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International Monetary Reform: the Feasible Alternatives Fp Federal Reserve Bank of Minneapolis Quarterly Review Summer 1978 Does the sinking U.S. dollar mean the float isn't working? (p. l) l6V International Monetary Reform: The Feasible Alternatives fP. 2> District Conditions (p. 8) : m #tf'J.i * fh r il ** -I M, I M i5 Federal Reserve Bank of Minneapolis Quarterly Review VOI.2,N<>.3 This publication primarily presents economic research aimed at improving policy making by the Federal Reserve System and other governmental authorities. Produced in the Research Department. Edited by Arthur J. Rolnick, Senior Economist, and Kathleen S. Rolfe, Editor/Writer and Visuals Specialist. Graphics assistance provided by Phil Swenson and Karen Maccario, Graphic Services Department. Address requests for additional copies to the Research Department, Federal Reserve Bank, Minneapolis, Minnesota 55480. The views expressed herein are those of the authors Articles may be reprinted if the source is credited and the Research and not necessarily those of the Federal Reserve Department is provided with copies of reprints. Bank of Minneapolis or the Federal Reserve System. International Monetary Reform: The Feasible Alternatives John Kareken and Neil Wallace Economic Advisers Research Department Federal Reserve Bank of Minneapolis Professors of Economics University of Minnesota It may seem odd, our writing about international We can put this point another way. Having monetary reform. It has been not much in the news floating exchange rates is feasible only when inter- since April 1976, when a revised International Mone- national borrowing and lending are effectively pro- tary Fund Articles of Agreement, a new international hibited by law, or in other words only with portfolio monetary constitution produced with great effort and autarky. There is a floating rate regime—the port- anguish, was made public. We believe, though, that folio autarky/floating rate or PA/F regime—under before too long finance ministers and their experts which there is no official exchange market inter- will again turn, if perhaps with less flourish than last vention and international borrowing and lending are time, to the task of monetary reform. That appears an prohibited. And that regime is feasible. Under it, odds-on bet, for even as it was being published many there is an equilibrium, an equilibrium characterized governments were lamenting their new constitution, by trade balance, for every choice of budget or particularly the part which made floating exchange domestic economic policies. But the libertarian rates legal. Nor has the experience of the past two and regime—which we sometimes refer to as the laissez- a half years been reassuring. Among governments, faire/floating rate or LF/F regime—although vigor- there is now more opposition to floating rates than ously advocated by Professor Milton Friedman and there was in early 1976. others, is not feasible for any choice of budget What concerns us is that governments may not policies. understand what their options are. And presumptu- Our other essential point (much more easily ous though it may be, that is why we write: to explain accepted, we are sure) is that no fixed exchange rate which international economic policy regimes are regime is feasible except when governments, fore- feasible and which are not. swearing autonomy, continuously run identical bud- It is reason enough for concern that academic get surpluses or deficits (identical in the sense that experts in international economics have shown so their respective national debts, inclusive of their little understanding of what the feasible choices of noninterest-bearing liabilities, increase or decrease at governments are. Many of the most eminent have the same percentage rate). long urged a hands-off or libertarian regime, under There is a clear implication. If governments want which there is no official exchange market inter- autonomy, independence in choosing budget poli- vention and international borrowing and lending are cies, then they must prohibit international borrowing not at all restricted. But that regime is not feasible. and lending. More particularly, each must insist that Under it, there is no equilibrium; more specifically, its citizenry hold only its money. equilibrium exchange rates are not determined. Such capital controls are distorting, though, and 2 Federal Reserve Bank of Minneapolis Quarterly Review/Summer 1978 real resources must be used to make them effective. monies. Nearly every national government has its And that should give governments pause. Is auton- own. So there is a choice of which to hold or use as the omy worth what, directly and indirectly, it costs? We medium of exchange. Thus, to recognize that ex- think not and at another time will make a case for the change is costly is not to deny that one fiat money can best of international economic policy regimes: that dominate another or that fiat monies are perfect under which