The Wall Street Journal

January 28, 2005

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See complete coverage3 of the World Economic Forum's annual meeting in Davos, Switzerland.


One Global Currency?
Exchange-Rate Angst
Draws Out Radical Ideas

January 28, 2005; Page A11

FRANKFURT -- Even as the world economy becomes increasingly integrated, governments are more reluctant than ever to act together against big swings in exchange rates. That is causing a growing number of officials, businesspeople and economists to ponder more-radical ideas in pursuit of currency stability.

This year will feature talks "about a set of issues that haven't been talked about for a long time, such as how does the international monetary system operate," predicts Mervyn King, governor of the Bank of England. British officials, who will preside over meetings of the Group of Seven leading industrial economies this year, want to debate whether the present exchange-rate system -- in which Asian currencies including China's yuan are linked to the U.S. dollar while the euro, yen and pound float freely -- is the best way to balance the world's trade and capital flows.

And central bankers expect to debate the merits of revamping the global currency system later this year at a Vienna conference titled "A New Bretton Woods?" -- a reference to the post-World War II system of fixed exchange rates.

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Instead of getting more-stable exchange rates along with a globalized economy, "we are moving in the opposite direction -- into a world in which there are extreme swings among the major trading currencies. Are we happy with this?" says Augusto Lopez-Claros, chief economist at the World Economic Forum, the Swiss organization that hosted last week's meetings of global business elites in Davos.

Many businesspeople aren't. Big currency moves force companies to change or delay their strategic decisions about where to produce and market their products -- for the wrong reasons, says Rainer Hundsdörfer, chief executive of German machine-tool maker Weinig Group. Currency swings "lead to decisions that are driven by reactions to temporary events, but which don't make strategic sense," he says.

Most economists believe floating exchange rates are needed to allow economies to adjust to disturbances such as recessions or oil-price shocks that can affect different countries at different times. Some experts argue that with globalization, the downsides of floating currencies are growing. "The current exchange-rate system has functioned reasonably well since the 1970s, but I think it's not suitable for the future," says Richard Cooper, a professor of economics at Harvard University. "Floating exchange rates will become less and less a shock absorber, and more and more a source of shocks."

Economic shocks from events such as oil-price rises won't go away, Prof. Cooper says. But because G-7 economies are increasingly integrated and industrially diversified, he argues, such disturbances will tend to affect the major advanced economies more equally than in the past, meaning that exchange-rate shifts between these countries are becoming less relevant to absorbing shocks. On the other hand, he argues, global financial markets are growing bigger and more autonomous in relation to the flow of trade and investment in the real economy. Swings in exchange rates often reflect capital flows that are only indirectly linked to the real economy, and can be dominated by traders' attempts to predict others' behavior.

Trading flows of this kind can lead to prolonged currency swings that disrupt the real economy, by making a country's industry exaggeratedly competitive or uncompetitive for a period. Ronald McKinnon, a professor at Stanford University, argues that the large swings in the yen caused Japan's economy to overexpand in the 1980s and led to its deflation in the 1990s. "Exchange rates do sometimes go to levels that have nothing to do with the need for adjustment," says John Williamson, a senior fellow at the Institute for International Economics in Washington. Although he supports floating exchange rates, he says governments should be more active in saying what long-term value their currency should have and intervening to resist extreme swings.

Some other economists go further, supporting target zones for major currencies, and Prof. Cooper even says a common currency for the U.S., euro zone, Japan and U.K. would be the best solution -- an idea he admits is "quixotic" at present.

A common currency would require countries to surrender sovereignty over interest rates, which the 12 European users of the euro were willing to do thanks only to a strong commitment to political unity. Outside Europe, enthusiasm for a common currency is low, owing partly to the breakdown of past attempts to fix exchange rates. Fixing exchange rates is viewed as inviting speculation when economies get out of sync.

But floating currencies create strains at a micro level, critics say. Many companies, besides using derivatives to secure the value of near-term earnings, are trying to spread their production around different currency zones, so that their costs move in sync with their revenue when currencies fluctuate. Such tactics, if pursued on a large scale, would mean that industrial production doesn't necessarily take place where it is most efficient -- reducing global prosperity, says Mr. Lopez-Claros. "If companies decide where to produce in order to defend themselves against exchange-rate volatility," he says, "that is the tail wagging the dog."

Write to Marcus Walker at marcus.walker@wsj.com1

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