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SIDNEY WEINTRAUB

Flexible exchange rates:

old vinegarin new wine?

Few experiments began with such exuberant expectations and dire

predictions as the introduction in 1973 of flexible exchange rates.

The literature on both sides is familiar.The exuberants, almost all

academics, had posited that true flexibility would permit avoid-

ance of trade and capital controls, provide more independence for

monetary policy, help to insulate domestic macroeconomic policy

from external shocks, and potentially provide greater exchange-rate stability than fixed but adjustable parities (Friedman, 1953;

Johnson, 1969; Machlup, 1969). The Cassandras,mostly officials

and traders, predicted trade disruption, erratic capital movements

(resulting in overshooting and undershooting of rate changes), and

a loss of internal discipline leading to higher levels of inflation

(Coombs, 1976).The officials controlled the policy-makingmachinery, and flexi-

ble exchange rates came not by design but by default. Give creditto events in the real world rather than to learned persuaders.The shift was accompanied by requiemson the end of the Bretton

Woods system, implying that the heart of the International Mone-

tary Fund (IMF) was embodied in the undefined phrase funda-

mental disequilibrium, when, under the old rules, parities could

be adjusted. Although its originalexchange rules have passed away,

the legacy of Bretton Woods (the IMF) is not dead, although it isoperating in a different milieu. If anything, the role of the IMFhas

increased in recent years as a result of the quantum leap in current

account surpluses and deficits. It is clear now that both sides had

overstated their positions, the one on the benefits of flexible ex-

changerates and the other on its costs.

The author is Professor of Public Policy at the University of Texas. He is not

an editor of the Journal of Post Keynesian Economics.

Journal of Post Keynesian Economics/Summer 1981, Vol. III, No. 4 46 7

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468 JOURNALOF POSTKEYNESIANECONOMICS

Has the exchange-rate system we now have-not fixed for the

major currency blocs, not fully floating either--led to policymeasures different from what might have been expected under the

old system? Or are we witnessing a classic example of plus ca

change, plus c'est la meme chose?

The laws at work

As an aside, it is instructive to go beyond economic theory and

delve into Parkinsonianreasoningto understandthe before and af-

ter logic of exchange-rate positioning. Three laws are at play.1. The more categorical the prediction, the more equivocal the

outcome. Numerous examples of this law can be cited outside the

sphere of economics. Communism, instead of leading to a classless

society, has bred a new class. Closer to home, balanced-budget pre-dictions by President Carter came out in the campaign mainly as

lower deficits than had he not made the effort. Despite the predic-tions, protectionism has not diminished in the United Stated since

1973, and monetary policy is not made without one (or two)

eye(s) on balance-of-payments considerations; and on the other

side, trade has not been stifled by exchange-rate flexibility, nor

has inflation control been ignored, as some commentators feared.

I will return to these substantive outcomes; my point here is to

note that outcomes are equivocal.2. The more equivocal the outcome, the more dogmatic the ex-

planation(s) for differences between expected and actual results.

Again, examples abound in all fields. Communists blame the mach-

inations of capitalist states for the failure to achieve a classless so-

ciety. Developing countries for many years cited questionable evi-

dence on long-term structural deterioration in their terms of trade

to explain the failure of development plans. Exchange-rateflexibil-

ity has not stifled protectionist pressure because governments in-tervene in the exchange markets (Schmidt, 1979, pp. 129-44), or

because trade adjustment lags behind adjustment in asset markets

(Dornbusch, 1978, p. 118), or because protectionism really is a

political phenomenon (disease) even when the overall trade posi-tion is satisfactory (Blackhurst, 1977; Nowzad, 1978).

3. The law of overriding extraneousness. The outcome was not

as predicted because extraneous developments (that is, those exog-enous to the pure model) intervened. President Carter asserted

that it was the playing out of real increases in oil prices which





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FLEXIBLE EXCHANGE RATES 469

caused the discomfort index in the United States to increase dur-

ing his administration, and which brought on unbalanced budgets.

