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Jared Friedman

December 13, 2004

Exchange Rate Systems in Two Periods of Capital Mobility

Choosing an exchange rate system is unquestionably among a country’s more

important policy decisions. The choice of exchange rate system has direct effects on
exchange rates, interest rates, and inflation. But the choice is also often difficult, as each
currency option has distinct costs and benefits which can be difficult to weigh. An
excellent conceptual framework for understanding competing options for an exchange
rate system is provided by the Mundell-Fleming model, which states that the three
generally desirable qualities of capital mobility, fixed exchange rates, and an independent
monetary policy can never all be had simultaneously. The general prevalence of the first
of these conditions, capital mobility, has changed greatly over the past two centuries.
Before the mid- to late nineteenth century, capital mobility was low, as large international
financial markets had not yet developed. In the late nineteenth and early twentieth
centuries, international finance and the global economy caused significant capital
mobility for the first time. In the years between 1914 and 1973, capital mobility plunged
worldwide, destroyed by the world wars and the Great Depression, and then restricted by
the capital controls of the Bretton Woods fixed-exchange rate system. After the demise
of the Bretton Woods gold-dollar system, the rise in the size and importance of financial
markets has made restricting capital mobility difficult, and free capital exchange has been
the rule (obviously with some exceptions). There are thus two periods of high capital
mobility, where the choice of exchange rate system has been largely between fixed
exchange rates and an independent monetary policy – the decades before 1914, and the
decades after 1973. This paper examines the motivations for exchange rate system
choices in these time periods.

First, it is helpful to consider in the abstract what makes each Mundell-Fleming

condition desirable and the effect of incorporating it into an exchange rate system.
Capital mobility is favored obviously by financiers and anyone involved in capital

transfers, but also by governments who want to run large deficits. Fixed exchange rates
generally increase international trade and particularly international investment by
reducing the risk of currency fluctuation in those transactions. Fixed exchange rates also
often reduce the risk of inflation and generally increase the stability of the money supply.
An independent monetary policy allows counter-cyclical management of the economy,
and will also allow some control of exchange rates if used in a system without fixed rates.
These basic effects were equally true in both time periods. However, as we shall see, the
effects a country saw as most important, and thus which currency option it chose to
adopt, changed considerably across the two time periods.

In the decades before 1914, there were essentially three choices for exchange rate
systems: the gold standard, a free-floating currency, or a silver-backed currency. The
pattern for which countries chose which was clear: the industrial countries were
invariably on the gold standard, and less industrialized, primary product exporting
countries were either free-floating or silver-backed.1 It might initially seem that both
gold and silver backed currencies represent a choice of fixed exchange rates, and free
floating currencies represent a choice of monetary independence. This is true to some
degree, but silver-backed currencies are probably better classified as a choice of
independent monetary policy over fixed exchange rates. One reason for this is that silver-
backed currencies were quite small in total monetary value versus gold-backed
currencies, making the gains of the fixed exchange rate smaller. A more important
reason, in terms of its historical significance, was that silver had a history of consistently
declining in value compared to gold, and as we shall see, the monetary policy countries
on silver wished to pursue was one of competitive devaluation, of an undervalued
currency. And unlike with the gold standard, if silver failed to decline as expected, a
devaluation of the exchange rate was much more permissible with a silver-backed
currency than with the international gold-standard, where such a devaluation would have
completely destroyed credibility.

The section on this time period draws mostly from Frieden, The Modern World Economy 1896-200. chap.
5, pp.11-19.

Thus, the industrial countries were essentially choosing fixed exchange rates over
an independent monetary policy, and the developing countries were choosing the ability
to devalue their currencies over fixed exchange rates. The reasons for this split have to
do with the relative benefits for different countries of being able to use competitive
devaluation to increase their exports versus having the privileged access to world
financial markets that came with adherence to the gold standard. It is not hard to see that
wealthy industrial countries with active international financial markets would benefit
more from this privileged access to capital than agrarian countries with no such markets,
and also that the special interests from financiers and potential borrowers of capital to
keep that privileged status would be much stronger in the industrial countries. However,
the reasons that exporters of primary products would want to devalue their currencies
more than exporters of industrial products would are somewhat more subtle.

One key difference is the often-mentioned volatility of primary product prices.

