Foreign Exchange: The Complete Deal. James McDowell. Sharpe
who prefer the floating system will claim that under fixed exchange rates there is loss of freedom in internal policy. This is clearly the case for those who joined the euro in January 1999. Some commentators in the UK regularly quote this as a good reason not to enter and cite the positive effects of devaluation post-1992 and the ability to devalue after the financial shocks of 2008. However, it begs the question of whether if there had been financial discipline prior to these events then devaluation would not have been an issue. In both cases the inflationary impact was muted as fortunately global deflationary pressures dominated.
Looking at the euro in more detail provides some interesting insights.
The euro experience
The euro experience has been broadly positive and the euro now ranks as the second reserve currency behind the dollar. The major criticism of it has been the one size-fits-all monetary policy, but this has also crucially been allied to failures to adjust fiscal policy. This was clearly evident in 2010 in Ireland, Greece and Portugal, which prompted a sell off in the euro and speculation of a break up of the entire union.
The need for fiscal convergence was recognised at the outset of the European Monetary Union but subsequently ignored or manipulated by politicians. The Maastricht Treaty signed in 1992 said that governments had to have budget deficits of no more than 3% of Gross Domestic Product (GDP) and a national debt of less than 60% of GDP (it was known as a stability pact). The importance of balance between monetary and fiscal policy has never been more clearly evident. Unfortunately, the euro-zone countries have behaved as if they were each managing their own currencies.
Each country appears to go its own way in raising taxes or borrowing money. In the past, imbalances would be adjusted over time through an appreciation or devaluation of the currency. This option is no longer available and in the case of Greece the only option was severe austerity measures, including cuts in wages and pensions.
Since the introduction of the Maastricht Treaty the deficit rules have been violated over 40 times. Greece tops the list in this respect. It has only once managed to push its deficit below 3% and this was through creative accounting in 2006. Also, Greece has raised debt through complex structures which have not been included in official statistics.
Ironically, it was Germany that was the second member state, after Portugal, to be subjected to an excessive deficit procedure by the European Union. It was also the German government who steered an “improvement in the implementation of the Stability and Growth Pact” at a special meeting of the Ecofin Council on 20 March 2005. This improvement could only be seen from a political viewpoint as it allowed more frequent exceptional and temporary violations of the deficit rules.
The Bundesbank declared that the changes would “decisively weaken the rules of sound financial policy” and the “goal of achieving sustainable public finances in all member states of the monetary union is being jeopardised”. This judgement has been borne out by recent events in Greece and other periphery countries, notably Ireland and Portugal. It has highlighted that while there is a common monetary policy the members of the euro lack a coherent and credible shared economic policy. It has shown that even small countries can jeopardise the entire currency project. Politically, it has prompted a change in awareness that its members are dependent on one other.
Conclusion
Fixed exchange rates are not just about numbers. They signal intent for co-ordinating economic behaviour and financial discipline. At best they unite the economic performance and policies of nations. In the case of Europe and the USA they represent political integration. Floating is more a statement of self interest which of late has become polarised between the West and Asia. When the industrialised nations went over to floating in 1973 it was not because flexible exchange rates were regarded as a better system but simply because the system of fixed rates had temporarily collapsed.
Floating certainly has its advocates who would argue that it has coped well with oil crises and recession, and provided a more benign adjustment mechanism. This is important when set against the backdrop of the electorate holding governments increasingly accountable for economic performance. It has, however, seen the demise of financial discipline and has led to overshooting and undershooting of exchange prices, which is its major flaw. This has prompted active government intervention, although the primary stated ambition has been to stabilise disorderly markets rather than to create artificial exchange rates. The effectiveness of this intervention has not been firmly established.
During the period in question foreign exchange dealing has seen enormous changes. The rapid changes in communications and computing power has forged the 24-hour dealing market and the speculator; this pair is often blamed for chaotic markets. In reality 24-hour dealing and speculators are the symptom of the problem not the problem itself.
Increasingly wild fluctuations in the exchange rates, which is the situation in the 21st century, have little attraction in the medium term, both in terms of trade and asset allocation. The recent lessons from Europe, discussed in this chapter, are that to achieve stability the politicians will have to learn to live with financial discipline and take responsibility for managing electoral expectations.
Foreign exchange and the UK – 1960 to the 2000s
1960s
By the 1960s the deterioration in the UK’s competitive position was becoming increasingly evident. This was partly a legacy of the war and partly due to an economy heavily dependent on trade, but it was also caused by an inability to change working practices and restructure industry to the new world order.
In 1964 the Labour Prime Minister Harold Wilson made the famous declaration that he would defend the sterling parity as established at Bretton Woods at $2.80. The inevitable revaluation away from $2.80 was stalled by various support packages but by 1967 (18 November) it was finally recognised that sterling was fundamentally overvalued and that the economy could not support the rate and so a devaluation of 14.3% was arranged. This reduced the parity rate from $2.80 to $2.40.
1970s
The sterling demise had been coming for some time; rising deficits, rampant inflation, political gridlock and industrial unrest on a grand scale (for example, the miners’ strike) had become features of the 1970s. In December 1973 Idi Amin, the Ugandan dictator, launched a Save Britain Fund and even offered emergency food supplies. Unemployment was also rising and in January 1975 breached the psychological barrier of one million.
The events of 1976 that lead up to the sterling collapse can provide useful insights into the situation facing European economies in the early years of the 21st century: attempting to control public deficits while supporting demand. A lesson then, as now, was that material changes in policy may not arrive soon enough to placate the markets. The problems in Ireland, Greece, Spain and the UK, to name but a few, did not appear overnight but politicians, the financial press and economists were slow to conclude that previous policies were unsustainable and this was the same in 1976.
In the 1976 crisis the turning point in policy came as late as the beginning of 1975. As the then Chancellor, Denis Healey, wrote: “I abandoned Keynesianism in 1975.” As we saw with Ireland and Greece, action was forced on them as borrowing costs rose to extreme heights; and for Greece in particular borrowing was nearly impossible. A common trait of politicians both this century and the last is that they are loathe to admit to any crisis and so policy shifts are inevitably late in coming. Edmund Dell captured this speaking after the February 1974 election. He said: “Some ministers seemed unconscious of the economic crisis that had struck the country. Their attitude resembled that of characters in Jane Austen’s novels who carried on their lives undisturbed by the Napoleonic Wars.”
Crises tend to build on small events. In the 1976 crisis the cracks started to appear on 9 March 1976 when Nigeria announced its intention to diversify its foreign exchange reserves, which for historical reasons were heavily weighted towards sterling. The following day the Labour government lost a House of Commons vote on public expenditure cuts designed to win support from the IMF (the