Floating Exchange Rates

Floating Exchange Rates and World-Wide Inflation PATRICK FEW WHO M. HAVE SEEN the movie “Jaws,” that tour de force of scare films, will have been u...
Author: Victor Richards
5 downloads 0 Views 743KB Size
Floating Exchange Rates and World-Wide Inflation PATRICK



HAVE SEEN the movie “Jaws,” that tour de force of scare films, will have been unaffected by its depiction of the terrors of floating, even near shore. Floating in unknown waters, ci la the advocates of floating exchange rates, must seem all the more imprudent. It smacks of irresponsibility and of a kind of benign neglect that can have the most fateful: consequences. Indeed, floaters in economics and in life tend to be simultaneously chauvinistseager to escape discipline of any kind and to shove off the consequences of whatever they do onto others, and fools-seemingly unaware of and unconcerned by those looming shapes in the depths below that could finish them off. Moreover, floating as applied today to things economic confuses or obscures an important distinction, well-known to economists of an earlier generation, between those things in the economic universe which ought to be free to move, like prices, and those which ought to be fixed, like the monetary framework. The overwhelming majority of economists, certainly in the United States, be they liberal or conservative, are in favor of floating exchange rates. If, as I believe, the floating rates mechanism is merely a device for escaping the constraints on domestic economic policy that would normally be imposed by the movement of monetary reserves into or out of a country, that is, by balance-of-payments discipline in the traditional sense, then the liberal liking for such a system is entirely understandable. To want to do your own thing at the expense of others is the essence of liberalism, or at least of the American late-twentieth century version of it. What is difficult to understand


is why so many conservative economists are floaters. The Conservative Defense of Floating Conservatives in the economics profession have offered a variety of arguments in defense of rate flexibility, or in opposition to fixed rates, but these are not as impregnable as commonly thought. Consider the proposition that flexible rates of exchange are simply a further application of the principle of market freedom and of free price formation to foreign currencies. If one accepts the law of supply and demand, so runs the premise, then he ought not to exempt foreign exchange from it. That argument i s powerful; it was a main element of Milton Friedman’s classic defense of flexibility a quarter century ag0.l The difficulty with that point, then and now, is that foreign exchange, a foreign currency, is not just any old commodity. It is a constituent element of international money. It is generally conceded that a prime attribute of national money should be stability of value. It follows that money is the one good whose quantity cannot be left to the random influences of the market, or to the profit motives of private bankers, however legitimate these might he, and certainly not to government officials who have many powerful incentives to increase that quantity. The monetarist emphasis on the nondiscretionary adjustment of the quantity of money in accordance with a predetermined rule--e.g., Friedman’s suggestion that the supply of money be increased by a fixed annual percentage related to the economy’s real rate of growth-simply underscores the need, in the case of the mone281

Modern Age


tary framework, for control and for stability. Curiously, when the monetarist analysis moves to the international level, the virtues of a free market in money suddenly come to the fore. Notwithstanding, if it is desirable to have control of money domestically because it is the fundamental lu6ricant of all other exchanges, it should be equally deshable that the stock of world money and the ratio of the growth of this stock to the quantities of goods available for sale in international markets also be controlled and to the same end, namely, that there be stability of international1 money and consequently freedom in all other international transactions. Since international money is, in the first instance, the structure of exchange parities that happens to exist among the different (major) currencies, stability of international money means stability of the structure of existing exchange rates. It also implics an authority that will assure such stability or, at a minimum, it implies a commitment on the part of the major countries at least, to a rule or rules-such, for instance, as those that operated under the old gold standard-to hold national money supplies within the limits that will ensure relative stability of the structure of exchange parities. Put in another way: an exchange rate is more than a price. It is a hinge which links I one national economy to another and makes comparative measurements between them possible. If prices of goods and services in different countries are to fluctuate freely, as they should, and if to that extent they are to reflect the true supply-demand conditions in the markets in question, then the link, the rate of exchange, which makes international comparisons possible, must itself be stable. Fluctuating exchange rates conceal and confuse the signals that relative prices in different countries should be conveying to international markets. The analogy which is drawn in the conservative argument for rate flexibility between the market for eggs or automobiles and the market for foreign exchange is invalid, because 1





