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1986 AEI Economist 1 (1986)

handle is hein.amenin/aeieco1986 and id is 1 raw text is: the W economist American Enterprise Institute for Public Policy Research January 1986 Thinking Twice about Monetary Reform Bill Gradison According to conventional wisdom, the current interna- tional monetary system is causing significant problems for international trade, economic growth, and the con- trol of inflation. A consensus seems to be developing for the establishment of a new international monetary sys- tem, presumably some return to fixed exchange rates or, at the very least, increased international policy coordi- nation. Indeed, hardly a day goes by without someone- more often than not an expected future presidential candidate-calling for a variety of talks, summits, con- ferences, reviews, discussions, and so on, all designed to begin the process of restructuring the international monetary order. While talks and reviews can be helpful, they also pose a danger. Advocates of a return to fixed exchange rates and increased policy coordination seem not to under- stand what is required to make these policies work. Those who argue for greater control of the value of the dollar often lose sight of the long-run outcome of these policies. In all likelihood, we will never be able to put together a workable system of fixed exchange rates, and efforts to do so will hinder efforts to control inflation. With the value of the dollar so high, and the conse- quent deficit in the U.S. balance of trade so large, it is hard for the floating exchange rate system to escape blame. The dollar, after all, is overvalued in terms of the relative purchasing power of currencies around the world. The speculative forces given play by the current exchange rate system have driven its value higher than can be sustained over time, to a level too high for U.S. industry to compete fairly with the rest of the world. Constant fluctuations,undershooting and overshooting of rates, inject an element of uncertainty into world commerce that inhibits trade and stunts the growth of developing nations. Yet, all things considered, the system of floating ex- change rates has worked well. Indeed, it is doubtful that any alternative system could have survived, much less accommodated so well, the shocks of the 1970s and the Bill Gradison, a Republican Congressman from Ohio, serves on the House Ways and Means and Budget com- mittees and is a member of AEI's Fiscal Studies Advisory Council. past few years. World trade has grown dramatically under the floating rate regime; so whatever its faults, they have not been serious enough to stunt economic activity. The system is not ideal, and it has fallen short of expectations; but it works and does so without impos- ing an intolerable burden on U.S. economic policy. The high value of the dollar has not, after all, been caused by floating exchange rates. Rather it has re- sulted from market fundamentals, primarily U.S. fiscal policy. Massive federal borrowing to finance the deficit Those who argue for greater control of the value of the dollar often lose sight of the long-run outcome of these policies. In all likelihood, we will never be able to put together a workable system of fixed exchange rates, and efforts to do so will hinder our efforts to control inflation. and decreases in taxes on the returns from capital have raised real yields in the United States to the point that they have been an attraction to foreign investors and to U.S. investors who might otherwise have chosen to lend abroad. The resulting net capital inflow has driven the dollar above the value that is consistent with relative purchasing power, which has resulted in our record bal- ance of trade deficit. A system of fixed exchange rates would not have prevented this capital inflow. Neither would it have pre- vented the capital inflow from being accompanied by a massive deficit in the balance of payments and balance of trade. The capital inflow would have increased the demand for dollars. To keep that from raising the dollar exchange rate the Federal Reserve would have to buy foreign currency. That would expand the money supply in the United States and raise the U.S. price level, rais- ing the real exchange rate of the dollar even though the nominal exchange rate was fixed. The cost of U.S. prod- ucts relative to foreign products would rise, and it would rise far enough to create a balance of payments deficit equal to the capital inflow. The only way to avoid that would be the same as the way now available to lower the

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