The cost of floating exchange rates

The trade in complex derivatives effectively created a black market fiat monetary system that almost brought capitalism to its end. Why did this situation develop and what must we do stop its reoccurrence?

No doubt this question will spawn countless years of academic research. We will have dozens of well thought out culprits. Maybe we should list the leading contenders:

• remuneration packages within the financial sector skewed to rewarding short term risky economic activity;
• ratings agencies having inherent conflicts of interest in assessing financial products for a fee;
• central banks having too loose monetary policy;
• separation of risk from credit originator;
• lack of fiscal policy response to asset bubbles;
• short selling; and
• accumulated market share of financial institutions make them too big to fail.

No doubt significant work needs to be done on all of the above. However if the global community only looks at addressing these types of issues we will continue to treat the symptoms not the disease.

The Economist (October 17, edition) provides some information that sheds light on the disease. Non-financial institutions in the interest-rate and foreign exchange markets account for $50 trillion of outstanding derivatives. In other words non-financial institutions have to divert $50 trillion from their production investment cycles to interest rate and foreign exchange derivatives for hedging purposes.

Non-financial institutions have to gamble $50 trillion to guard against unexpected exchange rate movements. That is the cost of floating exchange rates.

This huge pool of investment creates asset bubbles which distort investment and resource allocation within economies around the world.

The instability within exchange rates is causing huge sums of money to be diverted from long term productive investments to gamble on currency movements.

Letting the market decide exchange rates creates uncertainty and consequently corporations need to reduce the risk from such uncertainty. That is done by trading in derivatives which reduces the proportion of capital linked to physical assets such as new factories. These derivatives are a virtual new monetary system outside the control of national governments or central banks. The very nature of these derivatives generates asset bubbles that threaten national economies.

The Australian dollar has gyrated from close to parity with the $US to dropping to 60c and rebounding to 90c all within a space of 12 months. It is obvious that the markets are no longer able to price currencies based on the underlying fundamentals: speculative investments are distorting the value of the currencies. Thus the volatility in currency markets has reached a point where concerted intervention by national governments is required.

IMF working paper WP/01/197 found that institutional stabilisation significantly increased market integration than instrumental stabilisation policies. That is common currencies, currency pegs or dollarisation was far more effective in reducing price dispersion.

Rose (2000, Forthcoming Economic Policy) found that bilateral trade between countries with a common currency was 300 per cent more than what was observed in comparable nations without a common currency.