'Inexplicable' Exchange Rates

October 29, 1998

Just when everyone was betting that Japan's yen would continue to weaken against the U.S. dollar, guess what happened? The yen halted its decline and went from 135 yen to the dollar on Oct. 1 to 110 yen to the dollar on Oct. 8, which meant the value of the dollar fell 20% against the yen in a week. (As of publication it stood at 118 yen to the dollar.) These are not emerging market nations we are talking about here; these are the currencies of the two largest industrialized nations in the world.

An editorial in the Oct. 10 edition of The Economist described the swing as "inexplicable" and noted it would be more productive to examine the consequences of such a move rather than seek an explanation. After all, who could say if the sudden change in the exchange rate between the dollar and the yen was due to technical factors (speculators covering their positions, perhaps) or the accurate reflection of some deep shift in the underlying economic fundamentals of the two nations involved? Maybe everything in Japan just became 20% more valuable compared to everything in the United States in the course of a week. Sure.

When is this ridiculous state of international monetary affairs going to end? How much more can the world take? When will we restore currency stability and monetary integrity?

A financial 'mood ring'

Brazil is now the focus of unwanted global attention because it is perceived as the next potential economic disaster case due to money meltdown.

Can Brazil's currency avoid a blue mood?
Can Brazil's currency
avoid a blue mood?

The tragedy -- and travesty -- lies in the fact that so much of what Brazil has accomplished has been laudable. The nation and its people do not deserve to have their economic house rocked to the ground by a financial earthquake. But it is happening.

The earthquake occurs when there is an abrupt shift in the fault line that divides the currency used by the country from the currency used by foreign investors. Rushing to cash out of investments in Brazilian equities and debt instruments -- which represent capital extended to Brazilian companies or the government -- foreign investors put tremendous pressure on the limited pool of funds available in dollars.

The problem starts out as one of illiquidity -- not enough cash in the form of foreign reserves to pay off investors who suddenly wish to withdraw their funds. But as the stigma of being the next victim of currency chaos begins to cling to a country, people start to dump the national currency. No one wants to be left holding unwanted baht or ringget or rubles -- or Brazil's money, the real. The value of the national currency drops at an alarming pace.

Now the problem begins to be transformed from a condition of illiquidity to the much more serious state of insolvency. The loans are no longer viable; they cannot pay back sufficient funds to compensate lenders even if they continue to perform at expected levels. The underlying asset that provided the collateral for the loan, or the anticipated stream of revenues from the investment project that had been supported by the loan, are denominated in the national currency. That currency is now worth substantially less than it was when the project was first undertaken, and recovery appears impossible.

The currency, as it turned out, was not a reflection of the nation's underlying economic fundamentals so much as it was a "mood ring" providing a rough indication of the severe psychological swing in the global investment community. Instead of furnishing an objective unit of account for valuing the assets and opportunities of the victim country fairly and consistently, the currency served to chew up the value of domestic investments with smaller and smaller teeth.

No country can withstand the financial disconnect that occurs when the national money shrinks in the presence of foreign investors who have every reason to expect repayment in the same form of currency they used when they invested, the money that has meaning for them.

Toward the same standard

What if the world used a common currency? What if everyone had the same money in their pension funds, their bank accounts, their pockets? Although an obvious solution, it is nevertheless shocking.

But think of the benefits. No more "inexplicable" moves between the yen and the dollar to confound exporters and confuse speculators. Indeed, no more currency speculators. Buyers and sellers, lenders and borrowers, investors and entrepreneurs would all transact business in the international marketplace using a common form of money that would not change its value in the future.

Brazil or any other country might have investments that go bad under such conditions, just as any bank might have loans that do not perform as expected. But good loans and entire countries would not be forced into bankruptcy merely because there is a sudden scramble to cash out of a national currency that is fast declining in market value against the currency favored by foreign investors. Money would be a constant unit of account for conveying accurate signals to investors and borrowers about the value of their shared asset.

Ironically, the International Monetary Fund (IMF) was originally established to oversee a system of stable exchange rates among currencies. The Bretton Woods fixed-exchange rate agreement that resulted from that endeavor joined national currencies into a unified international monetary system anchored by a dollar convertible into gold at a fixed rate. For some 25 years, that mechanism provided a sound foundation for international trade and investment.

Contrast the legacy of Bretton Woods with the role played by the IMF today. Its officials behave like unctuous morticians discreetly offering "assistance" as desperate nations succumb to financial contagion. Emerging-market nations now face a bitter choice between making themselves vulnerable to currency chaos or withdrawing from the global economy. It is an unfair choice, an unproductive dilemma. And given that international monetary systems have worked in the past -- the classical gold standard was arguably the best -- it is an unnecessary state of affairs.

A real global economy

If major industrialized nations do not exercise leadership to restore stability to currency relations, the world stands to risk losing all the benefits of an open global economy dedicated to free trade. A common currency linked to gold should be pursued in the interests of universal acceptance of a monetary standard. Interim steps might involve establishing regional currencies. A currency union for the Americas makes sense as an answer to Europe's new money. Asian countries, too, could set up a regional currency to the diffuse the tension between Japan's floating yen and China's fixed yuan.

But the ultimate goal is not to build a "tripolar" global economy but rather an international marketplace. Regional blocks defined by the local dominant currency would be an impediment to free trade and could induce protectionism. What the world needs most is meaningful money to facilitate sound investment and trade decisions. All citizens should be able to use it to pursue their economic aspirations. Anywhere in the world.

The term “carat” comes from “carob seed,” which was standard for weighing small quantities in the Middle East.