Or, Senator Kennedy lost the Democratic nomination for presi-dent because of events in Iran and Afghanistan. Or, the cushioningeffect on the transmission of inflation that might be anticipatedunder flexible exchange rates (Fieleke, 1978) tends to be frus-

trated in countries where the rate is depreciatingby the downward

rigidity in money wage rates (Artus and Young, 1979, pp. 685-86)or because of a failure in macroeconomic coordination among in-

dustrial countries(Whitman, 1977, pp. 22-27).'Theory is uncertain on many critical points, whether trade ad-

justments from exchange-rate changes are swamped by inflation-

ary (deflationary) effects because of relatively long lags in the

trade response, whether internal inflation or transmission of infla-

tion among countries is a more (or less) serious problem under

fixed or flexible exchange rates, whether exchange markets are ef-

ficient (that is, fully reflect available information) in sorting out

exchange-rate relationships, whether rates overshoot or under-shoot, and whether long-term investments are more hampered by

uncertainty from flexible rates as compared with rates that are

ostensibly fixed but in reality are adjustable. My purpose is not to

try to sort out these questions but rather to consider how day-to-

day official policy has altered since the shift to flexible exchangerates. I will focus on U.S. policy because actions of countries dif-

ferdepending

on how authorities look at the theoreticalquestionsand on how open or closed individual economies are. On this last

point there is no question but that authorities of the European

Community countries have a greater yearning to return to a par-value system than do U.S. officials.

Substantivepolicy areas

1. Trade. The essence of the thinking at Bretton Woods andHavana (where the International Trade Organization was negoti-

ated) after World War II was not whether exchange rates were

fixed or flexible (although a par-value exchange-rate system was

1Frank A. Southard, Jr., and William McChesney Martin, rapporteur and co-

chairman, respectively, The International Monetary System in Transition

(Washington, D.C.: The Atlantic Council, 1980), p. 40, argue that flexible ex-

change rates have intensified inflation in countries whose currency is depre-ciating. The bias of the pamphlet is for a return to a par-value system.





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470 JOURNALOF POSTKEYNESIANECONOMICS

part of the original conception), but rather whether the mecha-

nisms established would lead to a progressive freeing of interna-

tional trade. Many techniques were established to accomplish this

objective: the availability of financing facilities under the IMF to

forestall prematurecontractionary policies in domestic economies;the abjuring of trade measures as a general balance-of-payments

corrective; the need to demonstrate injury, or its threat, before

raising a duty bound in the General Agreement on Tariffs and

Trade (GATT); and the need to compensate when this escape

clause was used. Despite some aberrations the conception was car-ried out effectively in practice.In the relatively tranquil times before 1973, the relative stabil-

ity of exchange rates probably did stimulate trade. It is preciselythis stimulation (or self-preservation)that has prompted the Euro-

pean countries with open economies to try to hold their exchangerates in line with those of their major trading partners (BIS, An-

nual Report, 1980, p. 19). This is probably the main attraction of

the EuropeanMonetary System.

However, the breakdown of the par-value system came about

precisely because what worked in fair weather did not in foul. It

was all but certain that if adjustment did not come from exchange-rate changes, it would come from trade protection (or deliberately

engineered domestic contraction, which, at that time, was not

deemed to be a feasible policy option). After all, hadn't many the-

orists argued that adjustment in the tradeaccount, and in the bal-ance of payments generally, need not be an areaof major concern

with flexible exchange rates?

In actual fact protectionist pressureshave been severe in indus-

trial countries since the advent of flexible exchange rates. Restric-

tions on trade in wearing apparel have intensified from what theywere earlier, the number of voluntary restraints forced on ex-

porting countries has increased (covering such products as televi-

sion sets and shoes), and trade is less free today than it was a de-cade ago in steel and shipbuilding. Bilateral aid remains generallytied, which is another form of protectionism. Part of the explana-tion for the recent rise in protectionism is the rise in unemploy-ment in industrial countries, but a properly working international

adjustment process is supposed to avoid protectionist efforts to

export unemployment. Part of the explanation is the growth in

competitiveness of middle-income developing countries, and ofJapan, but adjustment through exchange-rate change should help





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countries cope with this by increasing their own competitivenessin tradable goods. Part of the explanation may be that an increase

in the cost of imported goods occasioned by depreciation in theexchange rate has secondary inflationary effects which make the

depreciation very painful (Hooper, 1976), but this then arguesthat adjustment through flexible exchange rates is not all it was

touted to be. Part of the explanation may be that the reaction in

trade volumes to changes in the exchange rate is sluggish (Spitaller,

1980), whereas those who seek protection against imports are in a

hurry.Protectionism in industrial countries is not likely to manifest

itself today in across-the-board measures of the Smoot-Hawley

variety, or even of the type that stimulated the 10 percent U.S.

tariff surchargeon dutiablegoods from August to December 1971,2

but rather on individual instances of hardship (or the desire to

stimulate particularindustries,which is what is meant by trying to

pick the winners or reindustrialize the losers in industrialpolicy).

