Volcker says it's time to anchor floating exchange rates
Cambridge, Mass. — To Paul Volcker, the former chairman of the Federal Reserve System, the symbolism was perfect. Just after he advocated reducing ``entitlements'' as one way for cutting the federal budget deficit, the alarm bell on a door went off at the John F. Kennedy School of Government at Harvard University, where he was giving a lecture March 11.
In political circles, any suggestion for trimming social security payments or other government entitlements sets off alarm bells.
In his talk and reply to questions, Mr. Volcker spoke more frankly than he would have before his replacement last summer at the Fed by economist Alan Greenspan. He, for instance:
Advocated a boost in tobacco and liquor taxes and other ``cats and dogs'' in extra revenues as another way to trim the deficit. He doubted the political possibility of raising income tax rates.
Urged a reduction in the deficit of about $40 billion a year, through spending restraint as well as new taxes. But he complained about Congress's doing damage to the nation's security and foreign policy by holding back relatively small sums for GATT (General Agreement on Tariffs and Trade), the OECD (Organization for Economic Cooperation and Development), and United States embassies abroad. ``We are trying to do some of these things on the cheap,'' he said. But it damages the US image around the world.
Predicted that commercial banks will be permitted to underwrite all securities but those issued by corporations. He insisted, however, that the financial system should maintain a separation of banking and commerce because of the needs of banking supervision, possible conflicts of interest, and the danger of too great a concentration of economic power.
Forecast ``pragmatic groping'' by the noncommunist industrial nations toward a system of ``loose reference zones'' or ``target zones'' for foreign-exchange rates.
A return to the system of fixed exchange rates established by the Bretton Woods conference of 1944 or to a gold standard is ``way beyond our means at present,'' Volcker said. But he questioned the merits of the ``experiment'' in ``floating'' exchange rates that has prevailed between the US dollar, the Japanese yen, and West European currencies for 15 years.
Under a floating rate system, the demand and supply for a currency in the foreign-exchange markets determines the price of that currency expressed in terms of another currency. A US dollar, for example, buys about 1.65 West German marks these days. On average it bought 2.94 marks in 1985, the year the dollar began weakening.
Under the Bretton Woods system, government intervention in the foreign-exchange markets kept the value of major currencies fixed - except for the occasional dramatic devaluation. That system broke down in the early 1970s after a devaluation of the dollar.
Volcker, who earlier this month decided to teach economics part-time at Princeton University and become chairman of a small investment banking firm, James D. Wolfensohn Inc., argued in favor of more exchange-rate stability.
Floating exchange rates, he said, may have saved the world from a worse situation in the mid-'70s when the Organization of Petroleum Exporting Countries quadrupled the price of oil and shortages of agricultural products forced up prices. But the system has not lived up to the promises of its advocates.
These advocates said floating would automatically bring about equilibrium in the trade and current accounts of nations. Further, they said exchange rates should be fairly stable, with speculators bringing rates back to an equilibrium position if they got out of line. Further, policymakers would have greater autonomy to carry out domestic economic policy without worrying about its effect on exchange rates.
Instead, said Volcker, exchange rates have been far more volatile on an hourly, daily, weekly, or monthly basis. The dollar has fallen about 60 percent since February 1985. A sharper change in the dollar's value had never occurred previously, he added.
The US trade deficit, which caused much excitement in the late 1960s when it was running about $2 billion per year, last year reached $171 billion. Volcker suspects the deficit and exchange-rate volatility have stirred up trade protectionism. Anecdotal evidence suggests the exchange-rate swings have also influenced international investment by multinational corporations, he said.
Speculators have benefited from volatile exchange rates, Volcker noted. ``There is a certain feeling in financial markets that they love volatility, whatever it does to the rest of the world.''
No international monetary system will work without the complementarity and coordination of economic policies by nations, Volcker said. He recalled that as head of the Fed, he had engaged in efforts to bring about greater cooperation at meetings of the major industrial nations, such as those of the G-5 and G-7.
``I know how difficult it is and how frustrating it is and how much talking per decision there is,'' he said. Floating exchange rates enabled central bankers and finance ministers to intellectually rationalize going their own way in domestic policies.
Contrariwise, the fixed exchange rates of the Bretton Woods system often forced national leaders to make tough fiscal and monetary decisions. Historically, Volcker said, fixed exchange rates have had ``the kind of political context that can motivate action.''
Mr. Volcker wondered if an exchange-rate target system, which allows currencies to fluctuate within a wide band around a target exchange rate, would have the same political impact in nations.
Nonetheless, he argued the target system would be better than the present floating system, which is tending toward regional monetary blocs - Western Europe, North America, and Japan. Such blocs raise the danger of ``restrictions and tensions'' between them.