Strong Currency ≠ High Interest Rates

One potential criticism of the gold standard (fixing the dollar to gold) is that it would lead to high interest rates. This is wrong. This implies that weak currencies (or weakening currencies) cause interest rates to decline and that strong currencies or strengthening currencies cause interest rates to rise. This is utter nonsence and there is a vast body of empirical evidence against such a proposition. Currency devaluation (ie weakening) or even the mere threat of devaluation generally drives up interest rates. Strong currencies generally have low interest rates.

In the 1990s and early 2000s the YEN was so strong (the deflation even registered in the CPI) that ultimately interest rates could be set at 0%. During the 1970s when devaluation was the norm interest rates were consistently high nearly everywhere (except in parts of the US where high interest rates were illegal and so lending simply shut down).

Gold in so far as it might today be considered a currency has been very strong relative to nearly every major currency over the last 5 years. And yet interest rates for gold denominated debt are low. The chart below is from a selection by Kitco and shows the effective interest rate on gold denominated loans of various maturity terms during the last twelve months.

One of the traditional reasons that governments would return to the gold standard was because it would lower their cost of borrowing. Any currency today that was fixed to gold and which allowed interest rates to float free from capital controls would enjoy interest rates close to the interest rates on gold plus a slight premium to account for the risk of a future devaluation. Mere arbitrage alone would ensure such a near alignment with the interest rate on gold loans. Imagine having the opportunity to borrow gold at 1% interest, convert it to Aussie dollars and earn 20% interest and then convert it back to gold at the same exchange rate at any point in the future. Such a market scenerio would not be sustainable.

A gold standard gives you:-

  • Low or absent CPI inflation
  • Stable commodity prices
  • Stable exchange rates (if others adopt a gold standard also)
  • Low interest rates.

There are a million arguments about why a gold standard is a bad thing or why the world will end if we have a gold standard. However the empirical evidence across the ages all suggests otherwise.

UPDATE (by admin): The first sentence of this post originally referred to a comment by JC. However, it turns out that this was based on a misunderstanding of JC’s comment and following JC’s request the first sentence has been edited. The point of the article remains the same.

69 thoughts on “Strong Currency ≠ High Interest Rates

  1. As I have admitted elsewhere if Australia unilaterally adopted a gold standard (ie went it alone) while other currencies continued to float then our manufacturing and tourism export sectors would probably have some difficultly at times when foreign currencies are depreciating. However most critics of tariffs on this blog would agree that we shouldn’t formulate economic policy to protect special interests even when they face “unfair” competition from abroad.

    Under a gold standard our commodity export sectors would be mostly better off as they could make do with a lot less hedging instruments. The banking sector would flourish as would the services sector.

  2. Terje

    We could not unilaterally fix to gold as our currency would be jumping around with the gold price. We are too small to fix to gold. I’ve had this discussion with bird before.

    Let’s assume we fixed to gold when the Aussie was around 50 cents and gold was $US270. Let’s see where that would have taken us earlier this year? With gold at $1032 (and the Aussie at 94 cents approx) our exchange rate would have been $US1.41 under a gold fix.

    It would have put us in an impossible situation.

  3. Terje

    Would you mind correcting the silly rebuke.

    If you had read my comment without jumping around thinking you had scored a direct hit you would have realized I was talking about a US dollar linkage in which case we would have seen rates over 30%.

    Here is my comment again.


    If we had been linked to the dollar in the current climate domestic interest rates could have easily gone to 30% or even higher sending us in the worst depression for a generation.

    Careful what you wish for.

    ” the Dollar” is the US dollar.

  4. We wouldn’t have 20% interest rates of course if we had a gold link.

    As I said, I thought you were talking about a US dollar linkage.

  5. No terje it is not silly, our rates would be possibly higher than 30% if we have fixed to the dollar.

    it would be great if you gave this shit some thought instead of heading off to the pass.

    if we had a peg we would have basically US rates +or- perceived credit risk and no need for a central bank as we would be basically running US monetary policy. A fix is quite different.

