that it, too, had become unsustainable - not only because purchasing power parities had themselves diverged as economic performance and inflation rates varied widely among countries, but also because the overlay of capital flows created new uncertainties. As a consequence, for nearly a decade now, experimentation has been underway with various forms of limited floating or managed floating. In this environment, attention has also been revived in an essential underpinning of the earlier "free floating" school - the doctrine of "monetarism". The monetarist approach argues that a satisfactory position in international economic relations can be reached if each country adheres to a regime of domestic monetary expansion that is closely aligned with the expected growth over the years in the physical productivity in each country. Such a regime, these academic formulations suggest, would assure comparative stability in average prices domestically, and thereby provide a basis for developing comparative stability in the exchange rates among the currencies of similarly "monetarized" countries. That is, with a close gearing of money supply growth to average growth in productivity, individual price changes would only be ups and downs around a rather steady norm, and purchasing power parities among monetarized countries would support a relatively stable condition among their exchange rates. The difficulty is that a steady, gradual increase in a nation's money supply, the objective of monetarism, renders the monetary authorities

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indifferen t to any resulting fluctuatio ns in interest rates. Yet such rates may well swing over a wide range as variable economic performan ce (alternate ly higher or lower than the longtime average goal) interacts with an unwaverin g, regular rise in the money supply. And the consequences of interest gyrations in the present internatio nal setting - one of acute sensitivity to changes in interest rate relations among different countries and currencies - will be to incite moves of funds into a highrate currency and out of others, thereby creating further condition s of instability in the foreign exchange markets. The currency attracting funds will tend to become overvalue d in relation to its purchasin g power parity with other currencies . The currencies whose interest rates are relatively unattracti ve will be sold, and then will become undervalu ed. As a result, distortion s will be introduce d into the domestic economie s of each as imports are stimulate d by the overvalue d currency; and exports, by the undervalu ed currency. The outstandi ng examples of the new adherence to monetaris m have been the United Kingdom and the United States. A closer look at the United States' experienc e is more nearly within my range of vision. I attempt that in Section II, as a preface to examinin g other forces that influence exchange rates. While the monetaris t experime nt is still underway , it would be prematur e to write an epitaph. However, it seems to me unlikely that it can become a practicabl e and permanen t answer to the search for a stabilizing force. I suspect that the world is still awaiting the appearanc e of that all-embra cing theoretica l descriptio n of the economic s of internatio nal trade and capital movemen ts which can come as close to fitting the condition s of our times as the formulati ons of Alfred Marshall or John Maynard Keynes seemed to fit theirs. In economic s we can never hope for the comparati vely satisfying mathemat ical elegance that physicists seek in unified field theory, but we can probe for some of the boundarie s of meaningf ul theory by looking more closely at the actual performan ce of the three currencies that are now in widest use - the US dollar, the West German mark, and the Japanese yen.

II. DESTAB ILIZING EXCHAN GE RATES: 3 THE US DOLLAR , THE D-MARK , AND THE YEN In the aftermath of both oil shocks, that is, following 1973 and 1979, the internatio nal money and capital markets played a heroic role. The 2

3

Cf. Robert V. Roosa, "The Experiment with a Freely Floating Dollar", prepared for publication in the Nihon Keizai Shumbun, 17 August 1973. in William M. Reichert prepared all of the data and contributed much of the analysis included this section.

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massive initial flows of international payments from the oil-importing countries to the OPEC countries could have created a deadlock in world trade, and a depression throughout the oil-importing world, if those flows had simply been sterilized in idle balances. The story of recycling is, however, already an old one to all of you, particularly because it was in serving as one of the great entrepots of capital flows through this period that Singapore became one of the leading capital markets of the world. Consequently, as suggested earlier, I will not elaborate on the history behind the surging growth of these markets, nor on the great positive contribution towards economic growth and stability in the world that the international money and capital markets have been able to provide. What we must be wary of are the possibilities for perverse influences that also lurk within the framework of these same creative arrangements. The risks start with the kind of influence that the United States has, unintentionally but unavoidably, been exerting on the world economy over these past two or three years as a result of our own domestic economic situation. I will try to outline our problems briefly, and then trace through some of the ways our response to those problems has affected capital flows among countries with results that have, I am afraid, aggravated tendencies towards economic instability in the rest of the world. Without pretending to outline a complete picture, I will try, after describing the United States' situation, to indicate some of its repercussions on two other major countries, Japan and West Germany, whose performance in turn affects many others. The United States has, since even before the first oil shock, been struggling with the transition problems of a highly industrialized economy that has entered a maturing phase and is shifting its centre of economic activity towards the services sector. In the process of adjustment, partly because of and partly despite governmental economic policy, the United States developed both an accelerating inflation and an aggravation of unemployment; we became a seminal case of stagflation. As inflation began to soar following the second oil shock in 1979, priorities in public policy shifted from an ambivalent concern over both problems to a focus on the debilitating ·and destabilizing effects for our own real economy of a possible runaway inflation. A policy of monetary restraint was reinforced by the Federal Reserve in October 1979 through a change in operating criteria. It gave up the use of interest rate targets as its central policy guideline and pursued more explicitly and narrowly announced targets for controlled growth of the money supply. In effect, the shift was to a monetarist, or quasimonetarist, concept of central banking. Interest rates, which had previously been only moderately above those of most other industrialized countries (though substantially above rates in Japan and West Germany), then began a sharp rise. That was abruptly reversed, however, by the imposition of controls over the quantity of credit during the first half of 8