international borrowing and lending are substitutes, each for all the others. The most efficient unrestricted, all government budgets are continu- way of making exchanges may be by using paper ously in balance, and exchange rates are coopera- money. But that is not why the Mexican peso is the tively and indefinitely maintained at previously speci- medium of exchange in Mexico or why the Israeli fied values. But here we content ourselves with pound is the medium of exchange in Israel. The establishing the fundamental choice of governments: explanation is to be found in the policies of govern- they can enjoy autonomy in budget policies, but only ments. if they are willing to impose and enforce compliance The unconstrained demands for fiat monies with severely restrictive capital controls. (national currencies) are, then, very special. Being demands for perfect substitutes, they are of the all-or- Fiat Money: Intrinsically Useless nothing variety. Depending on how rates of return Undeniably, the world economy is a paper or fiat compare, any individual wants to hold only country X money economy. It long has been; we are now several money or only country Y money. Thus, with perfect decades beyond the time when gold was replaced by freedom of portfolio choice, equilibrium exchange national fiat monies. And as all would also agree, fiat rates can't be expected to change. Indeed, if individ- money is intrinsically useless. It is never wanted for its uals were never surprised, then equilibrium exchange own sake. Neither directly nor indirectly does it have rates would be constant over time. The argument is any value in consumption. (That is why it has so essentially that which establishes the well-known in- intrigued economists. Why then does it have a posi- terest arbitrage condition of the international eco- tive price? But that is by the way.) If an individual nomics literature. That condition says that the risk- gives up wheat, say, for a certain number of pieces of less nominal interest rates of any two countries, X paper, that is only because she or he expects that later and Y, can differ only by the expected change in the on another individual will take those pieces of paper country X-country Y exchange rate. But for fiat in exchange for wine or some other commodity that monies the nominal rates of return are zero. Hence, has value in consumption. so is the expected change in the exchange rate. That Something very important follows, though, from is a direct consequence of the intrinsic uselessness of the intrinsic uselessness of fiat money. A kind of fiat money. dominance is implied: If individuals are free to choose from among several assets, a fiat money being The Libertarian Regime: one, and if another of those assets has a greater An Indeterminate Equilibrium (expected) return in all circumstances, then no one The libertarian regime advocated by so many aca- will want to hold the fiat money. Suppose to the demic economists (what we're calling the laissez- contrary that someone does. That individual is will- faire/floating rate or LF/F regime) is characterized ing to trade valuable commodities for some fiat by perfect freedom of portfolio choice and no official money, even though she or he could enjoy more exchange market intervention. And under it there is consumption subsequently by acquiring the higher- no equilibrium. Because fiat monies are intrinsically yielding asset. And why? Any explanation contra- useless and money demands are therefore of the all- dicts what must be accepted, that fiat money is or-nothing variety, the equilibrium of the LF/F intrinsically useless. regime is indeterminate. Someone will perhaps object that we have over- To say the same thing another way, the LF/F looked the obvious: exchange is costly, and the use of regime has an equilibrium for not one but every paper money minimizes that cost. But it is not wrong choice of exchange rate values. With the time paths to overlook the obvious when the obvious is not of the national monies given, any set of unchanging relevant. The world we know is one with several fiat exchange rate values determines a time path of the 3 world money supply1 —and so an equilibrium. More- X want always to hold only the money of the govern- over, the world money supply time paths implied by ment of country X. different sets of exchange rate values are different, We do not say that individuals will never want to and so are the equilibria. But exchange rate values do hold diversified portfolios of national currencies. If have to be specified. There are no market-deter- there is the right kind of uncertainty about govern- mined equilibrium values. ment policies, they will. (Note, however, that not any Those reared on conventional theory may find kind of uncertainty will do.) But uncertainty about that conclusion hard to accept. For that theory, in government policies is not a characteristic of the any of its variants, certainly does say that the LF/F libertarian regime.
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