  6. i don’t think JC is totally wrong about interest rates with US dollar linkage. if the linkage is done without 100% backing with foreign currency reserves then the RB would have to defend the fixed rate using interest rate rises and other measures.

  7. Terje

    Ludwig von Mises’ support for the gold standard was based on his view that ‘in the existing circumstances [this was written in 1934] there is no other way of emancipating the monetary system from the changing influence of party politics and government interference, either in the present or, so far as can be foreseen, in the future.’ (see preface to the first English edition of Theory of Money and Credit)

    Mises saw a gold standard mainly as a technology for discipling government, but was otherwise well aware of its limitations. Friedman saw a constant money growth rule in much the same way.

    A gold standard is an effective discipline – right up to the point governments decide to drop it. I would suggest governments are more likely to go off a gold standard than other pre-commitment technologies such as central bank independence and inflation targeting, because it leaves economies more exposed to external shocks and relocates volatility from the price side to the real side of the economy (look at real GDP volatility under the gold standard).

    I would suggest Mises and Friedman were too pessimistic about the willingness of the authorities to accept monetary discipline, in large part because they underestimated the long-run influence of their own ideas on the way monetary policy is conducted.

  8. Terje

    If you’re not going to change the fucking thread comment about I will write my own thread accusing you of being a fucking liar.

    Now change the fucking comment.

    You know I didn’t say.

  9. JC,

    I have updated the article to admit that I misunderstood your point. This was a mistake not a lie. However it is not overly material because your point was still wrong.

    What you said was:-


    If we had been linked to the dollar in he current climate domestic interest rates could have easily gone to 30% or even higher sending us in the worst depression for a generation.

    Careful what you wish for.

    Which is hogwash. If the Aussie dollar had been fixed to the US dollar we would not have had interest rates at 30% and there would have been no risk of such an outcome. Our interest rates would have tracked quite closely to the US rate due to the aribitrage opportunity that any deviation would create.

  10. Stephen – the merit of flexible exchange rates in dealing with external shocks is over estimated. Robert Mundell wrote most of the early work on optimal currency areas (and got a Nobel Prize for it) and his ultimate conclusion has been that the most optimal currency areas is the whole world. When the Euro was estabilished the lack of flexibility was supposed to cause all sorts of problems across Europe which in reality have never materialised. The Eurozone is a success and certainly better than what preceded it.

  11. Dr Duck – A nation can readily fix it’s currency without owning any of the foreign currency it fixes to (or without owning any gold if fixing to gold). Of course the monetary authority does need liquid assets of some kind and in sufficent quantity.

    For example if New Zealand fixed to the Australian dollar in the range of A$0.900 to A$0.910 then it could maintain that tight range even if it only owned a mix of Euro bonds, US bonds and Yen bonds (ie no Australian dollars). If the price of the NZ$ drifted upward towards $A0.910 then it could buy more Euro bonds (print NZ dollars) to bring the value of the NZ$ down a touch. If the price of the NZ$ drifted down towards $A0.900 then it could sell US bonds (recall NZ dollars) to bring the value of the NZ$ back up a touch. Using such constant open market adjustments and fine tuning it could quite readily hold the fix.

    If New Zealands commitment to such a fix was clear then speculators would in fact move in to lend a hand. If the commitment looked doubtful then some speculators would push against the policy until their doubts subsided (or were proved right about the government). If a government wants a fix to hold it can readily do so.

    Fixing the value of the national currency using open market operations in this way is little different to the current approach towards fixing interest rates. However if chosen correctly a currency fix is far superior to an interest rate fix.

    New Zealand would have little down side in fixing to the Australian dollar. It would get greater trade with Australia and more ready access to capital.

  12. Terge

    Italian government bond spreads to German bunds would suggest the euro zone is about to lose at least one member.

    Intrade puts the chance of any one country dropping the euro by 2010 at about 34%, which is remarkably high given the amount of political capital invested in the project.

