The case for a floating exchange rate
AFTER THE BUDGET HARRY G. JOHNSON
Harry Johnson is Professor of Economics at the London School of Economics.
Like other Chancellors of the Exchequer be- fore him, but perhaps more strikingly than any of his predecessors, Mr Jenkins has presented his entire budget strategy as a means of achiev- ing a satisfactory balance of payments at the present, fixed, sterling exchange rate. In the weeks ahead we can look forward to the usual post-Budget comments—the Chancellor hasn't done enough, he's done too much, he's taken the wrong sort of measures—but all his critics will share with him the fundamental assumption of a fixed exchange rate. Yet it may well be that it is this aspect of Britain's post-war economic policy that most needs to be called into question.
As the Chancellor himself chose to point out, a floating exchange rate would, of course, provide no panacea for the country's economic problems. Developments that would cause difficulty under the present fixed rate system would cause difficulties under a floating rate system. But the difficulties would appear in a different form—through movements of the rate rather than through a balance-of-payments deficit—and both more immediately and more gradually, giving the policy-makers more elbow- room than the present system does. The float- ing rate provides an extra degree of freedom, or an extra shock-absorber. This extra degree of freedom could be used to eliminate a vast range of dubious policies and policy approaches which are at present allegedly justified on the grounds of their supposed contribution to im- proving the balance of payments.
For a variety of reasons, notably her com- mitment to a high level of employment, post- war Britain has had a persistent tendency to- wards a faster rate of inflation than the average of her competitors in international trade. Assuming that this tendency represents the out- come of a social consensus, it could be accom- modated under a floating rate system by a gradual depreciation of the exchange rate, which would adjust to keep the world market value of British goods in line with world prices. The balance-of-payments argument for con- trolling inflation would thus cease to be rele- vant, but the domestic arguments against infla- tion would remain. Since these are more readily grasped by the public, debate could fairly be joined on the issue, whereas at present it is clouded by difficulties in understanding the relation between inflation and the balance of payments.
The attempt to maintain a fixed exchange rate, while at the same time following domestic policies that persistently produce relative infla- tion and consequent balance-of-payments weak- ness, creates pressures for the adoption of a great variety of schemes for intervention in the economy, aimed at improving the balance of payments. Such schemes are usually ineffective, and merely create distortions and inefficiencies.
At the present time they include, controls on foreign investment by British companies and British holders of securities, and on the private purchase of foreign property; the farcical and degrading imposition of the tourist allowance; and subsidies of all sorts aimed in one way or another at increasing exports. Nor is this all: the objective of improving the balance of pay- ments influences a further range of policies that are mainly motivated by other objectives.
The distortions introduced by all these policies are obvious enough; one of the major objections to them is that, even if they are effective in improving the balance of payments, they invariably result in the marginal cost of a dollar of import saving or of additional exports varying widely from item to item of the balance of payments. But in fact it cannot be assumed that the policies are effective, at least in any- thing other than the very short term. True, they may be effective in altering the magnitude of particular items in the balance of payments, such as tourist spending or exports of specific products; but money is fungible and the economy interconnected, and there is no cer- tainty that money prevented from being spent on tourism does not leak out through other kinds of imports, or that increasing exports of some goods do not either reduce the exports of others or pull in more imports to replace them in the domestic market.
If Britain had a floating exchange rate, changes in that rate in response to market forces would automatically change the export `subsidy' and import 'tax' required to keep the balance of payments in balance; while the `subsidy' and 'tax' would be at the same rate on all exports and imports and would therefore not introduce distortions and differences be- tween the marginal costs of different ways of acquiring or saving foreign exchange. (A falling exchange rate is equivalent to a general export subsidy and import tax, a rising exchange ram to a general import subsidy and export tax.) A floating exchange rate would permit the ending of all the various restrictions on inter- national payments and the special subsidies for exports now imposed for balance-of:payments reasons. It would also permit retrenchment in the support now given to agriculture, the favourite defence of which is the resulting balance-of-payments saving. It would be pos- sible to rationalise fuel policy, which has been strongly influenced by the notion of improving the balance of payments by restricting the use of imported oil and favouring domestic coal and gas. Regional policy, in so far as it has been motivated by the desire to support old- established export industries, could also be re- viewed. All these policy changes would of course have to be undertaken slowly; but they would be made on grounds of efficiency tem- pered by social objectives, free from domination by alleged balance-of-payments consequences. One of the major consequences of the dilemma of trying simultaneously to maintain an inflationary pressure of demand for the sake of full employment and a fixed exchange rate has been the repeated recommendation, occas- sionally tried out in practice, of an incomes policy as a solution to the dilemma. Logically, the proposition, that if inflation yields no one any lasting real advantage it would be rational for everyone to desist from inflationary wage and price rises, is simplicity itself. But econo- zmically and politically it means trying to cajole or force workers and employers to act contrary to their own individual interests as they see them in their own situations: There is no evi- dence that a voluntary incomes policy makes any significant difference to the rate of inflation, while a compulsory incomes policy rapidly generates severe political strains. A floating ex- change rate would make the resort to an in comes policy, with all its political strains and its interference both with established institu- tions of collective bargaining and with personal freedom, completely unnecessary. Instead of the gargantuan efforts required in an attempt to ensure that individual wage negotiations and price changes average out at a level that is consistent with a satisfactory balance of pay- ments, the averaging would be done through automatic movements of the exchange rate effected through the market.
