The recent sharp decline of the dollar has led to renewed calls to abandon our system of floating exchange rates and return to the so-called fixed rate system that was established at the postwar Bretton Woods Conference. We think that would be a mistake. The floating system of exchange rates has actually worked quite well, and the alternative would bring with it more harm than good.
There has, as the critics of our current system say, been much volatility in the international value of the dollar since President Nixon decided to let the dollar float early in the 1970s. But that volatility is a result not of the floating exchange rate system, but rather of the fluctuations in domestic economic policies.
The runaway inflation that took off in the second half of the 1970s caused foreign investors to withdraw funds from U.S. markets and led to a fall in the value of the dollar internationally. When a return to sound monetary policy in the early 1980s restored confidence and reduced inflationary expectations, the dollar began to increase in value. This rise was later reinforced by the high interest rates offered to finance the massive current and anticipated future budget deficits.
The dollar's latest reversal began in early 1985. By that time the dollar had risen beyond a sustainable level. As foreigners become satiated with dollars, the level of the dollar inevitably has had to come down again. This fall has been halted intermittently by foreign and U.S. central bank intervention and by the temporary psychological effect of statements like the Louvre accord calling for exchange rate stability.
These sharp fluctuations have created dislocations for businesses that compete internationally -- American businesses when the dollar was overvalued and more recently businesses in Europe and Japan as the dollar has dropped dramatically. Some industries that grew abroad as the dollar was overly strong may now suffer and contract just as U.S. firms did several years ago. The reluctance to accept such readjustments explains why some of the Group of Seven countries are exerting pressure on the United States to stabilize the dollar.
What if the United States had been on a fixed exchange rate system throughout the Reagan administration? If it had been required to maintain a stable exchange rate in the early 1980s, there would have been two alternative policy choices -- one good and the other very damaging. A budget policy that implied a significantly lower budget deficit than the one we actually had would have been a good policy to follow and would have kept the dollar from rising. But the powers that be in Washington would have been more likely to choose instead a more inflationary monetary policy in order to maintain exchange stability while piling up the huge budget deficits.
There is no reason to believe that the requirements of a fixed exchange system would have persuaded Congress to cut spending or the administration to raise taxes. Remember, it was Treasury Secretary Donald Regan who forcefully asserted that the budget deficit had nothing to do with interest rates or the value of the dollar.
Given such fiscal profligacy, for the United States to satisfy the demands of a fixed exchange rate system, the burden would have fallen on monetary policy. The Fed would have had no choice but to pump up the money supply. The higher inflation would have stabilized nominal exchange rates, but the combination of a fixed exchange rate and a rapidly rising U.S. price level would have reduced the competitiveness of American industry by just as much as a rising dollar in an economy with more stable prices. A fixed exchange rate would therefore have produced inflation without doing anything to prevent the damage to American industry.
In the current situation, the requirement to stabilize the dollar would again put pressure on the Fed, but this time it would be to raise interest rates and risk an unnecessary recession. Trying to fix the exchange rate would again do more harm than good.
Although the European monetary system is often pointed to as an example of a successful fixed exchange rate system, there are in fact very frequent exchange rate adjustments among the European currencies. Furthermore, to the extent that the European system succeeds in stabilizing exchange rates, it is because the German central bank effectively sets monetary policy for all of Europe, with the other central banks just following the German lead. Certainly the United States is not prepared to allow the German Bundesbank to dictate U.S. monetary policy as well.
Calls for another Bretton Woods Conference to restore the fixed exchange rate system may sound like good international relations, but it's bad economics. Don't expect this administration or the one that follows to give up a system that works.
Martin Feldstein was chairman of the Council of Economic Advisers. Kathleen Feldstein is an economist.