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Why Not a Global Currency ?

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  • Anfas ulhaq
    Imagine having no exchange rates. Imagine having to do without the whole rigmarole of forex, currency transactions and the subsequent taxes. Wouldn t that be a
    Message 1 of 1 , Jun 10, 2005
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      Imagine having no exchange rates. Imagine having to do without the whole rigmarole of forex, currency transactions and the subsequent taxes. Wouldn't that be a wonderful dream come true? Internationally recognised, Harvard-based economist, Kenneth Rogoff disagrees.

      On Why Not a Global Currency

      By Kenneth Rogoff*

      Economics Department

      Littauer Center

      Harvard University

      Cambridge MA 02138-3001


      presented at the American Economic Association Meeting session on "Exchange

      Rates and Choice of Monetary Regimes," January 5, 10:15 a.m./ January 8, 2001


      It appears likely that the number of currencies in the world, having proliferated

      along with the number of countries over the past fifty years, will decline sharply over the

      next two decades. The question I plan to pose here is, where, from an economic point of

      view, should we aim for this process to stop? Should there be a single world currency, as

      Richard Cooper (1984) boldly envisioned? Should there remain multiple major

      currencies but with a much stricter arrangement among them for stabilizing exchange

      rates, as say Ronald McKinnon (1984) or John Williamson (1985) recommended?1

      Building on Maurice Obstfeld and Kenneth Rogoff (2000b,d), I will argue here that the

      status quo arrangement among the dollar, yen and the euro (which I take to be benign

      neglect) is not far from optimal, not only for now but well into the new century. And it

      would remain a good system even if political obstacles to achieving greater monetary

      policy coordination – or even a common world currency -- could be overcome. Again,

      this is not a paper on, say, the pros and cons of dollarization for small and medium-sized

      economies, but rather on arrangements among the core currencies.

      Any blueprint for the future core of the world currency system involves some

      crystal ball gazing. But at the same time, recent research in international

      macroeconomics offers several important insights that can help inform our discussion.

      I. The Exchange Rate Disconnect Puzzle

      The typical assessment of the modern floating rate era begins by noting just how

      wrong Milton Friedman (1953) was when he envisioned flexible exchange rates as

      adjusting slowly and smoothly in response to differentials in relative national price levels.


      Nothing could be further from the truth and, as virtually everyone knows by now,

      exchange rates fluctuate wildly in comparison with goods prices. Early in the flexible

      rate experience, theorists offered what appeared to be an attractive answer to this

      observation: currency is a durable, so fundamentally its price reflects a flow of future

      services, not simply its transactions value at a point in time. Thus, according to the

      "asset" view of exchange rates, it should be no surprise that they fluctuate almost as

      wildly as stock prices.

      But whereas the stock price analogy is useful, it is far from perfect. Given that

      domestic goods prices tend to move very sluggishly, at least at the consumer level, one

      would think that goods market arbitrage would prevent the exchange rate from fluctuating

      like a typical major stock price index-- but, of course, it does. At the aggregate level,

      shocks to real exchange rates damp out at a remarkably slow rate. Even the most

      optimistic estimates put the half-life of real exchange rate movements in years, not

      months (though as Obstfeld and Rogoff (2000a) demonstrate, a country’s terms of trade

      at the wholesale level seem to react much faster than at the consumer level). The

      "purchasing power parity puzzle" is but one manifestation of a broader range of puzzles

      Obstfeld and Rogoff (2000b) term "the exchange rate disconnect puzzle." Simply put,

      while the exchange rate seems to gyrate wildly, it does not appear to feed back into the

      real economy with nearly the force and speed that one would expect for such an

      important relative price. (Again, remember that my focus is on cross-country exchange

      rates between the largest economies.) Marianne Baxter and Alan Stockman (1989), in

      their comparison of macroeconomic variables under fixed and flexible exchange rate

      regimes, first pointed out the difficulty in demonstrating that exchange rate volatility


      affects macroeconomic quantities. Though more recent research has succeeded in

      showing that exchange rate volatility can impact trade and direct foreign investment,2

      overall the feedback to the real economy is far slower and less pronounced than canonical

      Mundell-Fleming models would predict. Some have gone so far as to interpret the

      evidence as showing that exchange rates have no short-run expenditure-switching effect

      at all, but this seems an overstatement; see, for example, the evidence surveyed in Paul

      Krugman (1991).

