MEMORY

Presented at the Chicago Mercantile Exchange International Finance Symposium, Le Meridian Piccadilly Hotel,
London, England,
November 11, 1986.

Explaining the virtues of free markets—particularly the advantages of floating exchange rates versus a system of fixed exchange rates—is a non-ending process. While the theme is always the same and our words repetitive, it is imperative that they be reiterated. One cannot become complacent or look the other way lest the proponents of central planning gain a foothold in the unending war between economic good and evil. Beware, it is a slippery slope—the road to central planning is paved with good intentions.

In the fall of 1986, the United Kingdom staged its well publicized Big Bang in which age-old traditions and regulations based on fixed modes of operation in the securities markets were abandoned in favor of competitive applications. It was a signal change for the British and an irresistible opportunity to again beat the drum for free markets.

The British cannot ever be accused of being rash. Indeed, the civilized world has come to expect the United Kingdom to act as the final filter for revolutionary ideas—where the probity of every untested concept will be settled with certainty; where every nuance is thoroughly analyzed; where every issue— pro and con—is exhaustively debated; and where every shred of evidence is convincingly scrutinized. Only then will the subject in question receive the British stamp of approval. Sometimes this process may be a bit slow.

On October 27, 1986, some 15 billion years after the original Big Bang, the British Isles staged their own version of this event. In doing so, the British government, at long last, accepted two fairly controversial ideas. It acceded that the original cosmic phenomenon had merit (pity Albert Einstein isn't around to agree); and it embraced the radical concept of competition (the tenets of Adam Smith take time to understand).

In contrast to British reverence for tradition, the United States is wedded to the spirit of pioneerism. As a rule, we encourage new ideas, give radical thoughts an even chance, and are famous for our innovations and inventions. Some detractors may even say we shoot from the hip. Alas, while we are not burdened by a fear of change, we have a problem staying with our winners. All too often, just when we are about to be reap the rewards of our risks, we snatch defeat from the jaws of victory. In other words we have a tendency to get cold feet.

Just when U.S. long-standing efforts to convince the world that capitalism is the only economic system capable of lifting the world from its mediocre fate are about to bear fruit, just when U.S. precepts of free enterprise are about to change the way the world works, just when U.S. theories about competition are about to become universally embraced, suddenly, some Americans have second thoughts. In China after centuries of economic dead-ends and endless false starts, the last decade witnessed a clear movement toward our side of the street. Perhaps the Peoples' Republic of China may have at last seen the light and concluded that the way to lift its masses from economic misery to something better is through principles that look suspiciously close to capitalism.

In Europe, after years of socialistic flirtations and dictates, there is a resurgence of capitalistic ideals, and a strong movement toward privatization and away from nationalization. All over South America, the Far East, and even Africa, the concepts of free enterprise have taken root and proved far more successful in raising economic standards and hopes than their counterparts of socialism or communism. And in England, one need not look further than Big Bang, embracing as it does virtually every standard of open competition including the concept of dual trading to understand which way the wind is blowing.

In short, American preaching about the virtues of capitalism, free trade, deregulation, competition, and free enterprise are finally paying off the world over. They may even win us the cold war. Yet, at this propitious moment of near-victory, some American business representatives have begun to have doubts about the sanctity of competition. Some of their elected officials have introduced 818 bills in Congress that, to one degree or another, will stifle or inhibit free trade. Some of their news media have begun to shout about the dangers of innovation to financial markets and lament the effects of the technological revolution. And some of their leaders openly begin to dream about a return to a system of fixed exchange rates—an issue close to my heart.

Snatching defeat from the jaws of victory is the single most effective deterrent to success. To be perfectly honest, the malady is not unique to Americans. Its symptoms can be found throughout human history. It stems from mankind's recurring problem with its memory. As Santayana put it, "Those who cannot remember the past are condemned to repeat it."

Surely 1971 was not so long ago that we have forgotten the economic setting of that day and the desperate measures it demanded? Remember the U.S financial confidence crisis? Remember the run against the dollar? Remember how President Nixon closed the gold window and ended dollar convertibility? What followed was an era of financial upheavals unequaled in the annals of man, such that tested the very foundations of western society. Surely we haven't forgotten the dollar's plunge to its lowest historical levels? U.S. unemployment in excess of 10%? Oil prices skyrocketing to $39 a barrel? The Dow Jones Industrial Average falling to 570? Gold at $800, inflation at 20% and interest rates even higher? These financial shocks and upheavals represented the crises of the 1970s and early 1980s. We dare not forget how all of that came to pass, nor ignore the lesson implicit in this history, lest we are prepared to repeat it.

In 1945, the western world instituted the Bretton Woods system of fixed exchange rates. It did so because it was the only sensible thing to do in a world completely ravaged by World War II. It did so with the express understanding that desperate measures were in order. The system was a resounding success. It was one of the essential ingredients that combined to stabilize the world monetary order and achieve the post-war era of prosperity. It worked because the United States represented the only remaining industrial nation with its financial system intact; it worked because the U.S. dollar was the only remaining currency of value; it worked because the U.S. could dictate its economic resolve; and it worked because the U.S. was capable and willing to use its own financial resources to the benefit of everyone else.

Alas, the finance ministers of that day forgot the reasons for their success. They forgot Bretton Woods was a short-term solution and began to believe that a system born of necessity and uniquely suited for reconstruction could continue to serve under normal conditions. The basic and fundamental flaw of a fixed rate system—its rigidity—was destined to become its undoing. The very system that served so well during conditions of post-war reconstruction was highly inadequate once the process was completed. By definition, a fixed system could not effectively cope with the constant demands of value change resulting from the daily flows of political and economic stresses between the member participants of Bretton Woods. Moreover, the system's cumulative effects were bound to result in disastrous imbalances that ultimately would produce momentous upheavals.