eggs and autos are goods whereas foreign exchange is money. ‘ Of course, the link, or hinge, between different economies can come under severe strain due to fundamental changes, in the different national economies, in underlying economic conditions. Where one is confronted with such “fundamental disequilibrium” an argument can be made for a one-time surgical operation to correct the imbalance via a devaluation or revaluation of a currency in respect to the rest of the world. Whether or not such an operation redly changes anything is a serioils qucstion which will be discussed later in this essay. But in the context of the operation per se, the assumption must be that following it, the “patient” will pursue henceforth whatever regimen is required to ensure that he stays “healthy,” i.e., in balance with the world economy. I n contrast, a floating rate system assumes that no serious efforts will be made by the different countries to stay in rough equilibrium with each other. Under such a system, monetary and economic permissiveness, previously an aberration to be ended, is institutionalized and legitimized on a worldwide scale. Floating in the Real World There is a group of arguments for floating rates that can be treated as a group since they intertwine with and reinforce each other : (1) Floating allows governments the luxury of ignoring the balance of payments, since the loss and acquisition of monetary reserves, including gold, is no longer an issue. In effect, the entire brunt of national adjustment to changing international conditions is taken by movements of the rate of exchange, rather than by the movement of reserves. (2) By the same token, floating permits governments to act autonomously in the management of their internal domestic economic affairs, for example, in controlling inflation. (3) Under floating, a depreciating dollar Summer 1976


will automatically lead to subsequent improvement in the trade balance and thus to a rise in domestic employment. (4) Currency depreciations under a floating regime will have a minimal inflationary impact. In assessing this ensemble of claims, it should be noted, first, that free or “pure” floating of the Friedman model has given way, everywhere, to managed or “dirty” floating, whereby central banks regularly intervene to limit the float of their currencies against others. This was to be expected on pragmatic grounds, since other nations will not passively look on while the depreciating currency of a deficit country progressively undermines their own export business. The US. itself, in its concern over the inflationary ramifications of a continuing downslide of the dollar has also, on occasion, intervened to prevent further downward movement and it is likely to move more aggressively on this front in the future. Thus, the much-touted “automaticity” of the adjustment process under floating is already seriously compromised. As the eminent Greek economist, Xenophon Zolotas, Governor of the Bank of Greece, opined at the recent International Monetary Meetings in Washington :


International monetary relations give the impression of being in a state of anarchy. Some currencies are independently floating with varying degrees of official intervention in the exchange markets; others are pegged to the currency of a major trading partner; groups of countries maintain relatively stable rates among themselves, while floating against the rest of the world. Meanwhile, the US. dollar, with all its predominant weight in international financial transactions, is appreciating or depreciating widely and erratically, bringing about a multitude of distortions both in the domestic economies of other nations and in international trade and investment. It is worth noting that during the last two and a half years the

dollar has fluctuated seven times in a double digit range, in one instance even over 20 percent.* But the objections that can be offered to the theses mentioned above go considerably deeper than this. In developing these, it will be useful to reconsider the assumptions on which the traditional explanation of how exchange rate changes produce equilibrium has rested. Thus, a country which elects to correct a trade deficit by devaluing its currency (or, under floating rates, by permitting it to depreciate vis-&vis other currencies) is presumed to undergo a worsening of its terms of trade, i.e., a decline in the ratio of its export prices to its import prices. This worsening of the terms means that the prices foreigners must pay for the export goods of the devaluing country are made to appear cheaper, whilst prices of goods the latter imports, rise. These price changes, in turn, cause foreigners to buy more of the (now cheaper) exports of the devaluing country and the latter to purchase fewer (of the now more expensive) imports leading to a reduction or elimination of a trade deficit in the case of a devaluing country. Devaluation and Inflation

