The European Monetary System, Essay Example

Question:

What are the differences between a pegged but adjustable exchange rate regime and a fixed one? Answer with reference to the Bretton Wood system and/or the Exchange rate mechanism of the European Monetary System.

Introduction

A country’s currency regime system can play an important role in the policy setting process; this influence is not limited to the setting of monetary policy for a country, but also in setting the parameters of economic policy. Indeed, for countries such as the United States that have a “full float” currency regime, the country’s financial policy makers, at least in theory, have few (direct) levers to influence the currency’s value. Few countries, globally, however, have a “full float” currency float for this very reason: a more controlled and flexible regime allows countries greater influence over the currency, and by extension, economic policy. This essay will look at two commonly adopted currency regimes: the pegged but adjustable exchange rate, and the fixed exchange rate to understand the advantages and disadvantages of each’s use.

Fixed Exchange Rate

The fixed exchange rate affords the government maximal control over currency policy; however, the policy also introduces externalities that must be dealt with in other realms. It is perhaps most profitable to understand the fixed currency regime as the theoretical opposite of a country that floats its currency. A country that floats its currency has little or no control over the currency’s movement and fluctuations; in contrast, a country with a fixed currency regime essentially sets the value of currency via a number of policy levers.

Traditionally, the gold standard has served as the main global example of a fixed exchange system. Under the gold standard, each country’s currency was pegged to a certain value of gold: This meant that any individual could go to the central bank with a set amount of the country’s currency and receive a set amount of gold in return. This system applied to all countries; thus, all currencies such as the British pound, France Franc, and US dollar were convertible on gold. This also meant that all currencies had a fixed exchange rate vis-à-vis gold: that exchange rate, for the most part, did not change unless there was a substantial change in a country’s balance of payments.

The gold standard survived from roughly the 1800s until the 1970s, when President Nixon officially took the US off of the gold standard. After World War 2, many of the countries that adhered to the gold standard had suffered devastation. Indeed, Europe, arguably the main economic power at the time, laid in shambles at the end of the war. In order to “recalibrate” the gold standard fixed exchange rates based on the new economic reality and sort out other war-related issues, the allies called the Breton Woods Conference in 1944. The Conference decided to peg the value of the US dollar to $35 per ounce of gold; other major currencies were then pegged at a lower standard with the explicit realization that the US was the preeminent economic power of the time.

Although Breton Woods attempted to reestablish the gold standard after the war, it ultimately did not work out. This development was largely a function of US economic policy: the US started to run large fiscal deficits during the Vietnam War, a policy that was largely incompatible with the fiscal discipline needed for the gold standard. Other countries eventually went to the US government for payments that could not be made; in the 1970s, US president Richard Nixon decided to take the US off of the gold standard. With Nixon’s decision, many countries decided to pursue a variety of different currency regimes.

A number of countries still pursue a fixed currency regime today. A hard-peg regime is a pure fixed regime where one currency’s value is directly linked to another (much like countries linked their currency’s value to gold during the gold standard). Countries with a hard peg include small trading nations that value the stability of a currency such as Hong Kong and Panama, whose currency regimes are directly linked to the dollar.

While a fixed currency policy affords a country with stability, it does not allow it to exercise as much control as many might think. In the 1960s economist Robert Mundell posited the idea of a “trilemma” in monetary economics; the concept stated that a country could not have the three following policies together: 1) fixed exchange rate; 2) monetary policy autonomy; 3) open capital markets. Indeed, if a country chooses to have a fixed exchange rate, it then usually cedes control of monetary policy out to a third party (usually the US Fed), or it cannot have robust capital controls. The tradeoffs of having a fixed exchange rate policy have been on full display during the financial crisis: For countries that have pegged their currencies to the dollar, the Fed’s policy of QE has meant the Fed controlled their country’s monetary policy, more so than in the past. Overall, while the fixed monetary regime allows countries some control over the currency, in an era of globalization, the many tradeoffs are making it more difficult to maintain.