  13. TP, what if you don’t have the assets required to defend your peg band? Isn’t that what happened in the Asian crisis?

  14. You’re a fucking liar Terje. And I’m more than pissed off at you’re disgusting attitude towards your fuck up.

    I’m going to ask Humphreys to remove the offending thread. Let’s see if John shows the courage to do so.


    Before you go into an economics discussion try and get your terms right.

    A peg, and a fix are two entirely different things.

    If we had pegged to the Dollar we would have interest rates at about the US level depending on credit risk.

    If our currency was fixed we would have seen our interest rates head to 30% and above. All you need to do is look at what happened to interest rates last time we were fixed to the US dollar.

    As I as said if we had fixed gold under you advice we could very well have experienced an economic depression.

    You’re now on the same page as Bird in quackery that is supposed to pass economics

    It not a matter of ” updating” the thread. You fucked up big time when I specifically mentioned a ” dollar” fix while you thought I was talking about gold.

    That doesn’t require a fucking update, Dipshit. That deserves the offending part to be rubbed.

    So stop being so dishonest and remove that comment out of there NOW or I put up my own to set the record straight.

  15. I have updated the article to admit that I misunderstood your point. This was a mistake not a lie. However it is not overly material because your point was still wrong.

    Bullshit it’s not material. You questioned my knowledge regarding my work background on your own faulty interpretation of what i was saying.

    it would be like me incorrectly attributing some programing error to you and then glancing over it in a casual way suggesting it was linked to something else.

  16. Terje — for an exchange rate “fix” to be equivalent to an interest rate “fix” you would need to be constantly re-setting the fix according to the projected rate of inflation.

    And JC seems to have a good point about a small open economy embracing a gold fix without the rest of the world.

  17. I never said an exchange rate “fix” was equivalent to an interest rate “fix”. I said that if the aussie dollar was fixed to the US dollar then our interest rate would converge towards the US interest rate with a slight risk premium. And likewise if the aussie dollar was fixed to gold then our interest rate would converge toward the interest rate on gold loans with a slight risk premium. The risk in both cases is the risk of devaluation (ie abandonment of the fix). This would not entail any adjusting for inflation. It merely entails three things:-

    1. The government demonstrating that it is commited to the currency fix.
    2. Open market operations are applied to maintain the currency fix.
    3. Normal arbitrage will then cause the interest rates to converge (assuming no credit controls).

    Given 1 and 2 then 3 should be self evident if you think it through. There is no need to adjust the fix for inflation in order to have interest rates converge. To suggest otherwise would be thoughtless (ie you have not thought it through)and would entail an indifference to empiracle evidence.

    JC does indeed have a good point about a small economy embracing a gold fix without the rest of the world. It is the similar in many ways to the risk associated with unilateral trade liberalisation. In both cases some industries would suffer but on aggregate the effect of a unilateral move to a gold standard would be beneficial just as a move to unilaterally remove tariffs would be beneficial. So whilst it is a good point it should not substancially change the assessment.

  18. Stephen – you are accepting my repeated point that there is a interest rate premium associated with the risk of devalation. However in the context of Italy and Germany the situation is different. They have a shared currency not a fixed exchange rate. As such I would expect that the Italian bond contracts are denominated in Euros and so even if Italy decided to use some alternate currency (a new one presumably) then it’s legacy debts would still be in Euros and not in the new currency. As such any differencial in interest rates on Italian bonds versus German bonds would represent a difference in the credit worthiness of the respective governments. Whilst devaluation under a fixed currency regime may be considered as a soft form of default the mechanics are slightly different.

  19. Terje

    Define exactly what you means by ” fix”. Is it a fix or a peg you’re talking about as those two terms mean different things in economics.

  20. No they don’t. The terms are used interchangeable all the time.

    The only discernable differency in the way the terms are used is that people sometimes refer to a crawling peg but almost never to a crawling fix. So we might say that a currency fix is a currency peg that is not changed.