Every one of the western world's partners achieved a different level of economic competence, each at a different rate of growth, each with widely divergent expectations and limitations. Each of the participating members of Bretton Woods was directed by significantly different fiscal and monetary philosophies and beholden to substantially different forms of governments.

A proper currency value cannot remain static in a world where countries are subjected to differing degrees of trade union bargaining power, have differing elasticities of both supply and demand for their exports and imports, are at different stages of their trade cycles, and suffer from different election timetables and differing kinds of political risks. External differences and internal self-interests of and between member nations must ultimately be the ruination of a system dependent upon a unified opinion about respective currency values.

Consequently, the very U.S. resources that saved the western world could not forever be expected to be drawn upon without themselves becoming weakened. Indeed, the cumulative effect of fixed exchange rates so disadvantaged the United States, that, by the time they were discarded, our nation's financial structure was in shambles. There were a few who saw the signs and read the handwriting on the wall.

... from the time Bretton Woods became effective, it was inevitable it would break down... It tried to achieve incompatible objectives: freedom of countries to pursue an independent internal monetary policy; fixed exchange rates; and relatively free international movement of goods and capital...As one of the architects of Bretton Woods, Keynes tried to resolve these incompatibilities by providing for flexibility of exchange rates through what he intended to be frequent and fairly easily achieved changes in official parities. In practice, this hope was doomed because maintaining the announced parity became a matter of prestige and political controversy. Countries therefore held on to a parity as long as they could, in the process letting minor problems grow into major crises and then making large changes...(1)

Unfortunately, by the time these warnings were heeded, it was too late. The pressures and imbalances created during reconstruction and exacerbated by virtue of fixed exchange rates were destined to take their toll. When that happened, it would threaten the very foundation of the industrial world.

Of all of the protective measures instituted by the United States in 1971, none was more telling than the abandonment of Bretton Woods and the defacto acceptance of floating exchange rates. Indeed, floating rates proved to be the single most effective tool enabling the western world to survive the dramatic shocks of the next decade and a half. Here is the International Monetary Fund's assessment of floating exchange rates as published in its Occasional Paper, July, 1984:

Given the events of the past decade, it is easy to be impressed by the resiliency of the present system...Indeed, in such an environment, managed floating might well have been the only system that could have functioned continuously.

A similar sentiment was expressed by the Group of Ten, as published June 21, 1985, "....it is questionable whether any less flexible system would have survived the strains of the past decade..."

1971 is but fifteen years ago, yet already some have forgotten this history and urge a return to those utopian days of fixed exchange. The free market causes too much volatility, they tell us. The free market causes a misalignment of values they argue. Not only have these folks forgotten their economic history, they have failed to recognize economic reality.

The western industrial world—West Germany, Japan, Great Britain, France, and the other EEC nations—are not even remotely the same pitiful entities that forty years ago looked to the U.S. for salvation. Today, they are strong and independent sovereignties who are financially as sound—or sounder—than the U.S. Today, it is exceedingly unrealistic to believe we can dictate to them our monetary or fiscal philosophy. Today, it is exceedingly unrealistic to assume that the U.S. opinion about relative values of foreign exchange will for very long be everyone's accepted view.

More important, the last forty years have achieved a technological revolution of monumental proportions. In today's world, the telecommunications capabilities of every financial participant—from the lowliest individual investor to the largest cartel—allow up-to-the-second recognition of every event worldwide, and the means by which to translate this knowledge into immediate action. This action is transformed into daily capital movements equal to many hundreds of billions of dollars that can completely overwhelm traditional fundamentals such as inflation differences, or the trend of the current account balance. These capital movements are the principle causes of today's volatility in foreign exchange as well as the reasons for recent long-lasting misalignments. The money flows resulting from the technological revolution cannot, for very long, be diverted from their course or channeled in a direction they do not want to go.

The overwhelming influence of capital movements and the huge amount of liquid dollar holdings in the world explain another unique feature of the dollar. It is the only currency for which it can be said with certainty that, under conditions of capital mobility, it can function only as a fully floating currency. Any fixed dollar rate, or even a mere target zone for the dollar, would sooner or later be toppled by irresistible capital flows and the enormous amount of volatile dollar holdings.(2)

Indeed, those among us who still nurture the belief that an international committee or system can indefinitely dictate the relative values of foreign exchange have failed to understand the effect of the marriage of the computer chip to the telephone.

The fundamental truths governing the value of money are no different than those for all commodities.  The market forces that make it difficult for OPEC to artificially ordain the value of oil or for the International Tin Council to unrealistically fix the price of tin are the same market forces which will similarly undo the manipulations of the G-5, G-10, or any artificial system created to dictate currency values.  In today's world, a fixed rate or targeted range for currency in international capital markets will last for only so long as the free forces of supply and demand are in agreement.

The September 1985 efforts of the Group of 5 seemed successful more because their timing was excellent and the market agreed with the result than for any other reason. To assume otherwise is to forget history, ignore reality, and perpetuate a false belief. In today's world, the free market is the only umpire that can command everyone's respect.

However, there are those who will tell you differently. There are those who are blind to the clear evidence about us. There are those who would have us, once again, snatch defeat from the jaws of victory. There are those who distrust the free market process and denigrate the forces of supply and demand. They dream of something better. Do not be fooled by such a dream. It denies us the advantage of our memory and condemns us to repeat our mistakes.

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     (1) There's No Such Thing as a Free Lunch, International Economic Policy, Milton Friedman.

     (2) The International Role of the Dollar, 1985, Otmar Emminger.

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