There is evidence that U.S. trade has become generallymore com-petitive since the advent of flexible exchange rates (Bergsten,

1980), but at the same time U.S. protectionism has risen. General

measures, like exchange-ratepolicy, are not intended to cope with

this particularistmotivation for protection.The argument that is left for those who support flexible ex-

change rates as a technique for avoiding trade protectionism is that

protectionism would have been worse with fixed parities. Perhaps,even probably, but assertion is less convincing than proof.

2. Intervention. U.S. officials do not talk today of clean and

dirty floats, as they did in the early 1970s.3 Experience has

erased ideology. European and Japanese officials never put much

stock in purity. In any case, direct intervention in the exchangemarkets and indirect intervention to attract or discourage capitalflows is substantial. Intervention by the world's central banks has

not noticeably diminished since the advent of flexible rates as com-pared with the pre-1973 par-valuesystem, under which interven-

tion was more or less obligatory to maintain narrowmargins.Offi-cial documents today talk of vigorous interventionby the United

States and of the need to intervene to restore a sense of two-way

2One purpose of the surcharge was to stimulate a larger depreciation of thedollar than it was felt could be obtained without this added pressure.3

But The Economist did, in an article entitled Wherenext in the dirty float?August 9, 1980, pp. 16-18.





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472 JOURNAL OF POST KEYNESIAN ECONOMICS

risk in the market for currency speculators, which a decade earli-

er was the argument floaters gave for not intervening(Federal Re-

serve Bank of New York, 1979, pp. 47 and 49). The key word isno longer intervention but rather IMF surveillance,with a compa-rable motivation that an exchange rate should not be so high as to

prevent effective balance-of-paymentsadjustment or so low as to

constitute an unfair competitive advantage (de Larosiere, 1979,

p. 339). Halm was prescient in 1977 (p. 16):

Themaindanger oes not lie in wide variationsnder he impactof

majordisturbancesnd afteryearsof wrongpegging;t lies in the stillpredominantesireon thepartof monetaryuthorities nd heFund o

approximatehe par-valueystemby rulesfor floating hatemphasizemedium-termtability f exchangeates ather han lexibility.

The watershed for the United States was the action taken on

November 1, 1978, to undertake coordinated intervention with

the central banks of Germany, Japan,and Switzerland,backed byan

impressive arrayof

swaps,to convince the market that the au-

thorities meant business. The intervention was designed to arrest

and reverse what was then felt to be an excessive decline in the

dollar. It did so. This was an official statement that free markets

can lead to overshooting and that markets may need official helpto determine what a correct rate is. Except for the greater day-to-

day variability of rates, the 1978 operation did not look very dif-

ferent from many similar operations during the 1960s to prevent

an excessive decline in the value of sterling.For trade reasons, because of concerns about imported infla-

tion, and because exchange rates are not immune from politics

(both domestic and international, since the argumentis that strongcountries have strong currencies), the exchange rate is not left to

find its own level. Policy authorities do not really want ex postevaluations of whether the exchange market is efficient. They pre-

fer to overlay their individual and collective judgments on puremarket forces.

3. Monetary policy. I want to speculate under this headingwhether domestic monetary policy is conducted substantially dif-

ferently under managed flexibility than under the par-value sys-tem. The question really is unanswerable, since policy is con-

ducted in the context of what exists and not what was or might bein the future. But do monetary authorities feel more free today to

ignore balance-of-payments considerations than they did in the





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FLEXIBLEEXCHANGERATES 473

1960s or early 1970s? I doubt it. There is not much talk todaythat the United States is practicing benign neglect of the bal-

ance of payments; there was a decade ago.In theory, exchange-rate flexibility should provide leeway for

many exchange-rate and interest-rate combinations, thereby free-

ing domestic monetary policy to a greaterextent than when there

is little play in exchange rates. However, this was a questionable

assumption for the United States as it shifted from its passiverole

under the par-value system-since other countries were left to

make their margins vis-ai-vis he dollar conform with the rules of

the system to what is now the system of substantial market in-tervention by authorities from countries of all the principal cur-

rencies, including the United States. For the United States, man-

aged exchange-rate flexibility may restrain monetary policy as

much as under the par-valuesystem as it functioned.