    To spell it out a fix means that the target of the monetary authorities open market operations is a specific exchange rate and they are commited to hitting and maintaing that target. The supply of currency is adjusted to ensure the objective is met.

  21. As the chart shows the value of the Hong Kong dollar has traded within a 4 cent range over the last 5 years. That is a range of roughly 0.5 US cents.

  22. The HK dollar is a peg, terje. it’s not a fixed exchange rate. The currency board will convert HK dollars to US dollars anytime unless this has changed over the past year or so and i haven’t noticed.

    As I said, you need to know the difference and why.

    Pegs don’t break while fixed exchange rates do.

  23. JC – I don’t accept that there is anything unconventional about my useage of the term “fixed currency” or “fixed exchange rate”. It is certainly consistent with numereuos articles on Wikipedia and the wider Internet and consistent with books I have read on the topic. You can invent alternate definitions if you want to but if so you really ought to let us know the alternative definition you are using.

  24. Terje, we’ve discussed this before and now you’re backtracking. If the RBA used a targeted exchange rate as the mechanism for monetary policy, then they would need to constantly adjust that exchange rate to ensure a stable money supply growth.

    Exactly the same as how they have to constantly adjust the interest rate to ensure a stable money supply growth.

    The only correct level of money supply growth is the amount that leads to low inflation. There is no specific exchange rate or interest rate that always produces the right level of money supply growth. So both would need to be managed.

    As for a small country switching to a gold standard, that would create significant volatility in the exchange rate and the interest rate.

    The price of gold has gone up recently in USD, which means a gold-linked AUD would have appreciated. Given the capital flight the only way to appreciate the AUD would have been a significant tightening of monetary policy, leading to higher interest rates. That would be the exact wrong policy at this time.

    Switching to a gold standard does not remove barriers to commerce, so I don’t see how the analogy with trade liberalisation works.

  25. Perhaps you are seeking a distinction between:-

    a) fixed and convertable.
    b) fixed and unconvertable.

    If so then when I say fixed exchange rates I definitely mean option (a).

  26. John – then you must have not understood my previously because my view on this has been consistent for about ten years.

    I don’t think the money supply, however you meansure it, should be kept constant or grown at some special magic rate. Friedman was wrong on this. I’m not a monetarist. I never have been.

    The objective of monetary policy should be to fix the value of the currency. Not the quantity. Not the M3. Not M2. Not even M1. The value. Not the quantity. V-A-L-U-E. Yes this is achieved by adjusting the amount of currency but the goal of adjusting the quantity is to fix the VALUE of the currency. Not to fix the quantity. Not to grow the quantity according to some magic number but to achieve a specific outcome in terms of the currencies VALUE.

    Pray tell me how Hong Kong manages to get by with a fixed exchange rate because by your reckoning their economy should be a disaster. And it isn’t.

    In case you missed the point I advocate a target called VALUE not QUANTITY.

  27. Terje
    It is certainly consistent with numereuos articles on Wikipedia and the wider Internet and consistent with books I have read on the topic. You can invent alternate definitions if you want to but if so you really ought to let us know the alternative definition you are using.

    Well yea, if you go to wiki which is wrong, visit silly sites and purchase quack books by authors that don’t have any economic training, i would guess that you would say that.

    As an aside, what system did we have before the float? What would you call that?

    If you call it a fix why do you reckon it fell on its arse?


    For a small country like us to gold standard would be suicidal. We may as well put on kamikaze suits and collectively do a Thelma and Louise.

    Interesting how some time ago you accepted that a small country couldn’t unilaterally move to a gold standard and now you do. Which scholarly book influenced you to change your mind?

    I might add that the Nobel prize winner in monetary economics only suggested we move to global monetary union by having the large blocs unite first.

    He never ever discussed the idea of a small country like ours doing so unilaterally with gold as the backing.

    Would you mind telling us what academic has proposed Australia move to a gold standard unilaterally?