Indeed, there are numerous disadvantages to a fixed currency. One of the main disadvantages is the challenge offered to investors that the peg will be broken. Looking back at monetary history, some of the most profitable investments have been based on a bet that currencies would not stay fixed such as Britain’s ill-fated attempt to join the ERM in 1992, or the speculators’ successful attempt to topple the Thai bhat and other Asian currencies in 1997. Besides the problem of speculation, countries must also decide how much they want to support currencies through using foreign exchange to prop up the currency once investors start to shift out of the currency for dollars or other currencies.

Adjustable Peg Regime

The main alternative to the pure fixed currency regime is the pegged but adjustable rate exchange regime. In the previous section, we explored countries’ use of a pure “fixed” currency system that focused on the convertibility between two different currencies. In the adjustable exchange rate regime, a country might have a “band” of acceptable ranges that allows it some flexibility to adjust monetary policy, without having a fixed currency that imposes undue burdens on fiscal and monetary policy.

Although there are numerous countries that have an adjustable peg policy, the most interesting is perhaps China. China moved from a “fixed currency regime” in 2005-2006 to an adjustable or “soft peg.” The People’s Bank of China (PBOC) previously enforced the currency peg at 8 yuan to 1 dollar. After that, the PBOC enforced a range of 6.5-7.5 yuan to the dollar. Instead of having to defend the currency peg, the PBOC can now set the price up or down on a daily basis based on its preference to have a stronger or weaker currency.

The European Monetary System (EMS) is another variation on the pegged exchange system. It should first be stated that the Euro floats vis-à-vis other major currencies such as the Japanese Yen and the British Pound. In Europe, however, in order to prepare the groundwork for the single currency, member countries entered into the EMS. Under the EMS agreement reached in 1979, member countries agreed to keep their exchange rates within a certain band to promote the ultimate unification of the Euro currency. The permissible band of the EMS was calculated as an average of all participating countries currencies. If a country fell outside the permissible band, it faced censure or moral suasion tactics from the European Central Bank. This, however, never happened. The EMS was used as a transitory mechanism for the ultimate adoption of the Euro. That is, the European countries wanted to use the peg currency band as a transitory mechanism to have member states’ get used to the idea of one day having a fixed rate across the entire continent. Although many individuals typically think of the Euro’s relationship with external countries, from an internal perspective, the currency is fixed across the entire region.

Some of the major advantages of an adjustable peg are that it imposes a degree of fiscal and monetary discipline on the country, without being tied to the straightjacket of a fixed currency policy. That is, similar to the PBOC and other central banks that implement an adjustable rate policy, they are given flexibility to move the currency higher or lower based not on the need to preserve the peg; but rather the need to have the currency support government policy in a certain area. This flexibility to influence currency value, as well as having other policy tools to focus on capital flows and conducting one’s own monetary policy has made this type of currency regime more popular than the fixed currency.

Some of the disadvantages of a pegged currency mimic those of the fixed currency. Although not as much a target as fixed currencies, pegged currencies also face the problem of speculation. If investors feel that the band of a currency is not defensible, they may attempt to make a run on the currency in the hope that a new band would be established. It also faces the disadvantages that if the band is not defensible that the country will need to spend precious resources in order to defend the band. One of the main differences between a fixed currency and peg, however, is that although a fixed currency is a much more attractive target, a country with a more flexible peg is able to change the rate without attracting as much attention.

Conclusion

Overall, most countries that are not a major economic power (with the exception of China) have some derivative of the fixed or pegged currency. Indeed, while the fixed currency regime is becoming more difficult to maintain in an era of globalization, an increasing number of countries prefer to have the flexibility of an adjustable currency rate, this includes up and coming powers such as China.

Although the fixed currency regime does offer greater stability and power over monetary policy, the limitations are vast and the disadvantages numerous in the era of globalization. There are only a couple of countries left that prefer to exercise this level of control over their currency. In contrast, the adjustable peg is gaining in popularity due to the flexibility it affords, as well as the policy ability to overcome the limitations of the trilemma. Without a fixed gold standard and countries abandoning the gold standard, remaining fixed countries (with the exception of Hong Kong) are unlikely to keep it.