The Case Against Benign Neglect of Exchange Rate Stability

• Author: Benoit Coeuré and Jean Pisani-Ferry
• Position: Exchange Market and Economic Policy Division, of the French Ministry of Economy, Finance, and Industry/Professeur associé at the Université Paris-Dauphine and Counsellor to the French Minister of Economy, Finance, and Industry

Large fluctuations in the exchange rates of major currencies can be extremely costly, not only for the countries directly involved but also for the rest of the world. In this article, the authors propose a framework for international cooperation in stabilizing exchange rates.

Since the demise in the 1970s of the Bretton Woods system of fixed exchange rates, the issue of exchange rate stability has received a great deal of attention. Governments have intervened, individually and collectively, in foreign exchange markets on several occasions in attempts to limit the damaging effects of wide swings in exchange rates and extreme misalignments. The two most elaborate arrangements set up by the major industrial countries to stabilize their exchange rates-the Plaza agreement of 1985 and the Louvre accord of 1987-have had a mixed record, however. Many observers have come to believe that governments should not waste scarce resources intervening in foreign exchange markets.

Notwithstanding the disappointing performance of the Plaza and Louvre arrangements, new avenues for exchange rate coordination should be explored, especially in light of two recent events-the financial crisis that erupted in 1997 in several emerging economies in Asia whose currencies were formally or informally pegged to the U.S. dollar and the introduction of the euro on January 1, 1999.

Impact of the euro

The multicurrency system ushered in by the introduction of the euro more accurately reflects today's global economy and therefore provides a more solid basis for trade and growth than a system dominated by the U.S. dollar. However, some exchange rate volatility can be expected while the world adjusts to the new system and Europe's policymakers go through the learning process under the watchful eye of the markets.

Moreover, the creation of a new currency will give rise to shocks to the demand for and supply of international currencies. With a unified European financial market and the growing substitutability between assets denominated in euros and those denominated in U.S. dollars, international investors could decide to make large changes in their portfolios. Although the euro's evolution since its launch seems to indicate that such portfolio reallocations have not yet taken place on a large scale, it is too early to rule out this possibility. Supply shifts have already occurred, especially in the international bond markets: euro-denominated securities represented 44 percent of total issues in January-April 1999, roughly the same as the dollar (46 percent), against 35 percent and 48 percent, respectively, in 1998.

Another reason exchange rate instability may increase in the near term is that the euro-dollar exchange rate will be of less concern to the European Central Bank than it was to the national central banks because the economy of the euro zone as a whole will be more closed and inward looking than the individual members' economies. The euro zone's openness rate (measured by the ratio of trade in goods and services to GDP) is about 14 percent, compared with 25 percent for France and Germany.

All of these factors enter into play in a disturbed monetary environment. The United States' current account imbalance represents a threat to the stability of the dollar, while the yen suffers from deeply rooted domestic weaknesses, and many emerging currencies are just beginning to recover from exceptionally severe crises.

Pitfalls of instability

The instability of floating exchange rates is well documented and, although moderate currency fluctuations can be accommodated without major difficulties, significant misalignments are harmful, especially between the major currencies. First, exchange rates between major currencies have the character of public goods for the world economy. Europe, Japan, and the United States are large export markets for many countries; wide swings in the dollar-euro and dollar-yen exchange rates have a destabilizing impact on these countries, as in 1997, when the appreciation of the U.S. dollar contributed to the collapse of the Asian currencies that maintained a formal or informal peg to it.

Although some of these countries may draw from the crisis the conclusion that they should let their currencies float...