    Thank Christ we have a floating exchange rate that allowed us to quickly adjust to changing circumstances otherwise we would really be in the soup.

  28. Terje,

    Why would want to have our interest rates converge with the US? They had real rates of -2% in 2004. This preceded the recent credit crisis which had a small “hidden”* recession in 2007 which preceded many foreclosures. Do we want to mimic this?

    The best options for Australia are austerity or free banking. Free banking transfers risk management from the RBA to private banks. I think it is the best option. It will have the advantage of adjusting prices smoothly with little transactions costs as with the classical gold standard.

    However a policy of austerity and a floating currency is the second best of all other options.

    Dollarisation won’t work for the same reasons as why the Euro may fall apart – with the size of our economy and volume of trade, it cause unrealistic mispricings. We are too big for dollarisation.

    Here is a case of successful dollarisation and no central banking:

    Panama Has No Central Bank

    A fix is appropriate for a small nation or where an underlying commodity transmits price changes. Pegs are more manageable and make sense for Singapore for example since most of their GDP comes from external trade. A gold standard wouldn’t work unless we were a much larger economy. At present, the price adjustment mechanism may be too variable to our GDP.

    Any potential mispricings from the float only directly effects 20% of output and about 0 to -5% of final GDP. Also, a lot of our export commodities are not vulnerable to exchange rate pass through – they are inelastic and have a degree of market power as they are quality based industries – grain, elaborately transformed manufactures and so on.

  29. Terje, I never said anything about targeting the quantity of money. In contrast, I specifically said “the only correct level of money supply growth is the level that leads to low inflation”.

    I can repeat that several times and put it in capital letters if it helps.

    By “stable money supply growth” I did not mean a constant rate of money supply growth. I meant an amount of money supply growth that lead to stable value of money. That was pretty clear by my above quote. And perhaps also by the fact that I’ve repeated it about 1000 times on this blog.

    A fixed exchange rate (like a fixed interest rate) does not necessarily lead to the correct amount of money supply growth. In both instances, the fixed rate would need to be adjusted in response to expected inflation.

    I didn’t suggest that a fixed exchange rate would be a disaster. If managed correctly (ie still inflation targetting) it would be very similar to using interest rates as a mechanism for inflation targetting. If used incorrectly it would produce sub-optimal monetary policy (which the US has had anyway for different reasons).

    Personally, I have some sympathy for adjusting the quantity of money (instead of a price) as a mechanism for inflation targetting.

  30. Lots to say but my laptop battery is nearly dead.

    Mark – I don’t necessarily want our interest rates to converge to the US rates. However nor do I think a fixed exchange rate with the US dollar would cause us to have 30% interest rates and a recession.

  31. JC – I accepted that a small nation moving to a gold standard would have negative consequences. I didn’t say it was hence a bad idea.

    Out of interst which book taught you that if we fixed to the US dollar we would get 30% interest rates?

  32. John – what made your point unclear to me was that you suggested that I had backtracked. I haven’t.

    I’m glad your not fixated on quantities as a end point. However I still find your prefered strategy to be vague. You seem to be saying your prefered strategy is the one that gets things right. Strangely enough that is also my preferred strategy.

  33. JC – I accepted that a small nation moving to a gold standard would have negative consequences. I didn’t say it was hence a bad idea.

    Out of interst which book taught you that if we fixed to the US dollar we would get 30% interest rates?

    No books, Terje , just watching enough devaluations of fixed currencies regimes to know it is the stupidest idea i’ve heard in the while.

    from memory

    Aussie devals in the early 80’s

    Countless EMU devals

    Several lat Am devals

    UK exit from the EMU

    Asian crisis

    Russian crisis.

    Let’s understand this clearly. You were the one who said you’ve read books on the subject. Which ones and who the the authors?

  34. However nor do I think a fixed exchange rate with the US dollar would cause us to have 30% interest rates and a recession.

    Oh bullshit. We had 100% interest rates during our fixed regimes in the 80’s prior to the two devaluations.