A further feature of post-war British experi- ence with the fixed exchange rate system has been the policy, or perhaps more accurately the policy experience, of `stop-go.' Stop-go' is not merely strongly encouraged by the fixed ex- change rate system: it is necessitated by it. The possession of what seem to be adequate gold and foreign exchange reserves tends (when these exist) to encourage experimentation with expansionist policies designed to stimulate economic growth, in the hope that faster growth will improve the balance of payments suffi- ciently rapidly to make good the 'temporary' loss of reserves. In fact it never does, and the approaching exhaustion of both reserves and borrowing ability sooner or later forces the application of the `stop.' Moreover, a govern- ment with an election looming ahead is under a strong temptation to stimulate the economy by demand expansion in order to help get itself re-elected, in the hope that the adverse balance- of-payments consequences will not emerge too soon, and in the expectation that, once elected, it will have sufficient mandate to clear up the mess it has itself created.
By contrast, under a floating exchange rate, a government that was determined to try the demand7expansion route to long-term growth would not be forced to desist by a balance-of- payments crisis. It would, of course, have to face instead the consequence of a falling ex- change rate, but if determined to do so it could persist with its policies-without being forced to call a halt by the unwillingness of other coun- tries' governments to bail it out in a balance- of-payments crisis. Again, a government that attempted to 'boom' itself into re-election would fairly soon be confronted by a falling exchange rate which, with its consequential effect on prices, would be much more widely noticed than a loss of reserves. It would also probably occur earlier, since the market would expect and discount the exchange rate move- ment in advance. (This assumes that the govern- ment does not have reserves large enough to support the rate during the pre-election period: otherwise, the pre-election developments would be the same as under the fixed rate; but after the election the Government could let the rate fall instead of, as now, being obliged to resort to 'stop' policies.) The above argument verges on the more general objection to a floating exchange rate, to wit, that it eliminates the 'discipline' of the fixed rate system. There are two answers to this. In the first place. the 'discipline' in ques- tion is not necessarily the enforcement of policies good in themselves, but rather the en- forcement of policies required for balance-of- payments equilibrium—which means policies consistent with what, on average, the rest of the world is doing. The chief complaint against the gold standard in the 'thirties was that it disciplined countries into having as much de- pression and unemployment as their neighbours, regardless of their own wishes; the correspond- ing complaint against the present fixed rate system, voiced most loudly by Germany, is that countries are obliged to accept the rate of inflation prevailing in the world as a whole whether they like it or not. To argue for this kind of discipline is basically to assert that. individually, national governments are in- herently irresponsible, while being collectively wise and responsible. By contrast, the case for the floating rate (in this context) is that national governments are in fact more likely to be responsible than the world collectivity of nations. This is because a 'responsible' policy can only be defined as one which pursues the best interests of the people, and because nations differ so sharply in the relative weights they place on different objectives—particularly on full employment vis-à-vis price stability.
In the second place, while a commitment to fixed exchange rates, if accompanied by a policy of non-intervention (or at least non-variable intervention) in international transactions. would force a nation to submit to the kind of discipline I have described, the actual rules of the game permit governments to evade this discipline by resorting to increasing direct inter- vention in response to unfavourable balance-of- payments developments. As our own recent ex- perience shows, a nation can go on in this way for a considerable period evading the fixed rate discipline and avoiding the need to take severely deflationary measures. Although a floating ex- change rate would also enable a country to escape the fixed-rate 'discipline,' at least it would do so by letting its exchange rate fall rather than by multiplying government inter- vention in the economy and reducing its own economic efficiency. finally, a word about the nature of edis- (
cipline'—which in this context means the pres- sures ultimately exerted on governments to conduct their policies responsibly. In the last resort such discipline must operate through electoral awareness of the nature and con- sequences of government policy. But the fixed rate system inevitably obscures this. 'Discipline,' under the fixed rate system, is, in the first instance, urged on the government of the day through the confidential advice and warnings of the central bank, and the electorate is eventually made aware of the consequences of irrespon- sibility only in the form of unpopular measures of restraint, or of devaluations, which are pre- sented to it as the consequence of foreign force majeure of an inexplicable and self-respect- wounding kind, rather than as the inevitable penalty of governmental irresponsibility. Under a floating exchange rate system, by contrast, irresponsibility would be directly reflected in a downward trend of the value of the country's currency in the world market and by an upward trend of prices: and since the electorate, whether rightly or wrongly, is accustomed to blaming its government for inflation, the floating rate is more likely than the fixed rate to enable the public to recognise and protest against govern- mental irresponsibility.
To put the point another way, the government is more likely to be disciplined by the hostile electoral reaction to rapidly rising prices under a floating rate system, than it is under a fixed rate system, when any protest against ir- responsibility has to come from the very few who understand that a continuing loss of gold and foreign exchange reserves portends a balance-of-payments crisis and eventual de- flation or devaluation.
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