On the March
By DAVID MALPASS
In the two years since the devaluation of the Mexican peso, governments
around the world have redoubled their efforts to find workable exchange
rate policies. The Mexican devaluation proved to be a cold shower for
devaluationists, who nevertheless continue to believe that a weaker
currency stimulates economic growth. Devaluationist theory--one of the most
harmful branches of central economic planning--seeks to discourage imports
by raising their cost to the public. It picks up from where the
protectionist, import substitution model left off, and completely ignores
the rattling effect of devaluations on the minds and entrepreneurial
inclinations of savers and investors--both domestic and foreign. Any boost
to exports rarely offsets the economic setback that results from changes in
the value of the currency, the most basic element in any economic system.
Without a monetary price rule, an economy usually wobbles within a
non-ending cycle of catch-up between devaluations and inflation.
A Safe Store of Value
The solution to this vital aspect of economic policy may be the single
most important determinant of world growth in the years ahead. With
foreigners holding an increasing share (approaching 30%) of the U.S.
national debt, our own economic well-being will be heavily influenced by
whether the dollar is perceived as a safe store of value or a risk. The
success or failure of any number of monetary policies--from Japan's
stagnant deflation to China's successful dollar link to Europe's
approaching currency meld with the German mark to Turkey's shrinking
lira--will ultimately depend on the outcome of the philosophical debate
over whether governments or markets should be responsible for the value of
In the months following Mexico's devaluation, financial markets tested
many other currencies including the U.S. dollar, imposing higher interest
rates and bringing increased discussion of proper policy. What came to be
known as the "tequila effect" hit hardest in Argentina in February 1995,
sparking an all-out run on the banking system. Brazil saw a 25% drop in its
stock market in early March 1995 when it attempted a small weakening in its
exchange rate band. Thailand, the Philippines, and Indonesia felt temporary
downward pressure on their currencies. The Japanese yen accelerated its
harmful appreciation, reaching 80 yen per dollar in May 1995 on the theory
that Mexico devalued after running a trade deficit, so Japan's trade
surplus must justify perpetual yen strength.
To date, the world's policy response has been an even more tenacious
search for currency stability. Quieted instantly were those clamoring for a
weak U.S. dollar to balance our trade deficit, leaving the U.S. with the
clearest strong-dollar policy since the pre-1971 gold standard (which
explains much of the 1995 and 1996 stock market gains). China, Brazil,
Argentina, Chile, and the Philippines strengthened their pursuit of
policies that have kept their currencies remarkably stable against the U.S.
dollar and gold, spreading the dollar-bloc or gold-bloc beyond the already
successful Southeast Asian economies of Hong Kong, Singapore, Thailand,
Malaysia, and Indonesia. In Europe, the drift toward a stable, unified
currency became a rush, turning once-weak currencies around Europe's edges
into a bond market's dream.
What of Mexico's peso? Good news there too. After policy experimentation
in 1995, Mexico settled on a workable monetary policy in January 1996. The
peso is allowed to float and respond to market forces, while the central
bank uses the exchange rate as an important feedback mechanism for its
monetary policy. When the peso is weaker than would be consistent with
steadily declining inflation, the Central Bank tightens monetary policy,
taking the extra pesos out of the economy by selling some of its assets.
Tested by markets three times in 1996, the peso has held almost all of its
value, enjoyed lower interest rates on longer maturities, and sparked a
degree of economic recovery.
Despite the world's generally positive currency experience in the wake
of Mexico's devaluation, the brief for "flexible"--meaning unpredictable
and usually weak--exchange rates is still alive in parts of Washington,
Cambridge, and lately Paris with calls for a weaker franc.
American academics extol the theoretical benefits that Brazil,
Argentina, and even Mexico could reap from weakening their currencies. This
"helpful" advice helps keep interest rates in those countries higher and
growth slower than would otherwise be achieved. Fortunately, governments
have shown resourcefulness in countering the devaluationists. Brazil's
response to MIT economist Rudiger Dornbusch's recent call for a devaluation
was a resounding raspberry and a nationalistic uproar in favor of currency
stability, while Mexico has built confidence in the peso by setting
realistic financial goals and exceeding them.
In light of all the evidence against currency manipulation as an
effective economic policy tool, it's surprising that advocates of these
policies continue to receive uncritical or even favorable treatment in the
press. Likewise, case studies and economic theories that contradict
supporters of devaluation and currency instability have been systematically
obscured by the media. The post-war granddaddy of devaluations was the U.S.
itself in its 1971 departure from the gold standard. Overnight, the value
of the dollar fell by two-thirds against gold. In the ensuing years, it
fell temporarily to one-tenth of its original value against gold, oil, and
real estate--nearly five times the severity of Mexico's recent
devaluation--resulting in a decade of inflation, recession, and oil
Another often overlooked case is Japan's harmful currency appreciation
from 1990 through 1995. Though defended as a necessary response to the
1980s real estate bubble and Japan's trade surplus, the government's
pursuit of a monetary policy that doubled the value of the currency against
gold, the dollar, and the value of local real estate and equities has
created an overhang of idle capacity, excess savings, and
undercollateralized bank loans which will take years to work out.
Vital Current Account Deficits
Two negative effects from the post-1994 introspection on exchange rates
have been an aversion to current account deficits and an unnecessary
buildup in international reserves. Current account deficits reflect capital
inflows to a country, and as frequently signify useful investment as
profligacy. In particular current account deficits are as vital for growing
countries as financial leverage is for a growing company. High levels of
international reserves have several negative aspects, including the
opportunity cost of carrying them versus reducing government debt, the risk
that a routine loss in reserves might trigger a negative shift in sentiment
toward a country, and the heavy and increasing reliance on U.S. Treasury
securities as the store of value for international reserves.
More good may yet come from Mexico's difficult experience. In Southeast
Asia, central bankers have begun meeting periodically to share ideas and
create a support network. Think of the positive effect on world sentiment
and local financial markets if Latin American countries met in a similar
way to declare the age of inflation and currency weakness over. The
International Monetary Fund has periodically considered programs based on
stable currencies, creating hope that Turkey or Russia might one day emerge
from their downward currency spirals. A simple step in the world's march
away from devaluationism would be for central banks to follow Mexico's 1996
example and use their exchange rate as a fundamental barometer of monetary
policy. At stake in this debate in coming years is economic growth, the
role of government in the economy, and perhaps even the stability of the
world financial system.
Mr. Malpass is director for international economics at Bear Stearns
& Co. in New York.