Imagine having no exchange rates. Imagine having to do without the whole
rigmarole of forex, currency transactions and the subsequent taxes. Wouldn't
that be a wonderful dream come true? Internationally recognised, Harvard-based
economist, Kenneth Rogoff disagrees.
On Why Not a Global Currency
By Kenneth Rogoff*
Economics Department
Littauer Center
Harvard University
Cambridge MA 02138-3001
[EMAIL PROTECTED]
presented at the American Economic Association Meeting session on "Exchange
Rates and Choice of Monetary Regimes," January 5, 10:15 a.m./ January 8, 2001
www.economics.harvard.edu/~krogoff/AER-May01.pdf
It appears likely that the number of currencies in the world, having
proliferated
along with the number of countries over the past fifty years, will decline
sharply over the
next two decades. The question I plan to pose here is, where, from an economic
point of
view, should we aim for this process to stop? Should there be a single world
currency, as
Richard Cooper (1984) boldly envisioned? Should there remain multiple major
currencies but with a much stricter arrangement among them for stabilizing
exchange
rates, as say Ronald McKinnon (1984) or John Williamson (1985) recommended?1
Building on Maurice Obstfeld and Kenneth Rogoff (2000b,d), I will argue here
that the
status quo arrangement among the dollar, yen and the euro (which I take to be
benign
neglect) is not far from optimal, not only for now but well into the new
century. And it
would remain a good system even if political obstacles to achieving greater
monetary
policy coordination � or even a common world currency -- could be overcome.
Again,
this is not a paper on, say, the pros and cons of dollarization for small and
medium-sized
economies, but rather on arrangements among the core currencies.
Any blueprint for the future core of the world currency system involves some
crystal ball gazing. But at the same time, recent research in international
macroeconomics offers several important insights that can help inform our
discussion.
I. The Exchange Rate Disconnect Puzzle
The typical assessment of the modern floating rate era begins by noting just how
wrong Milton Friedman (1953) was when he envisioned flexible exchange rates as
adjusting slowly and smoothly in response to differentials in relative national
price levels.
2
Nothing could be further from the truth and, as virtually everyone knows by now,
exchange rates fluctuate wildly in comparison with goods prices. Early in the
flexible
rate experience, theorists offered what appeared to be an attractive answer to
this
observation: currency is a durable, so fundamentally its price reflects a flow
of future
services, not simply its transactions value at a point in time. Thus, according
to the
"asset" view of exchange rates, it should be no surprise that they fluctuate
almost as
wildly as stock prices.
But whereas the stock price analogy is useful, it is far from perfect. Given
that
domestic goods prices tend to move very sluggishly, at least at the consumer
level, one
would think that goods market arbitrage would prevent the exchange rate from
fluctuating
like a typical major stock price index-- but, of course, it does. At the
aggregate level,
shocks to real exchange rates damp out at a remarkably slow rate. Even the most
optimistic estimates put the half-life of real exchange rate movements in
years, not
months (though as Obstfeld and Rogoff (2000a) demonstrate, a country�s terms of
trade
at the wholesale level seem to react much faster than at the consumer level).
The
"purchasing power parity puzzle" is but one manifestation of a broader range of
puzzles
Obstfeld and Rogoff (2000b) term "the exchange rate disconnect puzzle." Simply
put,
while the exchange rate seems to gyrate wildly, it does not appear to feed back
into the
real economy with nearly the force and speed that one would expect for such an
important relative price. (Again, remember that my focus is on cross-country
exchange
rates between the largest economies.) Marianne Baxter and Alan Stockman (1989),
in
their comparison of macroeconomic variables under fixed and flexible exchange
rate
regimes, first pointed out the difficulty in demonstrating that exchange rate
volatility
3
affects macroeconomic quantities. Though more recent research has succeeded in
showing that exchange rate volatility can impact trade and direct foreign
investment,2
overall the feedback to the real economy is far slower and less pronounced than
canonical
Mundell-Fleming models would predict. Some have gone so far as to interpret the
evidence as showing that exchange rates have no short-run expenditure-switching
effect
at all, but this seems an overstatement; see, for example, the evidence
surveyed in Paul
Krugman (1991).
So, although flexible exchange rates have indeed proven far more volatile than
Friedman envisioned, the flip side of the coin is also a surprise. The effects
of the
volatility are not as conspicuously disastrous as one might have guessed. So
what�s the
catch, and how should it affect our thinking about exchange rate regimes?