In practice we know from official statements that U.S. mone-

tary authorities do not ignore the effect of their actions on the

value of the dollar (Federal Reserve Bank of New York, 1980,p. 50). The steep run-upof interest rates in 1980 resulted from ac-

tions taken to deal with domestic inflation, but the actions gen-

erally were consistent with the objectives of foreign monetaryauthorities regarding the relationship of the value of their cur-

rencies with respect to the dollar.

It is really hard to see that management of monetary policy is

markedly different now from what it was a decade or more ago-

other than the fact that concern over the value of the dollar nowthat it floats up and down is, if anything, more intense now than it

was then. This says less about the difference between a par-value

system in which the dollar is the nth currencyand a managedflex-

ible-rate system in which intervention by U.S. authorities is sub-

stantial than it does about the different world ambience in the

1970s from that of the 1960s. In the earlierperiod the authorities

were concerned about the U.S. balance-of-payments position butwere not prepared to contemplate formal devaluation to correct

the weakness. After formal devaluation and depreciations of the

dollar were accepted, this was replaced by concern that a depre-

ciating dollar had inflationary and adverse international power

consequences. The best laid plans turn out to be jerry-built.4. Adjustment. At the heart of the argument in favor of sub-

stantial exchange-rate flexibility is that the adjustment process

among nations could proceed without resort to trade and ex-





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474 JOURNALOF POST KEYNESIANECONOMICS

change restrictions, and that internally, income and employment

objectives could be met with minimum interference from externaldevelopments. In the event, to cite the managingdirector of the

IMF, . . . there has been less difference between the operation of

the adjustment process under the par-valuesystem and under flex-

ible rates than many had expected (de Larosiere, 1979, p. 339).

Many reasons for this can be given. Withrespect to internal ad-

justment, Artus and Young dismiss an argument that sometimes

was made earlier, that flexible rates permit countries to choose

lower unemployment at the price of higher inflation-that is, a

Phillips curve argument-as having no validity (Artus and Young,

1979, pp. 656-59). With respect to external adjustment, the resur-

gence of protectionism already has been noted. Many observers

have pointed out that external adjustment under flexible rates re-

quires supporting demand-management policies to make the

adjustment effective, and this has not always been forthcom-

ing (Artus and Young, 1979; Black, 1977). Artus and Young citethe resistance of labor to downward adjustment in real wage rates

which would be required for a persistent change in the price ratio

between domestic and foreign goods. The slow speed of adjust-ment in the trade account to changes in the exchange rate has al-

ready been cited.

Dunn makes a persuasive case that flexible exchange rates did

not operate as expected because they could do little to alter the

reality of the OPECbalance-of-paymentssurplus and could serveinstead only the more limited function of distributingthe counter-

part current-account deficits among the oil-importing countries

(Dunn, 1979). This is a vivid example of the third law, that of over-

ridingextraneousness.

One final disappointment with the operation of flexible rates

should be mentioned. Their alleged superiority over stable but ad-

justable rates was based in part on the thesis that rate changeswould take place more smoothly, with less disruption to economic

actors, and would therefore be more acceptable-to traders who

prefer stability, to wage earners who want to avoid sudden and

substantial declines in real incomes, and to foreign investors who

must take exchange-rate relationships into account in their deci-

sions. In fact exchange rates have moved up and down a good deal

from day to day and over time (Artus and Young, 1979, pp. 672-

81). The managing director of the IMFhas arguedthat sharpfluc-tuations in the external value of reservecurrencies(he had the dol-





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lar in mind) affect confidence in the functioning of international

markets (de Larosiere, 1979, p. 338). This does not mean that a

par-value system would have been more stable in the circum-stances of the 1970s. Indeed, a par-valuesystem probably would

not have been feasible in that inflationary atmosphere, one which

also involved unprecedented current account deficits and surplusesin balance-of-payments positions occasioned by oil-pricing deci-

sions of the OPEC cartel.