1980 as part of a governmental emergency programme, which also created a sudden recession in the economy. Following the lifting of most controls in July 1980, however, the money supply was eased in order to replace the loss of money supply that had occurred during the credit freeze, and inflation had resumed by the end of the year at an even faster pace. It was into this situation that President Reagan entered the scene with a programme of tax cuts, which were intended to spur investment and incentives, and thereby improve productivity and abate inflationary pressures, while the Federal Reserve pursued a "monetarist" course. Unfortunately for all of us, the consequence has been that the US has been running very substantial federal deficits, which have added to the claims on our capital markets sufficiently to maintain extraordinarily high real interest rates. Adding to the perplexity and confusion, these interest rates have gone through tremendous oscillations, as many of you have been aware ups and downs that were reflected in a peak in the LIBOR of 20 per cent in early 1980, which then went down to as low as 8~ per cent by mid-year and back up to over 19 per cent by the end of the year. Rates have been up and down several times since. As these oscillations have occurred in a capital market where funds are flowing freely, one would have hoped that movement of funds from outside would have occurred on such a scale that the extremely high rates would have been brought down and the fluctuations moderated. After all, prices are supposed to be determined by both supply and demand, and with the supply of funds at home having been somewhat limited, the supply coming in from outside should have been an equilibrating influence. But what has become clear during this experience is that any forces towards equilibrium were overwhelmed, and the forces of instability were actually accentuated by the sustained attraction of high interest rates, with a resulting rise in the exchange rate of the dollar to an extreme overvaluation. One primary reason that interest rates, and consequently exchange rates, do not equilibrate is that sovereign governments and central banks, such as those in Japan and West Germany, actively manage and frequently suppress the level of interest rates in their own domestic economy. While their aims are understandably rooted in the desire to support output and employment at home, the result has been a tendency for the low interest rates to cause capital to move out of yen and DM and into dollars. The relative ease of this movement of money and capital is a testimony to the constructive evolution of the system towards free movement among financial markets on the international scale. The effect, however, has been to push the dollar to a perversely overvalued level. 4 4

Note, however, that interest rates in equilibrium are not necessarily equal. For example, for West German investors who ultimately denominate their wealth in DM, a 15 per cent US rate of return (subject to foreign exchange risks) may be no more attractive than a 10 per cent rate of return in West Germany. Equilibrium interest rates, though, should move towards equality as expected foreign exchange rate volatility diminishes.

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Meanwhile, as suggested in Section I, the fluidity of the international capital markets in some ways contributes to their instability. In the absence of any credible exchange rate guidelines, the momentum behind exchange rate shifts can ebb and flow, just as it does in commodities markets. The presence and causes of these so-called "bandwagon" effects have come under increasing scrutiny of late, but their nature is not yet generally understood. At the same time, the new approach to monetary policy adopted by the US has added a further element of directional force towards overvaluation of the dollar, as well as towards volatility among the exchange rates of leading currencies. The markets interpreted the US "quasimonetarist" policy to mean that there would not be any effort by the American authorities to control interest rates with a view to minimizing overvaluation of the dollar. The tendency for free markets then was to run towards the currency whose interest rates showed very wide spreads (both in nominal and in real terms) over other major currencies. These extremes in the financial markets in the United States have certainly contributed to the two recessions we have suffered in the space of two years. In certain ways, by old-fashioned classical standards, these recessions may have been constructive through halting the long phase of inflation. But the instability in the financial markets appears to have prolonged any corrective process and forced the decline further than may have been adequate to bring the inflation under control. That might not be of concern to the rest of the world if the United States had merely flagellated itself, but for at least two reasons the repercussions have been wider. One is that the United States is still the largest single element in the whole configuration of world trade in goods and in services, so that whatever happened to create ups and downs in our own economy - generated perhaps initially in some part by these fluctuations in our own capital markets - in turn was transmitted abroad through the composition and size of our own imports and exports, with repercussions throughout the world in developed and less developed countries alike. The second and increasingly most significant reason is that the dollar is still the central world currency. Even though the yen, the D-Mark, the pound sterling, the French franc, and the Swiss franc can be considered serving in limited roles as transactions currencies, and similarly have limited roles as reserve currencies, the dollar still constitutes from 70 to 80 per cent of the payments that occur in settling the flows of both goods and capital. That is why everything affecting dollar interest rates at home provides a strong incentive for action, either speculative or precautionary, by anyone holding or involved in dollar obligations. The result often has been the kind of bandwagon swings which carry the dollar to an exchange rate with other currencies that is far out of line with any purchasing power relations between prices in the US and the other countries. During the decade of the sixties, the D-Mark remained close to the 10

FIGURE I Comparison of Nominal Exchange Rates with Purchasing Power Parities

360 340 320 - - Nominal Rates ---- PPP Rates (1975-79

300 V'f

280

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