Exchange Rates and International Finance.pdf

Notes 3711 Far from matching the freewheeling ‘cowboy’ image of popular imagination, the speculator ismost likely to be operating on behalf of an international bank that has reached the conclusion– with more or less help from the economic model on its computer – that the exchange rate is‘out of line’.12 Notice the potential asymmetry: volatility in the pound/dollar rate creates difficulties for manyUK decision makers, but is in most cases of peripheral importance to their opposite numbers inthe USA.13 A short step, although not necessarily a sensible one – after all, cold weather is often damaging,but we only expect the government to help people live with the consequences, not to stabilizethe temperature!14 Apart, that is, from distorting the real sector of the economy, fostering the creation of ‘parallel’(that is, black) markets, with a consequent growth in criminal activity of one kind or anotherand an erosion of respect for the law, as well as abridging the freedom of the citizen in thecountries in question – marginally, perhaps, by the restrictions themselves, although much moreseriously by the measures taken to enforce the restrictions.15 The task of actually operating in the currency markets so as to fix a country’s exchange rateis usually assigned to another institution (often its central bank), which is not always strictlyan arm of government. For example, while the Bank of England is an agency of HerMajesty’s government, the US Federal Reserve Bank is independent of the federal governmentin Washington DC.For our purposes, these subtleties are ignored and at no point in the book will any attemptbe made to distinguish between the policies and responsibilities of the government and thecentral bank.16 In fact, traders may not even be aware that the central bank has been operating in the market.Very often they may only observe ‘business as usual’, with brisk two-way trading and no tendencyfor positions to accumulate on either side of the market. Where the markets do get windof intervention, it is often because the authorities intend the news to emerge.Of course, in the end, it all ‘comes out in the wash’ – in the UK and USA, at any rate – withthe publication of the monthly figures for the change in the reserves. But by then the informationis of more or less historical interest only.17 Except, that is, where the authorities are able and willing to impose a price by decree, ashappened in the Communist bloc for example. In such cases what is needed is not a buffer stock,but either a docile populace willing to accept queuing as a way of life or a secret police capableof preventing the market from reasserting itself – preferably both.Notice that this scenario is simply the equivalent in the egg market of inconvertibility in thecurrency market – with about the same moral authority.18 Since originally writing this chapter, reality has caught up with this particular example in theform of the UK salmonella scandal at the end of 1988, when the British government was actuallyforced to buy up a sudden excess supply of eggs in order to prevent the price falling.19 And often long afterwards too. For example, it is still unclear, even now, whether the rise inthe dollar in the mid-1980s was, in fact, an equilibrium or disequilibrium phenomenon. Whatis clear, of course, is that it could never have been prevented by intervention in the currencymarkets alone.20 In practice, fixed exchange rate mechanisms tend to be highly complex arrangements, specifyingin such detail the obligations and entitlements of the countries involved it would take awhole book to describe them fully. The objective here is, as always, simply to allow the readerto understand the general principles underlying the institutional arrangement.21 Obviously, this non-system has the dubious attraction that it maximizes the discretionary powerof the monetary authority.22 More generally, the relationship of balance of payments accounting to the analysis of exchangerate determination is the same as that between national income accounting and (closed economy)macroeconomics or, for that matter, financial accounting and corporate financetheory.23 It must be emphasized that balance of payments accounts are subject to a margin of error thatis wide even by the standards of economic data. It is highly likely that the 1992 accounts will be