Exchange Rates and Economic Policy in the Twentieth Century

Published by EH.NET (December 2005)

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Ross E. Catterall and Derek H. Aldcroft, editors, Exchange Rates and Economic Policy in the Twentieth Century. Aldershot, UK: Ashgate, 2004. xiii + 326 pp. ?57.50/$110 (hardback), ISBN: 1-84014-262-2.

Reviewed for EH.NET by Stefano Battilossi, Department of Economic History and Institutions, Universidad Carlos III Madrid.

Benefits and shortcomings of alternative exchange rate regimes have been hotly debated by economists and policy-makers throughout the second half of the twentieth century. Can the history of exchange rates during this period provide original insights that positively interact with theory and policy? The editors of this volume, Ross E. Catterall (Anglia University) and Derek Aldcroft (University of Leicester), assigned themselves a challenging task, namely to assess the impact of exchange rate regimes on national economies and the world economy, as well as to draw out the relevance of history for policymakers. However, both the organization and the content of the volume hardly match such ambitions. The book is mainly based on papers originally presented at the XII International Economic History Congress in 1998, subsequently revised and reworked. New chapters were also added to cover the transition to the European single currency. In fact, the last quarter of the twentieth century gets the lion’s share of the attention and accounts for more than two thirds of the total pages. In spite of the stated objective of providing “a background canvas” and a coherent framework for the collected essays (p. 4), the introduction by Catterall is rather an impressionistic journey through the modern history of exchange rate regimes and fails to direct the reader towards common threads and focal points. All in all the volume gives the impression of a medley of contributions occasionally brought together, rather than strategically arranged around a set of well-identified key issues.

That is unfortunate, since a wealth of theoretical and empirical analysis has been produced on the subject in the last decades. In the early 1970s the Bretton Woods anti-floating fundamentalism gave way to a more benign view, according to which floating rates were not inherently destabilizing but actually fostered monetary independence and enhanced governments’ flexible responses to exogenous shocks. Hard-pressed by overlapping oil and wage shocks, policymakers enthusiastically embraced the new credo, which was eventually institutionalized in the Jamaica agreement of 1976. Yet the sharp and quite unexpected increase in the volatility of both nominal and real exchange rates was an unwelcome surprise even for pro-floaters. Whereas European policy-makers quickly switched back to pegged exchange rates, academic researchers were puzzled by the apparent lack of a direct relationship between exchange rate fluctuations and macroeconomic fundamentals. This finding, clearly at odds with established models, paved the way to a new wave of empirical research along the lines of the expectations-driven asset approach proposed by Rudy Dornbusch and Jeffery Frenkel among others. By the early 1980s, Richard Meese and Kenneth Rogoff challenged the conventional academic wisdom by demonstrating that random walk forecasts outperformed economic models of exchange rates in the short-run [1]. Likewise, other empirical studies found the effects of exchange rate fluctuations on real macroeconomic quantities, such as trade volumes, to be small or insignificant. Nevertheless, from a policy perspective, in the 1980s pegged regimes continued to enjoy very good press due to their success in providing a nominal anchor in experiments of disinflation and macroeconomic stabilization in Southern Europe and Latin America.

With the collapse of the European Rate Mechanism in 1992-93, and even more in the aftermaths of the “twin” crises that savaged Latin America and East Asia in the 1990s, pegs’ popularity suddenly declined. Meanwhile, the relationship between exchange rate regimes and financial crises emerged as a subject of even greater dispute. The big issue was whether such crises had been determined by economic and financial fundamentals, or by financial markets’ behavior. Whereas international institutions such as the IMF were generally inclined to point to underlying macroeconomic divergence rather than to market pressures, the idea of self-fulfilling crisis cast into ‘second-generation’ models of currency crises became increasingly popular among policy-makers just too keen on blaming markets and speculators. In any case, a new consensus emerged around the notion that pegged exchange rate regimes were too rigid and thus prone to break-down as a consequence of sudden reversals of expectations (whether based in fundamentals or not). Thus, at the turn of the new century, a global switch to more flexible intermediate regimes could be observed.

In spite of the almost unanimous acceptance of such policy lesson, however, researchers are still struggling to assess the practical relevance of exchange rates: the “exchange rate disconnect puzzle” remains as elusive as ever [2]. Interestingly, a systematic revision of the recent history of exchange rates has been carried out by Carmen Reinhart and Kenneth Rogoff in order to reclassify postwar exchange rate regimes on a “de facto” rather than “de jure” basis (in fact, many official fixed regimes proved to be backdoor floats), and then to test their impact on growth and macroeconomic performance [3]. Their results suggest that in developing countries with partial insulation from global capital markets, pegged regimes enhanced inflation control with no apparent sacrifice of growth, which seem to run against the freshly emerged consensus that pegs are not viable for developing countries. Perhaps this announces a new swing of the policy pendulum back in favor of pegs?