The traditional view concedes that the devaluing country may experience some price inflation as a result of the now higher costs of imports, but confines this inflationary impact to the import and export sectors. I n the case of the US., the presumed inflationary results of devaluation would be inconsequential, given the small fraction of GNF represented by US. foreign trade (about five percent). The increase in the overall price level, whether measured by the consumer price index or the wholesale price index, would be the percent rise in the cost of imports multiplied by their share in either index. In short, a dollar devaluation (or depreciation) of, say, ten percent should lead to a rise in the US.price level of no more than 0.5 percent (ten percent

Modem Age



of five percent) , an insignificant amount. (It is clear that if the consumer price index were, perhaps with a lag, to rise by the fdZ amount of the devaluation of ten percent, the terms of trade change would be cancelled out, and the trade deficit would reemerge). There are major objections, both of a theoretical and empirical nature which can be made to this conventional analysis. Such objections have, in fact, been put forward in recent years by a number of scholars of repute (Robert Mundell of Columbia University, Arthur Laffer of the University of Chicago, Moon Hoe Lee of the University of Saskatchewan, Randall Hinshaw of Claremont Graduate School, and by myself). In the first place, the notion that a change in the exchange rate can bring about a quasi-permanent change in the terms of trade between countries really implies that a given good can continuously sell at different prices in real terms in different parts of the world economy (a real price, as distinguished from a nominal price, is what a good commands in terms of other goods). Such an assumption, in turn, requires one to view the world economy as a congeries of independent, closed national markets, hermetically sealed from one another and unable, therefore, to participate in the price arbitraging which is characteristic of an integrated international market.

The World Market is One Market The weight of the evidence (especially that assembled by Arthur Laffer)s is that, in fact, the present world economy is not a segmented one, however much it may have tended in this direction in prior periods, but a highly integrated system. There are various tests for the degree of such integration, including the measurement of similarity of price data in different countries and the extent to which various quantitative aggregates-GNP, unemployment rates, money supplies, and the business cycledisplay similar movements. Statistical measurement of these variables shows a striking

degree of correspondence and provides as compelling proof of the existence of a unique world market as can be desired. This world market is admittedly not a wholly efficient one (what market is?). Still, the obstacles which historically have tended to hold back the efficiency of the world market have, in recent decades especially, been rapidly reduced by international agreement to reduce tariffs and non-tariff barriers and by revolutionary changes in international communications and transportation technology. In any market, including the increasing ly efficient world market, arbitrage will cause red prices of the same commodity (the price in terms of other goods the commodity can command) to be the same. The more efficient the market, meaning the more widespread is the knowledge of comparative prices and the greater the ability to act on such knowledge, the less need there will be for goods to actually flow from one part of the market to the other to achieve price uniformity. In short, given price arbitraging, the devaluation of a currency must result in offsetting inflation in the devaluing country. If it were not so offset, then the same good would sell at two different prices at the same time, something which is precluded in an efEcient market. Were such a situation to obtain, speculators would be constantly engaged in reaping enormous profits moving underpriced goods (in real terms) from one segment of the world market to the other. Misapprehension of this point is widespread and finds expression in the oftmade distinction between internationally traded goods and “domesticy’ goods, with the implication that exchange rate changes affect only the internationally traded goods. Frank Graham pointed out many years ago that every international good is potentially a domestic good and that every domestic good is potentially an international good.4 Given the fungibility of all goods, in this sense, for purposes of trade, it is incorrect to suppose that the idationary consequences of a devaluation will be confined