II. Goods Market Are Less Integrated Than One Might Imagine
Obstfeld and Rogoff (2000b) argue that a broad variety of puzzles related to
international capital markets can be substantially resolved if one incorporates
(significant
but plausible) costs of trading goods into canonical models of international
trade. (Trade
costs include not only tariffs and transport costs, but also costs related to
differences in
language, legal systems and, yes, possibly currencies.) The puzzles include the
Feldstein-
Horioka puzzle (current accounts tend to be small relative to saving and
investment), the
home bias in equities puzzle, the international consumption correlations puzzle
(comovements in national consumptions are not as large as one would expect with
significant global capital market integration), and other puzzles including the
purchasing
power parity puzzle and the exchange rate disconnect puzzle. Incorporating
trade costs
not only allows one to resolve most of the major empirical puzzles in
international
4
macroeconomics at a qualitative level, but simple calculations suggest that the
puzzles
can be (substantially) explained at a quantitative level as well. Obstfeld and
Rogoff do
not deny the importance of frictions in capital markets, which they take to be
at least as
large internationally as domestically. But, they argue, one need not rely on
any large
difference between domestic and international capital market frictions to
explain many
apparent puzzles concerning why capital market integration is significantly
less than one
would imagine.
The way in which trade frictions can help explain the exchange rate disconnect
puzzle is straightforward. If the share of traded goods is relatively small
(or, to be
precise, if trade costs keep the consumption of traded goods relatively small),
then the
exchange rate � the terms of trade ---will likely play a relatively small role
in the
economy. Correspondingly, very large exchange rate movements may be required
before
there is a significant effect on the overall economy. Obstfeld and Rogoff
(2000c)
illustrate how a sudden reversal of the US�s 4.3% (of GDP) year 2000 current
account
deficit could lead to an extremely sharp depreciation of the dollar exchange
rate.
III. Implications For Exchange Rate Regimes
Most critics of the current exchange rate system accept the point that under
fixed
rates (or a common currency), countries would lose their ability to pursue
independent
monetary policy, and that this loss would be significant. The exact cost
depends on a
variety of factors, most conspicuously the correlation of macroeconomic
conditions
across regions. If trade between two large regions is relatively small, and if
trade costs
also limit capital market interactions (as Obstfeld and Rogoff contend), then
standard
5
models imply that it makes little sense to choose the exchange rate as the
fundamental
target of monetary policy.
Advocates of greater exchange rate stability across the major currencies argue
that
standard theoretical and empirical analyses of the efficacy of exchange rate
stabilization
are misguided, because they typically assume rational exchange markets. Even if
some
degree of exchange rate flexibility across two regions is desirable (say, to
accommodate
required movements in the real exchange rate due to imperfect output
correlation), in
practice the exchange rate fluctuates far more than any plausible theory would
dictate.
Thus a system of fixed exchange rates --- or currency unification --- is still
preferable to
any likely scenario under flexible rates.
But the argument I have just presented is robust to this objection. First, with
a
high degree of goods market segmentation, small changes in the fundamentals can
easily
lead to large (fully rational) changes in exchange rates (as Obstfeld and
Rogoff, 2000c
illustrate). Second, even if a significant share of exchange rate fluctuations
is indeed
driven purely by, say, investor psychology, the feedback to the real economy
may not be
so great as world currency advocates maintain. Thus, the mere fact that
exchange rates
between the yen, the euro and the dollar fluctuate wildly does not provide a
prima facie
case that we should permanently fix them.
Now, clearly, if moving to a currency union eliminates a substantial bulk of the
costs that limit goods and capital market integration, suddenly the efficacy of
the
common currency would be self-fulfilling. But I am skeptical that this would be
the case,
notwithstanding the interesting evidence Andrew Rose (2000) provides on the
currency
arrangements of mini-states. It is true that the common currency may ultimately
coincide
6
with much higher trade within Europe, but attributing the rise singularly to
the adoption
of a common currency would seem na�ve. In fact, at the same time countries in
Europe
have been pursuing a common currency arrangement, they have taken numerous other
steps towards economic integration, ranging from coordination of electric plug
sizes to
standardization of supervision and regulation of banks and financial
intermediaries.
There is a good analogy in the old fable of nail soup: A beggar, trying to talk
his way in
out of the cold, claims that he can make a most delicious soup with only a
nail. The
farmer lets him in, and the beggar stirs the soup, saying how good it will
taste, but how it
would be even better if he could add a leek. After similarly convincing his
host to
contribute a chicken and all sorts of other good things, the beggar pulls out
the magic nail
and, indeed, the soup is delicious. The euro is the nail.
IV. Other Reasons To Be Cautious About Adopting A Single World Currency
There are other reasons that it may not be desirable to pursue currency
consolidation all the way to a single world currency:
� Absent a global government, it would be difficult to establish adequate
checks and
balances on a global central bank. The US Federal Reserve is technically
independent, but it is also fundamentally a creature of Congress, one that
could in
principle be desolved at short notice. Although the nascent government
institutions
of the European Community are still fairly weak, they nevertheless provides some
forum for supervision of the European Central Bank. Into the foreseeable
future, no
parallel institution is going to exist at the global level.
