The International Monetary System and Exchange Rate Determination: 1945 to the Present
Harvey, John T., Journal of Economic Issues
Increasingly, the foreign exchange market bas become a focus for pecuniary pursuits at the expense of trade and direct investment. Two of the side effects of the increased use of exchange market operations for pecuniary gain have been rate volatility and chronic payments imbalances. While it is fairly clear that the problems of today have their roots in the tremendous growth of the international money market, it remains to explain the nature and causes of that growth. It is the purpose of this paper to summarize the developments responsible for making the foreign currency market the planet's only worldwide, 24-hour casino.
Exchange rates are marked by tremendous volatility and chronic misalignment.(2) Volatility discourages trade and investment by adding another cost to trading internationally, and misalignment means that trade imbalances can exist for long periods of time with no self- collecting tendency to restore balance [Pozo 1992]. Imbalances cause political friction and tend to break down the spirit of international cooperation and compromise. Both the volatility and at least part of the misalignment are consequences of the structure of the market today, which in turn is the result of the massive growth of the international capital market.
The relationship between volatility and misalignment is illustrated in Figure 1. To begin, the link between the volume of capital flows and the frequency and severity of payments imbalances is the result of the fact that the demand for foreign currency is not derived solely or even largely from the international demand for goods and services. The level of daily exchange rate transactions far exceeds that necessary for international trade.(3) Thus, the self-correction mechanism that is usually held to exist does not because the demand for foreign currency is derived from far more than the international demand for goods and services, and there is no guarantee that the exchange rate cannot settle at levels other than that which yields balanced trade.
The straight line of causation between the volume of capital flows and the volume of speculative activity is explained thusly. Trade flows tend to be much more stable, especially in the shortest of runs, than capital flows. The most obvious reason for this is the ease with which one can change the composition of a financial portfolio as compared to changing sources of supply of an international good or service. As capital flows have grown, the size and instability of the demand for foreign currency has grown.
If the size and instability of the demand for foreign currency grows, then the likelihood of episodes of volatility increases. And if foreign currency possesses the characteristics that make it desirable as an asset [Krause 1991, 65-66], then, as currency prices become more and more volatile, opportunities for speculation in that asset will increase. Assuming that parties exist who wish to take advantage of these opportunities, this leads to an increase in the volume of speculative activity [Moffit 1983, 83].
The increasing volume of speculative activity has a number of consequences and leads to three positive-feedback loops, each causing the role of speculation to become more important. For one, the rise in the volume of speculative activity directly contributes to the rise in the size and instability of demands for foreign exchange and therefore volatility.(4)
Second, the increasing importance of speculative activity has led to a situation in which there is no anchor or central tendency to exchange rates independent of those speculative forces. It is often stated that exchange rates respond to changes in "fundamental" variables. These values are supposed to yield the central tendency toward which rates are drawn. For such a tendency to exist, it is necessary that the factors determining the demand for foreign currency be relatively stable and easy to identify and that the processes affected by these factors be responsible for the bulk of foreign exchange trading. …