Summer 1976


to the foreign trade sector. ,Exportables, importables, and so-called domestic goods-all will’ be involved in the arbitraging process and all will be subject to the compensating domestic increase in prices produced by a devaluation. The propositions that emerge from these considerations are: (a) a currency devaluation or depreciation produces an inflation in the devaluing country roughly equal in percentage terms to the devaluation; (b) the inflation thus produced fully offsets any changes in the terms of trade brought about by currency devaluation or depreciation, with the result that (c) exchange rate changes cannot improve the trade balance; (d) under the condition of significantly increased inflation in the devaluing country, the currency is likely to decline still further vis-&vis other currencies, creating a “vicious circle” in which depreciation causes inflation which causes further depreciation. Flexibility of Rates and the Trade Balance With regard to the effect of exchange rate changes on the trade balance, the empirical data gathered by Moon Hoe Lee, Laffer, and others, suggests that the traditional view, viz., that devaluations improve trade balances, is just plain wrong. Thus, Mr. Lee, using annual wholesale price data from 1900 to 1972 for nine of the most important countries, finds that relative inflation rates fully offset exchange rate changes. He finds further that any single country’s expected inflation rate is approximately equal to the US. rate of inflation plus the rate of depreciation of that currency vis-6-vis the d01lar.~In a study done a few years ago, Laffer found that out of some fifteen episodes of devaluation in as many countries, ten of the countries had larger trade deficits three years after devaluation than they had the year prior to devaluation. Eleven out of fifteen had larger trade deficits three years after devaluation than the year of devaluation, and so on.6 One striking countrywide vindication of this critique of the conventional theory of

exchange rate changes is Germany, whose currency in the past few years has appreciated the most against the US. dollar and against several other major currencies. In this same period, Germany registered some of the largest export surpluses in its history of large export surpluses. Indeed, the surplus performance of Germany since 1961, the year in which the continuous upvaluation of the D-mark began, is an eerie demonstration that the exact opposite of the conventional doctrine about exchange rate changes may obtain. In 1974, the German export surplus reached $22 billion, even though the German GNP is only about one fourth that of the US. for which trade surpluses of a few billion dollars represent a good showing. In the same time frame, the exchange rate of the mark in terms of dollars rose steadily from a premium of 15.8 percent in January 1974 to 33.7 percent in December, as compared with the rate prevailing at the end of 1972. The upvaluation of the mark, rather than hindering exports, almost seems to have promoted them! In truth, however, the revaluation of the D-mark isn’t likely to have had much impact on the trade balance in the long run. Rather, the surplus is due to a complex of other factors, including German monetary policy, the level and quality of German investment, and the German government’s active assistance to its exporters. The Upward Ratcheting Effect Now if devaluation, or depreciation of currencies under floating does not accomplish what traditional theory claims, what does it do? As already noted, it tends in the first instance to cause an inflation in the devaluing country of roughly the same magnitude in percentage terms as the devaluation itself. But more than that, it tends to spread the inflation to those countries with which it has close economic ties. In virtue of an “upward ratcheting effect,” floating rates actually foster inflation on a worldwide scale. The argument starts with the fact that the impact of exchange rate

Modern Age



changes is not symmetrical when viewed from the perspective of a country which revalues its currency upward, or whose currency appreciates spontaneously under a floating system. Where a currency is appreciating internationally, the nominal prices of that country's goods internationally tend to rise. And it might be expected, therefore, that the reestablishment of the real price relationships for the world market would cause the domestic price level of the revaluing country to undergo a compensatory decline, thus tending to cancel out inflationary price rises in dcvaluing countries. In fact, this process tends to be frustrated for the country with the appreciating currency due to the downward rigidity of prices (and costs) in all modern industrial countries. This downward rigidity is, indeed, likely to be especially marked in the export sector of such a country, 'where there may be concern about the possible loss of competitiveness in international markets as its currency rises in value. In short, the effects of currency appreciation, which are normally anti-inflationary for the appreciating country, will tend not to be carried as far as depreciation effects in the devaluing country; downward rigidity sets a floor to the downward drift of the price level in an appreciating country whereas in the case of depreciation no upward limit to rising prices obtains. The result of all this is to bring about a net increase of inflation in the system.