    Every, Every single devaluation or a break of a fixed regime has been marked by extremely high interest rates.

  35. I nicely explained the difference to you terje, but you’re too caught up in quackery to understand it.

    hong kong is a peg, not a fix. there is a huge difference in that under hk’s currency board the authorities are required to convert HK cash into US dollars on request.

    that doesn’t happen in a fixed exchange rate.

    the other reason that the HK peg has worked quite well since the 80’s is that HK’s labor market is actually freer than the US allowing for incomes to adjust more readily than when labor markets are not so free.

    However HK’s is no longer well served by the peg, as US monetary policy especially over this past decade has been horrendously managed, so I would guess they will leave the peg in the not too distant future.

    Now please stop avoiding telling us the books you said you read including titles and authors.

  36. Look Terje, what you did last night pissed me off and I’m still upset. I have no issues with getting a caning when I’m wrong, but that wasn’t the case last night, was it?

    However I do recognize that you’re doing your best to understand this and are eager to learn about this area as much as you can.

    I for one think monetary economics is possibly the most important part because if you get that right the rest can more easily fall into place.

    I do generally know what I am talking in this area as i’ve spent 28 years learning about it each day (almost).

    Currencies and currency speculation is all I did for a good part of my adult life. Some people don’t need to know the general mechanics to be successful traders . in fact ignorance can actually be bliss at times. However I wasn’t one of them as I spent a great deal of time learning about this area- far more than I ever learned at Uni.

    there’s one author who i strongly suggest is possibly the world’s authority on currency pegs etc. Our I- bank actually hired him to consult and give advice to several Asian governments during the crisis.

    His name is Steve Hanke, professor at (I think) John Hopkins university in monetary economics.

    he also writes for Forbes and I suggest you comb through the magazine and read his columns.

  37. Terje – go back to what I said. How much of HK’s GDP is a determinant of foreign trade?

    Notwithstanding the nuances JC explains, that is why their system works for them. Their system would not suit us. Floating rates do not create instability for us even with wildly variable rates – our degree of internationalisation is too small and usually balances towards zero.

  38. JC for a good account of each of those devaluations the current book I am reading is quite comprehensive. I mentioned it here a few days ago. It is called “Gold The Once and Future Money” by Nathan Lewis. I’d buy you a copy if I thought you were interested in reading it.

    Not all of the devaluations you cite involved ridgidly fixed (or ridgedly pegged if you prefer) currencies. However lets work through them.

    1. The Aussie fix to the US dollar was broken in the 1980s. It was a good idea at the time because the US dollar no longer represented stability (the link between the US dollar and gold broke down in the early 1970s). However we didn’t really do any better without the fix. We subsequently suffered worse cummulative inflation than the USA. So maybe we should have kepted the peg. And whilst keeping the peg might have been better, breaking the peg didn’t cause any form of significant crisis beyond what was already in play (inflation).

    2. The exchange rate mechanism that proceeded the EURO did entail some nations deciding to pursue other targets at the expence of the exchange rate target. Notable the UK abandoned the fix. However it was ending the fix that caused an air of crisis not the fix itself.

    3. Probably the most notable recent exit from a fixed exchange rate by a latin American country was Argentina. They gave up on it because of merchanitalist tendancies. The local currency was being turned in for dollars at the fixed exchange rate. If it had been allowed to carry on to it’s logical extreme then Argentina would have been dollarised. Which would have been better than the alternative they undertook. The Balboa in Panamar which has been fixed to the US dollar at a 1:1 exchange rate since 1904 has been once of the most stable currencies in Latin America. Clearly a case for fixed exchange rates rather than against.

    4. Yes we mentioned the EMU. The EURO is now one of the biggest currency zones on the planet. Clearly the system was a dismal failure.