      So, although flexible exchange rates have indeed proven far more volatile than

      Friedman envisioned, the flip side of the coin is also a surprise. The effects of the

      volatility are not as conspicuously disastrous as one might have guessed. So what’s the

      catch, and how should it affect our thinking about exchange rate regimes?

      II. Goods Market Are Less Integrated Than One Might Imagine

      Obstfeld and Rogoff (2000b) argue that a broad variety of puzzles related to

      international capital markets can be substantially resolved if one incorporates (significant

      but plausible) costs of trading goods into canonical models of international trade. (Trade

      costs include not only tariffs and transport costs, but also costs related to differences in

      language, legal systems and, yes, possibly currencies.) The puzzles include the Feldstein-

      Horioka puzzle (current accounts tend to be small relative to saving and investment), the

      home bias in equities puzzle, the international consumption correlations puzzle

      (comovements in national consumptions are not as large as one would expect with

      significant global capital market integration), and other puzzles including the purchasing

      power parity puzzle and the exchange rate disconnect puzzle. Incorporating trade costs

      not only allows one to resolve most of the major empirical puzzles in international


      macroeconomics at a qualitative level, but simple calculations suggest that the puzzles

      can be (substantially) explained at a quantitative level as well. Obstfeld and Rogoff do

      not deny the importance of frictions in capital markets, which they take to be at least as

      large internationally as domestically. But, they argue, one need not rely on any large

      difference between domestic and international capital market frictions to explain many

      apparent puzzles concerning why capital market integration is significantly less than one

      would imagine.

      The way in which trade frictions can help explain the exchange rate disconnect

      puzzle is straightforward. If the share of traded goods is relatively small (or, to be

      precise, if trade costs keep the consumption of traded goods relatively small), then the

      exchange rate – the terms of trade ---will likely play a relatively small role in the

      economy. Correspondingly, very large exchange rate movements may be required before

      there is a significant effect on the overall economy. Obstfeld and Rogoff (2000c)

      illustrate how a sudden reversal of the US’s 4.3% (of GDP) year 2000 current account

      deficit could lead to an extremely sharp depreciation of the dollar exchange rate.

      III. Implications For Exchange Rate Regimes

      Most critics of the current exchange rate system accept the point that under fixed

      rates (or a common currency), countries would lose their ability to pursue independent

      monetary policy, and that this loss would be significant. The exact cost depends on a

      variety of factors, most conspicuously the correlation of macroeconomic conditions

      across regions. If trade between two large regions is relatively small, and if trade costs

      also limit capital market interactions (as Obstfeld and Rogoff contend), then standard


      models imply that it makes little sense to choose the exchange rate as the fundamental

      target of monetary policy.

      Advocates of greater exchange rate stability across the major currencies argue that

      standard theoretical and empirical analyses of the efficacy of exchange rate stabilization

      are misguided, because they typically assume rational exchange markets. Even if some

      degree of exchange rate flexibility across two regions is desirable (say, to accommodate

      required movements in the real exchange rate due to imperfect output correlation), in

      practice the exchange rate fluctuates far more than any plausible theory would dictate.

      Thus a system of fixed exchange rates --- or currency unification --- is still preferable to

      any likely scenario under flexible rates.

      But the argument I have just presented is robust to this objection. First, with a

      high degree of goods market segmentation, small changes in the fundamentals can easily

      lead to large (fully rational) changes in exchange rates (as Obstfeld and Rogoff, 2000c

      illustrate). Second, even if a significant share of exchange rate fluctuations is indeed

      driven purely by, say, investor psychology, the feedback to the real economy may not be

      so great as world currency advocates maintain. Thus, the mere fact that exchange rates

      between the yen, the euro and the dollar fluctuate wildly does not provide a prima facie

      case that we should permanently fix them.

      Now, clearly, if moving to a currency union eliminates a substantial bulk of the

      costs that limit goods and capital market integration, suddenly the efficacy of the

      common currency would be self-fulfilling. But I am skeptical that this would be the case,

      notwithstanding the interesting evidence Andrew Rose (2000) provides on the currency

      arrangements of mini-states. It is true that the common currency may ultimately coincide


      with much higher trade within Europe, but attributing the rise singularly to the adoption

      of a common currency would seem naïve. In fact, at the same time countries in Europe

      have been pursuing a common currency arrangement, they have taken numerous other

      steps towards economic integration, ranging from coordination of electric plug sizes to

      standardization of supervision and regulation of banks and financial intermediaries.