Distorting the Role of Reserves In addition, a strong inflationary impulse is likely to be imparted to any economy holding monetary reserves, say in the form of gold, because of the automatic writingup of the value of those reserves, for different reasons, in both appreciating and depreciating currencies. Thus, when official gold stocks are valued at a market-related price (the policy now under discussion and, in part, adopted by the French, Germans, and Italians) , a revaluation of the deutschemark, for instance, will cause the value of

German gold reserves expressed in foreign currency values to be written up, in effect, increasing Germany's international liquidity. In the case of a depreciating currency, the general increase i n prices induced by a depreciation will tend to increase the price of gold expressed in domestic currency terms, leading to an illusion of increased monetary elbowroom abroad. In both instances, such autogeneration of international reserves weakens the balance of payments discipline that a given quantity of reserves, undistorted by currency changes, would have imposed. The inflationary potential' of the resulting ballooning of world money supplies is a source of grave alarm to some governments, notably the government of France. In his statement to the 1975 meetings of the International Monetary Fund, Jean-Pierre FourCade, French Minister of Economy and Finance, declared that:

We [the Fund members] aimed at reducing the role of reserve currencies and installing the SDR [Special Drawing Right] as the center of the international monetary system. The reality has not come up to our expectations: today less than SDR 10 billion are in circulation; parities expressed in SDRs are not respected ; and there have been no regular international settlements in SDRs that could be interpreted as the introduction of general convertibility. Quite the contrary, the uncontrolled growth of reserve currencies in circulation continues. In 1970, the world's recorded reserves totaled the equivalent of SDR 92 billion, of which SDR 44 billion was in foreign exchange. By the end of April 1975, total reserves had risen to SDR 182 billion, of which SDR 133 billion was in foreign exchange. Thus, reserve currencies have proliferated at an average rate of 25 percent a year. Under these conditions, it is hardly surprising that foreign exchange markets are still disturbed and unstable, that inflation is spreading from country Summer 1976



to country, and that monetary speculation and transfers from place to place keep threatening our currencies.' These reflections underscore the persistence, even in a floating system, of a concern for and desire to mobilize monetary reserves, quite contrary to the purely theoretical model of floating in which reserves are supposedly not needed. The point is exemplified in the international monetary after-effects of the explosive oil price rise. The overcoming of the oil crisis is constant€y cited as one of the paramount accomplishments of the current floating regime. Had that crisis erupted under a fixed rate system, we are told, the massive movement of funds needed to accommodate the price rise would have bankrupted the oil-consuming nations and plunged the world into monetary chaos. But, as Laffer has observed : The only way the industrial country importers were able to keep the oil price rise in perspective was to use their reserves to finance net imports. It is exactly this use of reserves that floating rates prohibits. Fortunately, countries were not so foolish as to preclude the use of their own reserves to finance the imports of oil. In my opinion, the oil crisis would have been even less of a problem had the intervention taken place that would have kept rates literally fixed.*

International Transmission of National Cyclical Impulses Under Floating

1973. In contrast, the period 1950-1968, characterized by stable rates of exchange for the most part, was one of significantly lower inflationary pressure. It was, moreover, a period in which there were significant variations in the timing and in the degree of inflationary pressures in the different countries. One can hardly speak of the period as exhibiting a simultaneous or universal inflationary trend. These contrasting experiences, in which a regime of stable rates is associated over a protracted period with moderate inflation, while a series of ever more rapid and sizable exchange rate changes, culminating in a general currency float, coincide with an explosion of inflation in every country, unparalleled in recent history, demands explanation. And what is true of the transfer of inflationary impulses under floating is apparently also true of deflationary or recessionary impulses. The previous coincidence of cyclical peaks in the major countries has lately been succeeded by a coincidence of cyclical troughs, a process which may turn out to reflect the completeness and the rapidity with which inflationary and recessionary impulses are transmitted from one economy to another under a system of floating exchange rates. The recent record suggests that a world that floats together also inflates and slumps together. Both the intensity and the amplitude of such rises and falls under the current floating regime are without precedent.