The flexible exchange-rate system would not have been tested

at all if a crisis had not made the par-value system untenable.

Nothing succeeds like failure. At the same time, the times haveconspired to make the testing infinitely difficult. Nothing fails

like success.

Internationalcooperation

Managementof exchange rates among many countries requiresco-

operation. Under the pre-1973 par-value system, coordination ofintervention was less complex than it is today because then one

major country (the United States) did not normally intervene,whereas today it does. The present intervention system is overde-

termined. To the extent that countries act as though exchange-rate

flexibility does provide some insulation from external disturbances,

although certainly less than was anticipated earlier,internal policyexcesses could aggravate problems of other countries. This, like

overdetermined intervention, increases the need for internationalcooperation.

Safeguards were built into the par-value system to minimize

competitive devaluations for mercantilist purposes. Although the

evidence is that the major trading nations (perhapsother than the

United States) preferred under- to over-valuedcurrencies,nothingtook place that approachedthe beggar-my-neighborpolicies of the

interwarperiod. The potential for deliberate undervaluation

of

currencies is probably greaterunder a managedfloat, since there is

no precise bench mark such as a par value or a central value to

guide intervention. The IMF guidelines for intervention, plus IMF

surveillance of direct intervention, indirect intervention, and of

fundamental domestic policies, are designed to cope with such

problems.What has thus changed from the old to the new system is that

the exigencies of interdependence have made cooperation among





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countries more imperative than ever (Murphy, 1979, pp. 164-67).What has not changedis that while such cooperation takes place on

a superficial level, it does not run so deep as to deserve the descrip-tion policy coordination among countries. Central bankers dis-

cuss intervention plans with each other and may even sometimes

warn each other of impending shifts in domestic macroeconomic

policy, but this is rare. Heads of government now get together at

periodic economic summit meetings, but these generally do not in-

volve discussion of fundamental economic decisions before theyare made.

Manyeconomists

arguethat

preciselysuch

positiveco-

ordination (setting macroeconomic policies only after taking into

account what other majorcountries will be doing) is needed (Whit-

man, 1977, p. 23). But the reality is that the advent of flexible ex-

change rates has not profoundly altered the depth of international

cooperation.

Some speculations

Whatever reasons one adduces, it is evident that flexible exchangerates have not operated in practice as either the exuberants or

the Cassandras predicted they would. I would like to conclude

by speculating about the second law, focusing on what kind of

person gives what kind of explanation for the differences between

expected and actual outcomes.

Monetarists tend toargue

that theexplanation

is that the mar-

ket has not been allowed to work, that there is no floating but

rather managed exchange rates. The ex ante assumptions of proper

rates-par values-have been replaced by official judgments. In

both cases the judgments must be validated by interference with

(intervention in) the market. Schmidt (1979) provides an excellent

exegesis of this viewpoint.Those who distrust the workings of the market, at least as it re-

lates to currencies, tend to advocate a par-value system. Oneshould never have expected a flexible-rate system to work well.

Coombs (1976) presents this viewpoint. The foreign-exchangemarket determines exchange ratesby a complex mixture of relative

supply of and demand for currencies in asset markets, current ac-

count positions of countries, and expectations fueled by real phe-nomena (such as the foregoing), relative levels of inflation, of in-

terest rates, by political developments, and chance statements by





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key officials, and statements by officials without real responsibil-

ity for policy, such as congressmenin the United States. In such a

situation it is folly to leave such an important rate as the exchangerate to the vagariesof chance. Better to fix it and hold it until fun-

damental developments demonstrate that it cannot be held. Myown guess is that outside the United States, this is the majorityview.

There is a bureaucraticview that is well illustratedin a series of

speeches by the managing director of the IMF. This seems to ad-

mit that a return to a par-valuesystem is not now feasible, but weshould get as close to a par-valuesystem as we can. Flexible rates

have not worked as expected because of lags in adjustmentand in-

flation feedbacks from depreciation of a currency. This view

argues that most adjustment should fall on internal policy mea-

sures (demandmanagement policies) rather than on exchange rates,with the resultant outcome that exchange rates must be managed

by national authorities and through international cooperation.

The post Keynesian view seems to take the form of a market-

management mix, that is, favoring flexible as opposed to ostens-

ibly fixed exchange rates, but some management of rates depend-

ing on the nature of the disequilibrium that must be corrected.

