Currency Stability
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 their currencies.

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 shocks.

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.