Money makes the world go round — just not smoothly

Inflexible exchange rates are having severe consequences for economies around the world.

Trading of national currencies in exchange for others takes place around the world in dizzying amounts, estimated at US$5.3 trillion daily. To put this number in perspective, it is three times the value of what the Canadian economy produces in an entire year.

These transactions satisfy the need for settlements of receivables and payables for goods, services or assets between parties using different currencies. Also, foreign exchange trading facilitates risk management. For example, companies exposed to liabilities in one currency but wishing to do away with the currency risk associated with that liability can do so via currency swaps.

More fundamentally, flexible exchange rates allow changes to a country's global competitiveness to be quickly reflected in the international purchasing power of its currency.

This makes it possible for the average "national" wage rate in a country to quickly move up or down against the prevailing wages in other countries.

For a country facing a deteriorating competitive position, a depreciation of its exchange rate acts as a safety valve; when it is not available, and its prices and costs cannot adjust downward relative to those of competitors in other countries, unemployment results, which can foster serious social tensions.

Inflexible exchange rates between economies behaving differently have the effect of preventing such adjustment when it is needed. This perverse dynamic is at work now among countries that have adopted the euro as a single currency. Resentment is building against Germany because its high-quality manufactured goods are available at a relative bargain, thanks to the fact it shares a currency with less competitive countries.

Meanwhile, countries such as Greece — and entities that have lent to it — are in a pickle, because Greek industry is not competitive enough to generate the income needed to repay the debts the country has incurred, in part to buy German goods.

In the past, a compelling way to address this imbalance would have been to devalue the Greek currency, making Greek products more attractive to others. But because it now shares the same currency with Germany, Greece's competitiveness can only improve through a drop in wages and other internal prices, a gut-wrenching exercise politically speaking, as various groups try to pass off the cost of the required austerity to other groups.

A similar dynamic is at work in Asia. For many years, China and other countries competing with it in the US market bought US dollars and sold their currencies in foreign exchange markets to prevent their currencies from rising, in an attempt to sustain export-led development. Thankfully, China has begun to realize that this policy holds down its peoples' standard of living by making imports more expensive, and preventing the development of a robust domestic demand for goods and services. China has now let its currency appreciate, though in a very controlled way.

While the US and others have publicly berated China for an exchange rate policy that floods other markets with products made in China, they themselves are not blameless. Unsus-tainable fiscal deficits in an importing country, for example, can also contribute to unsustainably high imports and trade deficits. Yet a coordinated international approach to resolving imbalances has proven to be elusive: countries with large trade deficits will try to impose short-term solutions, requiring others to revalue their exchange rate while ignoring their contribution to the problem.

Governments that persistently intervene or seek to permanently fix the value of their currency relative to others' often do so to the detriment of their citizens and of global economic growth. The upshot is that countries with distinct economic policies and structures are usually better off with different currencies and with letting the marketplace set the relative value of these currencies.

About the Author

Daniel Schwanen


Daniel Schwanen is assistant vice-president, research, at the C.D. Howe Institute in Toronto.

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