The Case of Germany The recent worldwide bout of super-inflation began with the virtual collapse of the Rretton Woods system in 1968 (when the two-tier pricing system for gold was introduced and central banks agreed to refrain from buying or selling gold on the open market) and its formal interment in August 1971. Since 1968, exchange rate changes have been occurring with ever greater frequency, both in surplus and in deficit countries, with the tempo of such changes increasing up to the float of the dollar in

Alas, all this does not leave much of the vaunted autonomy and independence of national economic policy that flexibility is supposed to secure. Admittedly, in the prior era of exchange rate fixity, a characteristic dilemma was that which faced the Germans (in the late 1950's), anxious to maximize their returns from world trade and yet to preserve their rehabilitated version of capitalism. For the more the Germans strove to defend and secure the free market and sta287

Modern Age



ble money in a world in which the dominant philosophy-call it Keynesianism for lack of a better term-was more tolerant of inflation and of government budget deficits and had a kindlier view of the welfare state, the more certain it was the Germans would fail.g The most dramatic illustration of this point at the time was in the foreign sector of the German economy. The legendary growth of German exports from 1950 on was the result in considerable measure of the lower inflationary pressures in Germany. Ironically, the surge in exports-so marked it was referred to as “export hypertrophy”-produced an inflow of cash (gold and foreign exchange) in dimensions large enough to seriously compromise internal stabilization policies. For a time, the Germans strove to cope with this “imported inflation” by tighter monetary and ;fiscal policies, including higher interest rates. But these policies had the effect merely of lowering the level of domestic demand, thus freeing up still more domestic resources for export, and holding the general level of prices lower than elsewhere. The net effect was to provide continuous incentives to foreigners to buy more German goods. In desperation, the Germans finally resorted (in 1961) to a revaluation of the deutschemark, the first in a series of such revaluations, which became chronic in the generalized currency float of the past several years. Did the cutting of the umbilical cord of the exchange rate serve to rescue the German conception, to insulate the Erhardian view of things from the Keynesian? For a time, it did, certainly. But I think it is highly significant that the period of relative insulation lasted only as long as the system of fixed exchange rates. Since the advent of floating rates of exchange, the German ability to withstand externally generated inflationary forces has virtually crumbled. In a dramatic reversal of its previous situation, Germany, by 1975, suffered all the ills of the other countries: an inflation rate of six percent; enormous budget deficits; a high rate of unemployment approaching,

on an adjusted basis, that of the United States; a sharp fall in industrial output, with exports, the mainstay of the economy for twenty years, representing one quarter of all the goods and services produced annually, declining precipitously. In short, if Germany had not yet caught the English sickness, it seemed to have caught the American sickness. And floating appears to be the mechanism which has served both to convey the disease and to aggravate it for the system as a whole.

ControUing Worldwide Inflflation Manifestly, not only has floating not assured autonomy, it has all but negated any chance of an independent national policy anywhere. On this point, we have a most pertinent set of observations by Arthur Laffer: Without making any excuses for particular policies of the Federal Reserve System, it would seem hard to justify single-minded attention to the US. money supply on the basis of the evidence. In the first place, the bulk of the evidence points to inflation as a worldwide phenomenon and not as an isolated US. occurrence. In the second place, it does not appear as though the US. money supply has, in practice, had much of an effect on the rate of monetary expansion in the world. Far more important for dollar inflation than Fed actions are foreign money supply growth rates, Eurodollar growth rates, and changes in the dollar value of foreign currencies. The U.S. has little, if any, control over these sources of growth . . . . . . As far as I can tell, the best hope for controlling inflation is to reestablish control over the world’s monetary growth. In order to do this, it is obvious that domestic restraint has to be excrcised. In addition to domestic monetary restraint, monetary authorities must also control the effects of exchange rate changes and Eurodollars. This means that movement toward more fixing of Summer 1976



