Too Sensational: On the Choice of Exchange Rate Regimes.

Tower, Edward

By W. Max Corden. Cambridge, MA: MIT Press. 2002. pp. xiv, 274. $29.95.

This volume is the 10th in the series of Ohlin lectures initiated in 1988 at the Stockholm School of Economics. This volume, like the others (the first of which was Bhagwati's 1988 lively Protectionism) is characterized by clear and imaginative thought with no equations. Corden describes his method as "story telling informed by theory" (p. xiii). The jacket of Bhagwati's book was a cartoon from Punch, which showed the British Prime Minister being led to free trade. My choice for the jacket of this book would have been something like The Economist's November 28, 1968, cover, which showed the heads of Charles DeGaulle, Richard Nixon, and Harold Wilson bobbing among the waves, with the caption "It's much better to float." That is the message of the book for most countries: floating is better than a fixed-but-adjustable exchange rate regime, or a FBAR, to use Corden's abbreviation.

Instead, the jacket of the book displays the quote from Oscar Wilde's The Importance of Being Earnest that introduced one of the chapters in an early edition of Samuelson's textbook. "Cecily, you will read your Political Economy in my absence. The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational. Even these metallic problems have their melodramatic side." Since my introductory course in economics, I had wondered about what that quote meant. Now 42 years later, I discover that the rupee had been pegged to silver, the pound to gold, and when the price of silver plummeted in the 1870s, the rupee depreciated. Indian goods became more competitive, creating competitiveness problems for British industry, and the "home charges," which India had to take to Britain, were denominated in sterling, creating fiscal problems for India. Corden notes that the more recent FBARs have also been "too sensational" (p. x). This is his way of saying it is important to keep exchange rates in line with fundamentals, or "It's much better to float."

Corden credits Ohlin with seeing clearly in 1931 the importance of adjusting the Swedish Kroner in order to stabilize the Swedish price level, yet another contribution in addition to his ideas on the factor price equalization theorem and the transfer problem, and his service as leader of Sweden's liberal party for 34 years. Corden quotes Keynes in 1923 as favoring price level stability as more important than exchange rate stability and believing that the most cogent rationale for a gold standard was the rather weak discipline argument, "strapping down Ministers of Finance" (p. 13).

Corden reminds us of core ideas about exchange rate regimes. For example, there is Milton Friedman's point that there is a presumption that currency speculation will be stabilizing, for destabilizing speculation is unprofitable. He laments the "jerkyness" of FBARs. He suggests that either flexible nominal wages or inflexible real wages creates an overwhelming case for an absolutely fixed (exchange rate) regime. In the former case, exchange rate change is not needed to maintain competitiveness, and in the latter it is not useful. A peg to an individual currency is preferable to pegging to a currency basket in that the former Saves transaction costs and is easier to monitor. What follows is a collection of Corden's insights that I found particularly interesting.

"Not many economists living in the real world would dispute that in the short run there is some degree of sluggishness downward of nominal wages in most, if not all, countries" (p. 89). And "based on overwhelming empirical evidence, Keynesian analysis and policies as presented here are still appropriate for short-to-medium-term situations" (p. 90). Also, the Barro-Ricardo complication that forward-looking tax payers will offset fiscal actions is only partial at best, leaving Keynesian demand-side prescriptions in tact.

For a fixed exchange rate to work well, a disciplined fiscal policy is essential. No exchange rate regime can discipline fiscal policy, and "an unstable or out-of-control fiscal policy must be faced up to directly" (p. 111). Corden's preference is, "in general, for a direct attempt at fiscal discipline, with the aim of avoiding a crisis, rather than using a crisis to bring about discipline" (p. 114). He also argues that the problem of unhedged borrowing of foreign currency in the presence of currency depreciation should be less of a problem in the future as borrowers drawing on the experience of the Asian crisis should hedge against exchange rate changes in the future. And part of the problem lay with the belief by financial intermediaries that their governments were likely to bail them out of any difficulty that their unhedged borrowing put them into.

The author's "hunch is that asymmetric policy shocks are generally much more important than asymmetric product shocks" (p. 145). Consequently, the case for flexible exchange rates is much stronger between countries that fail to cooperate on macro policy. Countries with powerful trade unions that do not coordinate with their trading partners' unions are more likely to need to resort to exchange rate change to maintain competitiveness. Also, "exchange rate flexibility has been conducive both to the avoidance of increased protection and to trade liberalization" (p. 147), thereby supporting "the conclusion that flexible exchange rate regimes are more favorable to trade liberalization than fixed exchange rates" (p. 152).