Many of the above mentioned recent developments in empirical analysis are unfortunately neglected in the volume. Some of the essays are, however, keen on elaborating on the interaction between theories and policy implications, with a special interest in monetary policies and exchange rates in Western Europe in the 1980s and 90s. Michael Oliver’s contribution (pp. 103-29) offers a useful survey of the theoretical underpinnings — from Mundell-Fleming to the monetary approach to the balance of payments — of disinflationary policies based on monetary and exchange rate targets, and provides a critical assessment of their effectiveness based on the experience of the U.S., the UK and the EMS. In turn, Ross Catterall (pp. 228-53) focuses on the failure of theoretical models to account for the post-1973 volatility of exchange rates. He blames the increased volume of speculative (i.e. not related to real international transactions and portfolio investments) flows for this volatility puzzle, and contends that nowadays currency speculators “determine the degree to which countries can compete in export markets” (p. 238). For instance, the “mysterious” rise of the euro against the U.S. dollar and the British pound since 2003 brings him to conclude that “the European economies, despite the existence of the single currency, are indeed at the mercy of the exchange rate roller-coaster” (p. 244), which in his view also spells disaster for the future sustainability of the single currency experiment. More or less in the same vein, George Zis (pp. 254-95) discusses the ebb and flow of the theoretical case for flexible exchange rates. By examining the original contributions of Milton Friedman and H.G. Johnson, the “abysmal failure of the flow foreign exchange market model” (p. 279) and the subsequent emergence of a monetary theory of exchange rate determination, Zis contends that the case for flexible exchange rates as a means of achieving monetary independence was (and still is) ill-founded as it is based on undemonstrated assumptions — such as the efficiency of foreign exchange markets — and fails to incorporate basic elements of open economy macroeconomics (such as the impact of currency substitution on the demand for money) into its original “insular” approach. Finally, Angelos Kiotos (pp. 296-320) provides a survey of the current literature on the potential benefits of the adoption of the Euro (aka ‘euroization’) by Balkan countries as a de jure or de facto base of their monetary regimes.

Apart from survey chapters, the volume makes little contributions to original empirical analysis. Although explicitly devoted to assessing the impact of exchange rate regimes on economic performances in the 1930s, Derek Aldcroft’s chapter (pp. 17-70) offers in fact a textbook-style review of the extensive literature on the monetary history of the 1920s and 30s. Special emphasis is given to the well-known fact that countries that devalued their currencies and subsequently resorted to managed floating performed better in terms of economic recovery than gold bloc countries with overvalued currencies and heavy deflationary pressures. Incidentally, this essay is an almost perfect replica of a couple of chapters already published by Aldcroft in a previous book on Exchange Rate Regimes in the Twentieth Century with Michael Oliver (Elgar, 1998). More original, on the contrary, is Scott Sumner’s essay, which uses both quantitative techniques and qualitative evidence in order to assess the impact of the Fed’s monetary policy on stock market behavior and expectations of devaluation and inflation in the 1930s (pp. 71-102).

Three other papers have a clear empirical focus. Allen Webster (pp. 130-71) addresses the issue whether trade barriers created by exchange rates “have historically been sufficiently important to provide a key justification for European monetary union” (p. 139). By gauging the microeconomic costs of exchange rates in terms of risk premia and transaction costs, Webster in fact estimates the potential benefits for Britain from joining the EMU. Based on simulations of effective rates of protection and anti-export bias resulting from exchange rate barriers for the UK in the period 1989-90, he concludes that such barriers had a negligible effect on value added, although “a markedly stronger effect on average upon the returns to capital” (p. 148). The findings strike a clear Euro-skeptic note, suggesting that the removal of such distortions would have no significant impact on economic efficiency. With Kieron Toner (pp. 172-201) we move unexpectedly to the Southern hemisphere with a detailed analytical narrative of liberal reforms implemented in Australia in the 1980s. Toner argues that, by putting the cart of exchange rate and financial market liberalization before the horse of macroeconomic stabilization and structural reforms, Australian governments hindered industrial development and contributed to increasing the country’s financial fragility — which he takes as evidence of the ‘irretrievable flawness’ of the ‘classical strategy’ for reform (p. 197). Finally, we travel back again to Europe with Costas Karfakis, who offers an interesting analysis of the role of monetary and exchange rate policies (‘hard-drachma’) in the process of macroeconomic stabilization and adjustment in Greece in the 1990s (pp. 202-27). This is the only essay in which explicit modeling and quantitative techniques are employed in order empirically to address important issues raised in the exchange rate literature, such as sterilization policies, the credibility of exchange rate-based disinflation and the impact of a nominal exchange rate anchor on inflation inertia.

In spite of the unquestionable merits of some of its individual parts, altogether the thematic dispersion, lack of analytical focus and relative scarcity of empirical content make the volume a rather disappointing read.

References:

1. R. Meese and K.S. Rogoff, “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?’ Journal of International Economics 14 (1983), pp. 3-24.

2. R.P. Flood and K.R. Rose, “Understanding Exchange Rate Volatility without the Contrivance of Macroeconomics,” Economic Journal 109 (1999), pp. 660-72; M. Obstfeld and K. Rogoff, “The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?” in B. Bernanke and K. Rogoff, eds., NEBR Macroeconomics Annual 2000 (Cambridge: MIT Press, 2000, pp. 339-90).

3. C. M. Reinhart and K. S. Rogoff, “The Modern History of Exchange Rate Arrangements: A Reinterpretation,” Quarterly Journal of Economics 119 (2004), pp. 1-48.

Stefano Battilossi is visiting professor at Universidad Carlos III Madrid. He is currently carrying out research projects on the determinants of multinational banking during the first globalization and on financial repression in Western Europe in the second half of the twentieth century.

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