Competitive devaluations are effective only in the short run, as eventually the higher
prices of foreign goods will cause inflation equivalent to the devaluation, offsetting its
initial effects. Thus competitive devaluations can be highly effective for primary product
producers, greatly reducing the negative effects of a sudden drop in prices, but for
industrial goods producers, there are fewer sudden shocks causing voters to cry for
competitive devaluation, and it is difficult to bring an uncompetitive industry to
competitive levels in the long run simply by revaluing currencies without capital controls.
Also, the oligopolistic nature of markets for industrial goods made them inherently less
competitive and thus less sensitive to small price differences. So why would a less
developed country want to fix to silver, which was expected to decline continually
against gold? One, such declines, possibly fixed by occasional interventions in the
supposedly fixed rate, could offset the shocks as described above. But it is also true that
farm prices in general were continually declining in that period, so having an inflating
currency acted towards keeping them steady and helped avoid deflation.

Another reason is the fact that many of the primary product producing countries
produced a few major products for export which together made up most of their

international economies, while the industrial countries generally produced a large number
of manufactured goods, each of which was a small part of their exports. Thus when a
price shock affected a single agricultural good, it would not be unreasonable for a country
that depended heavily on that good to devalue its currency for the benefit of the
producers of that good at the expense of the inflation this would cause for the rest of the
economy. For an industrial economy, such a devaluation would only happen if a large
number of goods were impacted simultaneously. A third reason is that all the industrial
countries were on the gold standard, so that the prices of industrial goods rose and fell
simultaneously with no country having a competitive advantage. Since most primary
product producers were not on the gold standard, any such producer on the gold standard
would quickly be put out of business when the currencies of its competitors devalued
against gold.

Evidence and examples for this theory abound. When the price of copper in Chile
fell from 70 to 40 pounds sterling, the percentage price change was precisely the same in
all the countries on gold. But the Chilean government devalued the peso against the gold
currencies from .18 to .10 pounds sterling, causing the price of copper to remain almost
exactly the same. Similarly, when world wheat prices dropped by half in the late
nineteenth century, Argentina dropped the gold standard in order to devalue the peso to
keep local wheat prices steady, which it did. Since copper and wheat were enormously
important components of the economies of Chile and Argentina respectively, it seems
likely that there was in fact a causal relationship between the price declines and the
monetary response. The difference of opinion between industrialists and farmers was
particularly stark in America, which was unusual in having both large manufacturing and
large agricultural sectors. In America, the Populist anti-gold movement, encompassing
basically the farmers and miners in the south and the Midwest, was brought into violent
conflict with the pro-gold industrialized northeast and west, making gold the primary
issue of the 1896 presidential campaign.

But the Mundell-Fleming choice of monetary independence versus fixed

exchange rates was not the only exchange rate system choice faced by these countries.

Why did some countries choose to fix to silver and others to float? And why did the
countries choose to fix currencies to gold, as opposed to creating a single currency as is
much more common now? The answer to the first question is that the decision was based
largely on tradition. China and India had used silver for ages, and they simply kept it.
Mexico’s decision to stick to the silver standard, though, was probably based more on the
fact that it was a major silver producer. The answer to the second question is
complicated, and not entirely relevant to the topic at hand, but the answer lies in several
factors. First, there was tradition, as gold had been used as currency for most of history.
There was also a fear of inflation and a general lack of confidence in the ability of
governments to maintain the value of floating currencies. Perhaps most importantly, the
lack of international political organization made the gold standard, which required no
international central bank, much easier to implement than a new currency.

The apparent currency options during the period after 1973 were quite different
from those during the pre-1914 period. Virtually all countries chose to float (e.g.,
America, Japan (mostly)), to peg or fix their currency to another one (Argentina, Hong
Kong, etc.), to create a new international currency (Euroland), or to dollarize (Argentina,
Mexico, Peru, etc,). However, when viewed in terms of the Mundell-Fleming conditions,
the options were not really so different. All of these choices typically went with high
capital mobility, so the choice was really between the monetary independence of the first
option and the fixed exchange rates of the other three options. The effects of each of
these options were also similar to what they were in the pre-1914 period. However, the
costs and benefits of each of these effects had changed dramatically in the intervening
years, and so countries made different choices from the ones they made before 1914.