� More generally, political problems could make it difficult to choose
top-notch central
bankers and, equally importantly, conservative central bankers who place a
strong
7
weight on inflation. In principle, one can design mechanical rules (such as
inflation
targets) which reduce the importance of the individuals governing the central
bank. In
many developing countries, this second-best approach may indeed be far
preferable to
a random draw from the political process, but I am very skeptical of claims
that any
simple mechanical rule can come close to what can be achieved by a grandmaster
of
monetary policy such as Alan Greenspan. This is indeed a common finding in the
artificial intelligence literature; i.e., that computers can equal "expert"
level in many
fields but not "master" level.
� Though currency, particularly in its function as a unit of account, is a
natural
monopoly, there are several reasons why it may be desirable to maintain some
level
of competition. Through a number of channels, global currency competition
provides
a check on inflation (as illustrated, for example, in Rogoff, 1985). A related
concern
comes from the natural regulatory functions that a global central bank would
have to
assume (or, if not, that a sister agency would have to assume). In an era of
ongoing
financial innovation, in which paper currency may well become defunct, there are
ample reasons to be concerned that a global central bank might constrain
innovation
either out of the desire to maintain a strong monopoly, or simply due to
misjudgment.
These are also going to be problems in the current system, but they would only
be
exacerbated by having a single currency.
� One could bypass many of the objections I have raised by adopting a world
currency
pegged to a commodity basket (or just, say, to gold). But I believe the
invention of
the modern central bank has actually, on the whole, been a very good one, and
certainly not worth abandoning for the uncertain gains of global currency
unification.
8
V. Why Not A Lessor Level Of Coordination Among The Big Three (Euro, Dollar,
Yen)?
Even if an optimal system requires some degree of monetary response to
exchange rates, there is a case to be made that the current system already works
reasonably well. Obstfeld and Rogoff (2000d) show that when monetary policy is
governed by a rule-based environment (that is, if standard time consistency in
monetary
policy problems can be overcome), then the gains to international monetary
cooperation
are not necessarily very large. While in principle countries may be tempted to
tilt their
rules in a way that improves their individual terms of trade (via the effects
of risk on
wage and price setting), or provides a more favorable correlation between
consumption
and the exchange rate, theory suggests good reasons to believe that these gains
are likely
to be only second order. Loosely speaking, improvements in the terms of trade
come
only at the expense of less effective risk sharing. In their empirical
simulations, Obstfeld
and Rogoff find that the gains to having an optimal global exchange rate system
(over the
noncooperative equilibrium) are two orders of magnitude less than the gains from
following active versus passive monetary stabilization policy. Interestingly,
the argument
here does not depend at all on having sizable trade costs, and indeed the need
for global
coordination in rule setting is weakest at the extremes where either all goods
are traded or
no goods are traded. Of course, one can argue that some of the world's major
central
banks (notably the ECB and the BOJ) have not yet fully converged to a rule-based
equilibrium, in which case there is still scope for coordination in the
transition.
VI. Conclusions
Currency consolidation seems like a desirable and (at present) likely process.
But
it is already important, now, to begin thinking about where consolidation
should stop. I
have argued here that, into the foreseeable future, it would not be desirable
to aim for a
single world currency, and that from an economic point of view, it would be
preferable to
retain at least, say, three to four currencies if not n currencies.
---------------------------------
Yahoo! Messenger NEW - crystal clear PC to PCcalling worldwide with voicemail
[Non-text portions of this message have been removed]
------------------------ Yahoo! Groups Sponsor --------------------~-->
In low income neighborhoods, 84% do not own computers.
At Network for Good, help bridge the Digital Divide!
http://us.click.yahoo.com/EA3HyD/3MnJAA/79vVAA/NJYolB/TM
--------------------------------------------------------------------~->
��������������������������������������������������������
This is ZESTEconomics. Post economics-related articles and event info to
[email protected]
If you got this mail as a forward, subscribe to ZESTEconomics by sending a
blank mail to [EMAIL PROTECTED] OR, if you have a Yahoo! ID, visit
http://groups.yahoo.com/group/ZESTEconomics/join
==theZESTcommunity======================================
[1] ZESTCurrent: http://groups.yahoo.com/group/ZESTCurrent/
[2] ZESTEconomics: http://groups.yahoo.com/group/ZESTEconomics/
[3] ZESTGlobal: http://groups.yahoo.com/group/ZESTGlobal/
[4] ZESTMedia: http://groups.yahoo.com/group/ZESTMedia/
[5] ZESTPoets: http://groups.yahoo.com/group/ZESTPoets/
[6] ZESTCaste: http://groups.yahoo.com/group/ZESTCaste/
[7] ZESTAlternative: http://groups.yahoo.com/group/ZESTAlternative/
[8] TalkZEST: http://groups.yahoo.com/group/TalkZEST/
Yahoo! Groups Links
<*> To visit your group on the web, go to:
http://groups.yahoo.com/group/ZESTEconomics/
<*> To unsubscribe from this group, send an email to:
[EMAIL PROTECTED]
<*> Your use of Yahoo! Groups is subject to:
http://docs.yahoo.com/info/terms/