    5. Malaysia refixed after a devaluation to account for the preceding strengthing of the US dollar and in refixing they avoided most of the troubles that other nations such as Indonesia endured. Hong Kong and China both retained their fix to the US dollar and suffered very little in the way of crisis relative to those that broke their fix. The Asian financial crisis is a text book example of why abandoning a fix isn’t necessarily so clever. Clearly the nations that abondoned fixing would have done better if they had a ready alternative however they could have just retained fixing as a strategy. But as usual the IMF was there to hand out stupid advice.

    6. Russia should have gone for a currency board as Estonia did in 1993 when it fixed to the Euro. Estonia has done a lot better. George Soros recommended tax cuts for Russia in the late 1990s when most western advice was tilted towards deficit fighting tax hikes for Russia. George Soros also recommended a currency board and a fix to the US dollar. Putin would ultimately implement the tax recommendations but unfortunately for Russians not the currency board.

    A list of good books that you might like to read:-

    “Gold The Once and Future Money” by Nathan Lewis
    “The Way the World Works” – Jude Wanniski
    “The Crisis of Global Capitalism” – George Soros.
    “The Future of Money” – Bernard Lietaer.

    All those authors have an understanding of currency boards and explain fixing (pegging) exchange rates.

    However none of them specifically mention that fixing the Australian dollar to the US dollar will not create 30% interest rates. To understand this point you need to spend 10 minutes with a pen and paper thinking it through. It isn’t that hard.

    If you want to look at some specific examples of small nations with a currency fix that works well then consider the African nations that use the CFA franc which is fixed to the Euro. Unlike a lot of their neighbours they enjoy low inflation.

    Also a lot of the baltic states have fixed to the Euro as does Denmark.

  39. JC – Some interceding comments were made whilst I typed that mass above. Never mind.

    And you were wrong when you said that fixing the aussie dollar to the US dollar would cause us to have 30% interest rates and a recession. However perhaps by fixing you do in fact mean something quite different to me. In which case fine but please define.

    In my book (and in many books) a fixed exchange rate is a pegged exchange rate. However if you have some examples of fixed exchange rates that are not pegged exchange rates then please share the distinction. I don’t want semantics to be the problem here.

  40. Terje, some counter points;

    1. “We subsequently suffered worse cummulative inflation than the USA.”

    That is a function of monetary policy, not having a fixed rate, which under Bretton Woods were able to be changed – if there was enough inflation.

    2. “However it was ending the fix that caused an air of crisis not the fix itself.”

    Okay, why did they abandon it?

    3. Agree.

    4. I don’t think so. The Euro is suffering a lot of problems. There is not enough fiscal coordination and regional imbalances.

    5. The Asian crisis was overblown as well. A lot of investment was FDI, not portfolio investment. May I ask you how many floating currencies are victim to these crises?

    6. Dollarisation would have been better, as it was for Panama and could have been or Argentina. I doubt a large enough in per capita GDP nation would benefit from such a policy however.

    Essentially the CFA is applied to a small customs union with quasi dollarisation – which is possible due to low per capita income and a lower level degree of internationalisation.

  41. JC – an extract from the book by Nathan Lewis that I mentioned above. The section is in relation to the asian financial crisis and Indonesia and how currency boards and a fixed exchange rates could have stabilised the situation. It is praise for Steve Hanke.

    “None of the IMF’s 100-plus conditions for lending did anything to solve the monetary crisis in Indonesia. Nor did the IMF’s loans, which merely provided the financing to allow the Indonesian taxpayer to bail out the foreign lenders. The only thing that did support the ruppia, briefly, was a proposal to institute a Hong Kong-style currency board. The idea came from Steve Hanke, a professor of economics at John Hopkins University, who was invited to Jakarta by President Suharto to discuss the plan. When Suharto made promising comments about the plan on February 10, 1998, the rupia soared to 7,450 per dollar, from 9,500 per dollar the day before.”