Looking at which countries chose to float and which to fix after 1973, it is clear
that the economic size of the country correlates strongly with this decision. Larger
countries are much more likely to choose floating rates, and one explanation for this is
that currencies are goods with economies of scale.2 Why should a currency have
economies of scale? There are several reasons. First, small currencies tend to be treated
Alesina, Barro, et al.., Optimal Currency Areas. National Bureau of Economic Research, working paper
9072: 4

as higher risk, thus mistrusted by international finance, based on previous experience.
Also, since large currencies are held as reserve currencies, using a large currency means
that a country can borrow money in its own currency, greatly reducing the real price of
sovereign debt. The value of smaller currencies is controlled by a smaller total volume of
exchange, leading to greater volatility. And smaller currencies tend to be supported by
smaller and less efficient central banks. A different reason why larger countries should be
more likely to choose floating rates is that smaller countries are less self-sufficient than
larger countries and therefore trade more; thus, the decreased transactions costs in trading
that come with fixed currencies are more important to small countries.

Armed with this understanding of the effects of the Mundell-Fleming conditions

and how they relate to a country’s size, we can readily explain most of the exchange rate
system choices in this period. One of the most dramatic currency events in this period,
indeed in the whole century, was the adoption of the Euro. But the euro makes a great
deal of sense: it is a currency union of a number of relatively small countries that even
before its adoption were highly integrated in trading patterns3. Here the benefits of fixed
exchange rates on trade, combined with the economies of scale for a currency, were most
important. The dollarization and dollar pegs common in Latin America can be explained
for a different reason. Trade is undoubtedly important here too, but more important are
probably the stability provided by using the dollar instead of an inflation-prone national
currency and the ability to manipulate exchange rates by changing the peg. Unlike in the
pre 1914 period, Latin American countries have usually manipulated the peg to keep their
currency over-valued, in order to keep imports cheap and reduce the value of the national
debt, with sometimes disastrous results.4 Likewise, the Hong Kong Dollar’s dollar peg
was instituted to maintain monetary stability. By contrast, we can see why the dollar, the
euro, and the yen have remained independent and floating against each other: these
currencies are large enough to enjoy most of the economies of scale, they can easily
borrow money, and their central banks pursue different enough policies that combining
them would be a significant cost.

Frieden, chap. 16, p. 33
Carodo, Eliana, et al., Latin America’s Economy: Diversity, Trends and Conflicts. 80

Of course, as in the period before 1914, countries after 1973 have faced not only
the general Mundell-Fleming trade-offs but also more specific currency decisions. In
particular, those who decided to fix rates had to decide whether to peg to a currency (and
which currency to peg to), to dollarize (to the extent this is a choice of the government),
or to form a new currency. One interesting question is why the euro is unique as the only
large-scale currency union in this time period. This is quite simply because there is no
other group of nations similar to the European ones – no other group of countries with
relatively small, tightly integrated economies that together form a large economic block,
and a lack of strong political and military tensions between them. For example, one
possible other currency union that might come to mind would be the nations of Mercosur,
but this would likely be too small a union to realize economies of scale, and it might well
be dominated politically by Brazil.5 Thus, other nations that have wanted to fix rates
have fixed to other currencies, and most have chosen the dollar because it has been the
predominant currency for many decades.

Certain aspects of exchange rate choices are difficult to compare across the two
time periods. Dollarization, for instance, has no obvious equivalent in the pre-1914 time
period. However, one aspect that can be readily compared is the choice between the two
competing Mundell-Fleming conditions: fixed exchange rates and monetary
independence. In the pre-1914 period, this choice was primarily determined by the
industrialization of a country – more industrial countries chose fixed rates. In the post-
1973 period, this choice was primarily determined by a country’s economic size –
smaller countries chose fixed rates. Why this dramatic change? One, primary products
are much less important in today’s economy, and so the motive of using the exchange rate
as a tool to offset changes in those prices is much less potent. Two, countries have
realized over time the economies of scale in currencies, and small countries now
generally adopt larger currencies in order to maintain stability and attract investment.
Finally, the three primary currencies are now so large that the industrial economies
realize much of the benefit of having a single currency (as in the gold-standard) by
instead having three super-currencies. While the Mundell-Fleming conditions and their
Mundell, Robert. Currency Areas, Exchange Rate Systems and International Monetary Reform. Journal
of Applied Economics, Vol. III (2000): 234

implications are virtually timeless truths, the changing aims of national politics will lead
to changes in exchange rate policies.