It is remarkable how the world's short recent history of floating exchange rates among flat currencies has affected popular thinking about what is eternally normal and proper in the economic system. Recently, Senators Charles Schumer and Lindsey Graham (2006) wrote matter of factly in the Wall Street Journal that "One of the fundamental tenets of free trade is that currencies should float." Such a "tenet," if it were such, could only have emerged since the 1970s. Of course, exchange rates had fluctuated widely in previous centuries, but it has been only since the 1970s that such fluctuations have been taken as connatural with the international monetary regime. Even John Maynard Keynes, the arch slayer of the last remnants of commodity money, was an adamant supporter of fixed exchange rates. (1)
Before the 1970s, it was generally taken for granted that international transactions would be best served by a system of fixed exchange rates relative to the international standard of value, which was a commodity or a claim on a commodity. Money accepted across borders had generally been gold, or claims on gold, for about 2,500 years. The post-1971 international monetary "system," certainly a misnomer, is comprised of 150-some-odd currencies, primarily national, all circulating in the form of irredeemable IOUs, or IOUs redeemable only in other IOUs. Some trade freely against others, some trade freely but with governments buying and selling so as to maintain a desired price, and some are subject to exchange restrictions by their government issuers. This would appear a recipe for continual global chaos, but it functions with far more stability than one might expect, given the complete absence of agreed rules or an agreed international money. This is because one currency, the U.S. dollar, is widely accepted voluntarily as money for the purposes of international transactions.
Nonetheless, it is a source of tremendous periodic instability, manifesting itself in currency crises afflicting countries whose currencies are not acceptable for international transactions, but which build up currency imbalances in their national balance sheets through their imports of dollar capital. Over the past two decades, devastating currency crises have hit such countries across Latin America and Asia, as well as countries just beyond the borders of western Europe; in particular, Russia and Turkey. This has led to international capital flows becoming far and away the most widely condemned flaw in globalization.
That the destabilizing effects of today's cross-border capital flows should be considered, however, even by economists who should know better, a manifestation of "market imperfection" or "irrationality" is to my mind astounding. The fundamental difference between capital flows under indelibly fixed and non-fixed exchange rates was well known generations ago, decades before the modern era of globalization. Consider this excerpt from a lecture by Friedrich Hayek in 1937:
Where the possible fluctuations of exchange rates are confined to narrow limits above and below a fixed point, as between the two gold points, the effect of short-term capital movements will be on the whole to reduce the amplitude of the actual fluctuations, since every movement away from the fixed point will as a rule create the expectation that it will soon be reversed. That is, short-term capital movements will on the whole tend to relieve the strain set up by the original cause of a temporarily adverse balance of payments. If exchanges, however, are variable, the capital movements will tend to work in the same direction as the original cause and thereby to intensify it [Hayek 1937: 64].
This was because
Every suspicion that exchange rates were likely to change in the near future would create an additional powerful motive for shifting funds from the country whose …