Monday, July 12, 2010

Mankiw on Exchange Rate Policy

A nice piece on exchange rate policy by Greg Mankiw appeared in The New York Times over the weekend.

Here is an excerpt:

What is the trilemma in international finance? It stems from the fact that, in most nations, economic policy makers would like to achieve these three goals:

Make the country’s economy open to international flows of capital. Capital mobility lets a nation’s citizens diversify their holdings by investing abroad. It also encourages foreign investors to bring their resources and expertise into the country.

Use monetary policy as a tool to help stabilize the economy. The central bank can then increase the money supply and reduce interest rates when the economy is depressed, and reduce money growth and raise interest rates when it is overheated.

Maintain stability in the currency exchange rate. A volatile exchange rate, at times driven by speculation, can be a source of broader economic volatility. Moreover, a stable rate makes it easier for households and businesses to engage in the world economy and plan for the future.

But here’s the rub: You can’t get all three. If you pick two of these goals, the inexorable logic of economics forces you to forgo the third.

In the United States, we have picked the first two. Any American can easily invest abroad, simply by sending cash to an international mutual fund, and foreigners are free to buy stocks and bonds on domestic exchanges. Moreover, the Federal Reserve sets monetary policy to try to maintain full employment and price stability. But a result of this decision is volatility in the value of the dollar in foreign exchange markets.

By contrast, China has chosen a different response to the trilemma. Its central bank conducts monetary policy and maintains tight control over the exchange value of its currency. But to accomplish these two goals, it has to restrict the international flow of capital, including the ability of Chinese citizens to move their wealth abroad. Without such restrictions, money would flow into and out of the country, forcing the domestic interest rate to match those set by foreign central banks.

Most of Europe’s nations have chosen the third way. By using the euro to replace the French franc, the German mark, the Italian lira, the Greek drachma and other currencies, these countries have eliminated all exchange-rate movements within their zone. In addition, capital is free to move among nations. Yet the cost of making these choices has been to give up the possibility of national monetary policy.

The European Central Bank sets interest rates for Europe as a whole. But if the situation in one country — Greece, for example — differs from that in the rest of Europe, that country no longer has its own monetary policy to address national problems.

Is there a best way to deal with this trilemma? Perhaps not surprisingly, many American economists argue for the American system of floating exchange rates determined by market forces. This preference underlies much of the criticism of China’s financial policy. It also led to skepticism when Europe started down the path toward a common currency in the early 1990s. Today, those euro skeptics feel vindicated by the problems in Greece.

To this I would only add that the US doesn't have such a hard choice, as the Dollar is an international 'hard' currency we don't have to worry os much about exchange rate fluctuations as most contracts our businesses write with international counter-parties are in dollars.  True, those counter-parties will agree to terms that take exchange rate risk into account, but it is a small issue relative to a small country where exchange rate volatility can be devastating.  

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