Dealing with extremes of market behaviour

Jeremy Warner on why calls for fixed exchange rates are understandable but misguided

Imagine a world where all currencies were pegged one to another, so that there could be no currency devaluation or appreciation unless agreed by all through a recognised cross border organisation like the International Monetary Fund.

Plainly your pound would continue to buy more in some places than in others (though presumably even prices would eventually become homogenised across the globe), but essentially your pound would be worth the same where ever you were. To all intents and purposes what we would have is a global single currency. Exchange rate risk would be eliminated and international trade would flourish. A perfect, and in business terms, utopian world then?

OK. So maybe not. Actually it wasn't that long ago that something quite similar to this did exist. The Bretton Woods fixed exchange rate accord, established immediately after the Second World War in an effort to prevent the competitive devaluations which helped plunge the world into depression in the 1930s, prevailed for a surprisingly long time - nearly thirty years.

However, in so far as it ever worked as it was supposed to, this was because nearly all countries at that time had capital controls. The Bank of England maintained a staff of thousands to vet trade and foreign exchange transactions. It was a criminal offense to take more than pounds 60 a head out of the country with you.

Bretton Woods eventually broke down because governments, including our own, refused to devalue despite the burgeoning trade deficits they were running. But it took a long time. Undoubtedly, it would have happened far sooner if capital had been allowed to slop around the world in the way it does today.

One of the lessons of the economic crisis in the Far East, and indeed of our own membership of the European Exchange Rate mechanism, is that you cannot successfully combine a fixed exchange rate system with one that allows the free flow of capital. Inevitably the one will be trounced by the other.

Comparing the one system against the other, in terms of its ability to create opportunities for trade, growth and prosperity, there seems to be no contest. Today's global capital markets are infinitely more efficient in the way they allocate capital to economic ends, facilitate cross border trade in goods and services, and generally enhance living standards, than the alternative of fixed exchange rates combined with national capital controls.

So why is it that some policy makers, particularly in the Far East, are talking in lively anticipation once more about the possibility of reviving some kind of international fixed exchange rate system? The attachment of the fringe, Pacific Rim economies, to fixed exchange rates is well known.

Despite everything that has happened, President Suharto of Indonesia, still talks merrily about re establishing his peg against the US dollar. To make the peg more credible than it was, he now proposes going the whole hog and establishing a "currency board". Mr Suharto's motives are always suspect, and no more so than in this instance. If he were able to fix at a relatively high rate against the dollar, he and his family might find it easier to disentangle themselves from their own personal foreign currency debts, even though the wider economic consequences of such a move might be disastrous.

The tin pot dictators of the Far East are one thing, and perhaps don't deserve to be taken seriously. Japanese policy makers are quite another. This week, Eisuke Sakakibara, Japan's vice minister of finance for international affairs, has also been sounding off about the need for some kind of global fixed exchange rate system. Known as "Mr Yen" because of the power of his comments in foreign exchange markets, Mr Sakakibara said the time might be right to reintroduce something along the lines of Bretton Woods.

Later in the week be appeared to expand on this by suggesting that national currencies should peg or benchmark themselves against the world's three major regional currencies - in the Far East against the Yen, in Europe against the Euro and in the Americas against the US dollar.

One variation of this central idea, which Mr Sakakibara has also aired in the past, is that the regions would have their own international safety organisations - their own versions of the IMF - which because they would be closer and more in tune with their own regions, could apply more appropriate programmes of action and international aid to crisis torn countries than the IMF does. The three main currencies would meanwhile trade against each other within quite restricted target zones, enforced by central bankers and the international organisations. In other words, a global fixed exchange rate system.

Mr Sakakibara's precise relationship with the Japanese Government has never been entirely clear. He's plainly well informed about policy in Japan but he's not always representative of it and his views are often his own. Even so, there may be some sympathy for what he's saying on these issues, both within the Japanese Ministry of Finance and among Japanese political leaders. Certainly his view that the crisis in the Far East is one of global capitalism, and not as the IMF implies with its reforms, one of the Asian economic model, is widely shared across the region.

It's not hard to see why. The immediate cause of the crisis was a sudden and violent flight of foreign capital. In the West, there hasn't been anything comparable since the crash of 1929 - an extraordinary collapse in asset values caused by an abrupt reevaluation by international capital of an economic and corporate system that just months previously had been regarded as superior to the West.

We've no recent experience in the West of these extremes of market behaviour. It's easy for us to depict the crisis as one of crony capitalism, bad and corrupt government, inadequate regulation and a fragile banking system, but it was our Western capital that both fed the boom on the way up and compounded the bust on the way down. Even as foreign capital has fled the region, the corporate West has moved in to take advantage of fire sale prices with significant direct investment. No wonder Malaysia's Mahathir fulminates about a Western capitalist conspiracy to recolonise his country. No wonder the nationalistic backlash across the region.

And no wonder that fixed exchange rates are seen in the East as a panacea. Nor should we immediately condemn this proposed policy response as claptrap. The idea may be misguided, but it is also understandable. One of the consequences of globalisation, rapid advances in information technology, and deregulation of markets is that the international financial system has expanded at a pace far faster than either GDP or trade. This in itself has tended to enhance the extremes of behaviour in markets and increased the risk of systemic crises.

It is obviously appropriate, therefore, for policy makers to explore ways of limiting these extremes. The markets aren't always right. They exaggerate both on the way up and on the way down, with often disastrous economic and social consequences. But love them or loath them, they have become the way of the world. Fixed exchange rates aren't the way. The solution lies rather in greater transparency and supervision, and, ofcourse in appropriate macro economic policy. Persuading Indonesia, Malaysia, or even Japan, of this is another thing entirely.