Exchange Rate Protectionism: A Harmful Diversion for Trade and Development Policy

By Malpass, David | The Cato Journal, Winter 2005 | Go to article overview

Exchange Rate Protectionism: A Harmful Diversion for Trade and Development Policy


Malpass, David, The Cato Journal


Exchange rate protectionism usually refers to the idea that a country's exchange rate might be undervalued, causing the country to import less and export more than it would with a stronger exchange rate. I would like to discuss exchange rate protectionism in a different context.

The Primary Meaning of Exchange Rate Protectionism

I think most of the trade impact of an exchange rate policy is overwhelmed by the policy's impact on economic development. In practice, therefore, the primary meaning of exchange rate protectionism is that an unstable currency tends to cause underdevelopment, limiting a country's imports and exports. The converse also holds: countries with stable exchange rates have seen imports and exports grow rapidly, with China a clear example.

Needed: A Stable Dollar Policy

In my address at Cato's 1999 monetary conference, entitled "Replacing the Vacuum in International Economic Policy," I presented the view that exchange rates, rather than reflecting economic fundamentals, cause them. An extract follows:

   In recent years [as of October 1999], the United States has seemed
   to build its entire exchange rate view on the sound bite that "a
   strong dollar is in the national interest." Yet it has declined to
   explain how a currency's strength should be measured or whether
   unlimited strength is good.

      Clearly, a "stable" currency, not strong or weak, is appropriate
   during most of a country's economic life. A "strong dollar" policy
   made good sense after a period of currency weakness and inflation
   as the United States experienced in 1993 and 1994. President
   Clinton and Secretaries Rubin and Summers deserve credit for this
   constructive 1994 shift in U.S. policy. By continuing the policy
   into 1997 and 1998, however, the administration has created a giant
   momentum play into the U.S. dollar, adding to our asset values and
   our growth rate, but subtracting from those abroad and increasing
   the difficulty of the transition to currency stability.

      Meanwhile, the jingoistic "strong dollar" policy of the United
   States confused foreign countries. Since 1997, the world has
   suffered from a global competition to see who could have the
   strongest currency. The Japanese played the game, deepening their
   deflation spiral and prolonging their economic stagnation. Germany
   let the mark get too strong in 1998, setting the stage for a "euro
   crisis" earlier this year as the euro moved back to an appropriate
   value.

      The confusion sown by the United States in international economic
   policy has resulted in a world of momentum-based volatility
   in which exchange rates drastically overshoot a stable norm. At the
   core of the economic confusion is the prevailing, and harmful, view
   that the value of a currency should change with the business cycle
   to reflect economic fundamentals. When an economy slumps, the
   argument is that the currency should weaken, and vice versa. This
   was the market logic that pushed the euro to extreme weakness in
   early July when there was talk of it breaking par with the dollar.
   The same logic pushed the yen to 147 yen per dollar in May 1998 and
   has now strengthened it to 106 yen per dollar, so strong that it
   will choke off Japan's recovery. These wild swings in exchange rates
   are anti-growth and are the responsibility of government.

      Businesses don't devalue their accounting unit when they lose
   money. Nor do they increase their unit of account when their profits
   rise. Suppose auditors advised companies to report earnings in
   frequent flyer miles if profit growth slowed. Not only would
   investors have to analyze the earnings slowdown, they would also
   have to analyze the uncertainty caused by a new unit of account. The
   United States and the IMF actively promote this illogic, causing
   economic decline across Latin America, Africa, Russia, and parts of
   Asia. 

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Exchange Rate Protectionism: A Harmful Diversion for Trade and Development Policy
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