      There is a good analogy in the old fable of nail soup: A beggar, trying to talk his way in

      out of the cold, claims that he can make a most delicious soup with only a nail. The

      farmer lets him in, and the beggar stirs the soup, saying how good it will taste, but how it

      would be even better if he could add a leek. After similarly convincing his host to

      contribute a chicken and all sorts of other good things, the beggar pulls out the magic nail

      and, indeed, the soup is delicious. The euro is the nail.

      IV. Other Reasons To Be Cautious About Adopting A Single World Currency

      There are other reasons that it may not be desirable to pursue currency

      consolidation all the way to a single world currency:

      • Absent a global government, it would be difficult to establish adequate checks and

      balances on a global central bank. The US Federal Reserve is technically

      independent, but it is also fundamentally a creature of Congress, one that could in

      principle be desolved at short notice. Although the nascent government institutions

      of the European Community are still fairly weak, they nevertheless provides some

      forum for supervision of the European Central Bank. Into the foreseeable future, no

      parallel institution is going to exist at the global level.

      • More generally, political problems could make it difficult to choose top-notch central

      bankers and, equally importantly, conservative central bankers who place a strong


      weight on inflation. In principle, one can design mechanical rules (such as inflation

      targets) which reduce the importance of the individuals governing the central bank. In

      many developing countries, this second-best approach may indeed be far preferable to

      a random draw from the political process, but I am very skeptical of claims that any

      simple mechanical rule can come close to what can be achieved by a grandmaster of

      monetary policy such as Alan Greenspan. This is indeed a common finding in the

      artificial intelligence literature; i.e., that computers can equal "expert" level in many

      fields but not "master" level.

      • Though currency, particularly in its function as a unit of account, is a natural

      monopoly, there are several reasons why it may be desirable to maintain some level

      of competition. Through a number of channels, global currency competition provides

      a check on inflation (as illustrated, for example, in Rogoff, 1985). A related concern

      comes from the natural regulatory functions that a global central bank would have to

      assume (or, if not, that a sister agency would have to assume). In an era of ongoing

      financial innovation, in which paper currency may well become defunct, there are

      ample reasons to be concerned that a global central bank might constrain innovation

      either out of the desire to maintain a strong monopoly, or simply due to misjudgment.

      These are also going to be problems in the current system, but they would only be

      exacerbated by having a single currency.

      • One could bypass many of the objections I have raised by adopting a world currency

      pegged to a commodity basket (or just, say, to gold). But I believe the invention of

      the modern central bank has actually, on the whole, been a very good one, and

      certainly not worth abandoning for the uncertain gains of global currency unification.


      V. Why Not A Lessor Level Of Coordination Among The Big Three (Euro, Dollar,


      Even if an optimal system requires some degree of monetary response to

      exchange rates, there is a case to be made that the current system already works

      reasonably well. Obstfeld and Rogoff (2000d) show that when monetary policy is

      governed by a rule-based environment (that is, if standard time consistency in monetary

      policy problems can be overcome), then the gains to international monetary cooperation

      are not necessarily very large. While in principle countries may be tempted to tilt their

      rules in a way that improves their individual terms of trade (via the effects of risk on

      wage and price setting), or provides a more favorable correlation between consumption

      and the exchange rate, theory suggests good reasons to believe that these gains are likely

      to be only second order. Loosely speaking, improvements in the terms of trade come

      only at the expense of less effective risk sharing. In their empirical simulations, Obstfeld

      and Rogoff find that the gains to having an optimal global exchange rate system (over the

      noncooperative equilibrium) are two orders of magnitude less than the gains from

      following active versus passive monetary stabilization policy. Interestingly, the argument

      here does not depend at all on having sizable trade costs, and indeed the need for global

      coordination in rule setting is weakest at the extremes where either all goods are traded or

      no goods are traded. Of course, one can argue that some of the world's major central

      banks (notably the ECB and the BOJ) have not yet fully converged to a rule-based

      equilibrium, in which case there is still scope for coordination in the transition.

      VI. Conclusions

      Currency consolidation seems like a desirable and (at present) likely process. But

      it is already important, now, to begin thinking about where consolidation should stop. I

      have argued here that, into the foreseeable future, it would not be desirable to aim for a

      single world currency, and that from an economic point of view, it would be preferable to

      retain at least, say, three to four currencies if not n currencies.

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