This view is well presented in Bryant (1979). Rely on the market,but nudge it in the desired direction.

Looking at U.S. politics, the Carter administration leaned to a

combination of the bureaucratic and post Keynesian views. TheReagan administration is likely to support either the monetarist

and/or the par-value viewpoint, although the two are contradic-

tory as to their assessment of the efficiency of the currencymar-

ket.

REFERENCES

Artus, Jacques R., and Young, John M. Fixed and Flexible Exchange Rates: A Renewalof the Debate. International Monetary Fund Staff Papers, December 1979, 26(4), 654-98.

Bank for International Settlements. Fiftieth Annual Report. Basel, Switzerland, 1980.

Bergsten, C. Fred. The Growing International Competitiveness of the U.S. Economy.Speech before the National Foreign Trade Council, July 9, 1980, press release, Depart-ment of the Treasury.

Black, Stanley W. Floating Exchange Rates and National Economic Policy. New Haven:Yale University Press, 1977.





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Blackhurst, Richard; Marian, Nicolas; and Tumlir, Jan. Trade Liberalization, Protection-

ism, and Interdependence. Geneva, General Agreement on Tariffs and Trade, study ininternational trade No. 5, 1977.

Bryant, Ralph C. Comment. In The European Monetary System: Its Promise and Pros-

pects, ed. by Philip H. Trezise. Washington, D.C.: Brookings Institution, 1979, 17-24.

Coombs, Charles A. The Arena of International Finance. New York: John Wiley and

Sons, 1976.

de Larosiere, Jacques. Exchange Rates and the Adjustment Process. IMF Survey,October 29, 1979.

Dornbusch, Rudiger. Monetary Policy Under Exchange-Rate Flexibility. In ManagedExchange-Rate Flexibility. The Recent Experience, Proceedings of a conference spon-sored by the Federal Reserve Bank of Boston, 1978, 90-122.

Dunn, Robert M., Jr. Exchange Rates, Payments Adjustment, and OPEC: WhyOil Def-icits Persist. Princeton University, International Finance Section, 1979.

Federal Reserve Bank of New York. Treasury and Federal Reserve Foreign ExchangeOperation. Quarterly Review, Autumn 1979, 4(3), 47-64.

. Monetary Policy and Open Market Operations in 1979. Quarterly Review,Summer 1980, 5(2), 50-64.

Fieleke, Norman S. The International Transmission of Inflation. In Managed Exchange-Rate Flexibility. The Recent Experience, Proceedings of a conference sponsored by the

Federal Reserve Bank of Boston, 1978, 26-52.Friedman, Milton. The Case for Flexible Exchange Rates. Essays in Positive Econom-ics. Chicago: University of Chicago Press, 1953, 157-203.

Halm, George N. Jamaica and the Par-Value System. Princeton University, InternationalFinance Section, 1977.

Hooper, Peter. Forecasting U.S. Export and Import Prices and Volumes in a ChangingWorldEconomy. Board of Governors of the Federal Reserve System, International Fi-nance Discussion Paper 99, 1976.

Johnson, Harry G. The Case for Flexible Exchange Rates, 1969. Federal Reserve Bank

of St. Louis Review, June 1969, 51(6), 12-24.

Machlup, Fritz, in Gottfried Haberler, Henry C. Wallich, Peter B. Kenen, Milton Fried-

man, and Fritz Machlup. Round Table on Exchange Rate Policy. American Economic

Review, May 1969, 59, 357-69.

Murphy, J. Carter. The International Monetary System. Beyond the First Stage of Re-

form. Washington, D.C.: American Enterprise Institute, 1979.

Nowzad, Bahram. The Rise in Protectionism. International Monetary Fund, pamphletseries No. 24, 1978.

Schmidt, Wilson E. The U.S. Balance of Payments and the Sinking Dollar. New York:New York University Press, 1979.

Spitaller, Erich. Short-Run Effects of Exchange Rate Changes on Terms of Trade andTrade Balance. International Monetary Fund Staff Papers, June 1980, 27(2), 320-48.

Whitman, Marinav. N. Sustaining the International Economic System. Issues for U.S.

Policy. Princeton University, International Finance Section, 1977.

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