The experience of Brazil demonstrates that when the fiscal deficit is out of control there is no alternative to a flexible exchange rate. The depreciation of the Real in 1999 after a period of price stability and in the midst of a depression did not trigger substantial wage increases. Thus currency depreciation seems to retain the power to restore competitiveness if there is slack in the labor markets, and even if only a fairly short period of price stability has eroded wage indexation arrangements.

The Argentine crisis was the result of a combination of a failure to follow a tight debt-reducing fiscal policy during the boom years combined with a fixed exchange rate. This meant that when the recession of 2000-2001 hit, both exchange rate and fiscal stimulation were infeasible. In a recession a credible currency board can convert an incipient exchange rate crisis into a debt crisis, as the loss of competitiveness raises fears of default. A currency board is so rigid that both functional finance (fiscal policy aimed at stabilization needs) and sufficient wage flexibility are required for it to work. In Argentina, "neither has been politically possible on a sustained basis (p. 193).

The fixed bhat-dollar exchange rate facilitated a sense of confidence for the investor in Thailand, and hence encouraged the capital inflow into Thailand, which exacerbated the speculative boom and the ultimate bust in the 1990s. A flexible exchange rate, by contrast, would have thrown sand into this mechanism and damped the amplitude of the boom-bust cycle. Indonesia, in the throes of a political and social crisis, wisely permitted the rupiah to depreciate. Had Stephen Hanke's proposed currency board been established, the system could not have been sustained. The Malaysian capital controls of 1998 enabled expansionary monetary and fiscal policy to pull the economy out of recession without triggering a larger depreciation of the ringgit, with resulting inflationary pressure and worsening terms of trade. Capital controls helped avert crises in India and China.

The success of the fixed regime just prior to the establishment of the Euro shows that "the regime can survive if the political commitment is sufficiently strong" (p. 231). Others seeking to mimic the European Monetary Union (EMU) should remember that the EMU is based on a strong political will and a long period devoted to the European integration process. The EMU rule that no country's fiscal deficit shall exceed 3% of the gross domestic product (GDP) in any year, which was undertaken to avoid any responsibility for the new European Central Bank to bail out fiscally irresponsible regimes, flouts the need for functional finance under a fixed exchange rote regime.

"The fixed but adjustable regime in an environment of high capital mobility should be completely ruled out" (p. 245). It is too sensational, leading to crises. Corden cites the cost to the public finances of George Soros's run on the Bank of England--although noting that in this case the redistribution to the philanthropist-financier who used his wealth mainly to foster "open societies" in Eastern Europe and the former Soviet Union "happened to be a favorable redistribution of income." (pp. 245-246). It is possible, however, to maintain a fixed but adjustable regime and various forms of managed floating so long as adjustments are frequent. He finds currency boards that become in effect FBARs to be undesirable, arguing they work well "only when the exchange rate and associated monetary policy commitments are, in some sense, absolute" (p. 249).

For the United States, Euroland, and Japan, flexible exchange rates with macro policy guided by domestic considerations is optimal. For small open economies and those that have experienced lots of inflation, a currency board should be considered only if the commitment to maintain it is strong enough to sustain its credibility. For many countries a pragmatic managed float is the answer. For them it is important to avoid strong exchange rate commitments. Although some emerging market economies should not rule out controls on capital outflows during crises, their general effectiveness, in Corden's view, is open to question.

My reaction to the book is that the theory of optimum currency areas as developed by Mundell and refined in Corden (1972) has not lost its relevance. We have fleshed out that material with lots of experience. This book uses the theory and practice of exchange rate regimes to inform the choice of regime. This is a much more directly policy-focused study, which tries hard to sort out what is critical. I am left with confidence that I better understand how to approach this critical question that every country's policy makers face.

Corden always gives the sources of his ideas full credit. The annotated reference lists at the end of each chapter are particularly useful. For me, this is the standard source for students who want to understand and write about exchange rate systems and, for that matter, for those who want to understand how to write. The clarity and freedom from jargon is refreshing.

Finally, I applaud the M1T Press for keeping their prices reasonably low, and I have discovered part of what makes it possible: shipping books with blurred printing on the covers to reviewers. Waste not, want not! The other part, more regrettably, is that the black ink in the cover of the book kept rubbing off on my hands and was remarkably hard to get off--a small price to pay for this imaginative guide to finding the right exchange rate regime.

References

Bhagwati, J. N. 1988. Protectionism. Cambridge, MA: MIT Press.

Corden, W. Max. 1972. Monetary integration. Essays in international finance No. 93, Princeton University.

Edward Tower

Duke University