exchange rates and action to control the expansion of Euro-currency liabilities must be part of a viable strategy to combat world inflation.1° One could mention other probable sequences of events calculated to aggravate international inflation under a system of floating rates. For instance, since the inflation induced by a depreciating currency is simply a continuation of the same process, viz., inflation, which produced the depreciation in the first place, sheer momentum will tend to cause it to continue. There is little incentive for the authorities to take remedial action, at least insofar as the international consequences of inflation are concerned, since there is no perceived loss in the sense of a disruption of ongoing behavior or of customary economic activity (as, for example, is likely to be the case under a fixed rate system in which declining international reserves may cause an imposition of quantitative restrictions on imports, with a possible significant employment impact on import-using industries). Since, allegedly, the brunt of any national adjustment to international economic imperatives is taken by the rate of exchange, why worry about internal structural accommoda-

*This article is based on a paper presented at a conference sponsored by the Committee for Monetary Research & Education, Inc. and entitled “The Role of Money in Prosperity and Depression,” Atlanta, Georgia, October 2-3, 1975. ‘Milton Friedman, “The Case for Flexible Exchange Rates,” 1951, reprinted in Milton Friedman, Essays in Positive Economics (Chicago: University of Chicago Press, 1953), pp. 157-203. ’Xenophon Zolotas, statement at the annual meetings of the Board of Governors of the International Monetary Fund, Washington, D.C., September 3, 1975.

‘See especially Laffer’s papers, “‘The Phenomenon of World-Wide Inflation,” unpublished, and “Global Money Growth and Inflation,” The Wall Street Journal, September 23, 1975. ‘See Frank Graham, Protective Tariffs (New York: Harper & Brothers, 19341, pp. 14-41. Yjee Moon Hoe Lee, doctoral dissertation,

tions? Then, too, once the idea of defending fixed rates of exchange is abandoned, there is little motive for defending any particular rate any more. That is to say, the incentives to take any positive action to counter the forces that are pushing the rate up or down are reduced. The abandonment of fixed rates does indeed contribute in this sense to the general momentum of a process in which more and more of the technical and psychological barriers to the spread of inflation crumble and in which the authorities simply reconcile themselves to lower standards of performance in the fight against inflation at home and abroad. Flexible rates thus erode the moral fortitude and the self-discipline required to stop the inflationary process. While, a system of fixed rates of exchange in the nonconventional theoretical framework presented here would certainly not guarantee victory in the #fight against i n flation, it would at least help to eliminate the upward ratcheting effect induced by flexible rates. More importantly, on the evidence it appears simply to be much easier to mobilize and consolidate the moral resources needed to fight inflation under a stable rate system than under flexible rates.*

Graduate School of Business, University of Chicago, 1974. ‘See Arthur B. Laffer, “Exchange Rates, the Terms of Trade, and the Trade Balance,’’ unpublished. “Jean-Pierre Fouqade, statement at annual meetings of the International Monetary Fund, Washington, D.C., September 2, 1975. *Arthur B. Laffer, “Recent Experience and the Issue of Fixed Versus Floating Exchange Rates,” in International Monetary Reform and Exchange Rate Management, Hearings before the House Banking Committee and Joint Economic Committee, July 17-21, 1975 (Washington, D.C.: US. Government Printing Office, 1975). ‘For details see Patrick M. Boarman, Germany‘s Economic Dilemma-Inflation and the Balance of Payments (New Haven and London: Yale University Press, 1964). ”Arthur B. Laffer, “Global Money Growth and Inflation,” The V a l l Street Journal, September 23. 1975.



Modern Age