    I also skimmed some of the forbes articles by Steve Hanke and they are quite promising. The following article by Steve Hanke defined fixed exchange rates as follows:-

    There are three types of exchange-rate regimes: floating, fixed and pegged rates. Each type has different characteristics and generates different results. Although floating and fixed rates appear to be dissimilar, they are members of the same family. Both are free-market mechanisms for international payments. With a floating rate, a monetary authority sets a monetary policy, but has no exchange-rate policy–the exchange rate is on autopilot. In consequence, the monetary base is determined domestically by a monetary authority. Whereas, with a fixed rate, a monetary authority sets the exchange rate, but has no monetary policy–monetary policy is on autopilot. In consequence, under a fixed-rate regime, the monetary base is determined by the balance of payments. In other words, when a country’s official net foreign reserves increase, its monetary base increases and vice versa. With both of these free-market exchange rate mechanisms, there cannot be conflicts between exchange-rate and monetary policies, and balance of payment crises cannot rear their ugly heads. Indeed, under floating and fixed-rate regimes, market forces act to automatically rebalance financial flows and avert balance of payments crises.

    While both floating and fixed-rate regimes are equally desirable in principle, it must be stressed that floating rates, unlike fixed rates, do not perform well in developing countries because these countries usually have weak monetary authorities and histories of monetary instability. For a recent dramatic example, we have to look no further than Indonesia. It floated the rupiah on July 18, 1997. Unfortunately, but not surprisingly, the rupiah has not floated on a sea of tranquility. Indeed, the rupiah has fluctuated wildly and has lost 75% of its value against the greenback. In consequence, chaos has broken out, with people hoarding toilet paper, rice, and cooking oil.

    Click to access hanke.pdf

    Which further affirms that I was using the term “fixed exchange rate” appropriately. He does draw a distinciton between fixed and pegged. The definition he uses for pegged is what I would call “fixed but unconvertable”. However there is no difference between how he uses the word fixed exchange rate and the way in which I have used it.

  42. Here is Steve Hanke answering a question about Argentina and the currency fix they employed:-

    Q. Isn’t the currency board discredited even if it did not contribute to Argentina’s crisis?

    A. No. Argentina’s meltdown occurred after the convertibility system was officially abandoned on Jan. 6 and is still in progress. The only reason Argentina was able to hold its head above water before then was the convertibility system, with all its flaws.

    I’ll agree this Steve Hanke fellow is good. I wish more people would read his stuff.

  43. In my book (and in many books) a fixed exchange rate is a pegged exchange rate. However if you have some examples of fixed exchange rates that are not pegged exchange rates then please share the distinction. I don’t want semantics to be the problem here.

    I think it would be better all around if we clearly distinguished between pegged and fixed exchange rates as they are two entirely different things. But ok, you define fixed as pegged. Fair enough.

    Two examples of fixed exchange rates that weren’t pegged were the Aussie dollar in the 70’s and 80’s and the pound when it entered the EMU. They eventually turned into disasters as monetary policy could not be aligned with the currency it was/they were fixed to.

    The Aussie experienced a drastic fall in the terms of trade in the early 80’s that corresponded with the US Fed under Volker basically ringing every single ounce of inflation out of the system. We couldn’t cope primarily because weren’t prepared to allow the domestic economy take to the hit through a fall in real wages, so we maintained nominal wage levels while we let the currency fall.

    The UK fixed to the EMU at what was clearly an over valued level and also didn’t allow domestic wage levels to reflect reality. The germans realizing it was a lost cause did not intervene to keep the pound at central parity. The germans of course were the strongest currency in the bloc and were required to intervene to assist any weaker member maintain parity. they didn’t with the pound for the reason I mentioned.

    Soros (uncle George) by the way made US1 billion from the trade because he had decent information from the inside the Bundesbank through Karl Otto Pohl The former head of the buba) that the Germans wouldn’t maintain parity so he traded on what was essentially inside information others didn’t have- possibly not even the UK at the time. So much for the master magician and alchemist. How do I know? I just do.

    Don’t get me wrong I don’t begrudge uncle George making that money as he himself broke no laws and he was extremely generous with commissions to the street and we all made a living out of the commissions his fund gave us. 🙂

    that’s just an old war story.

  44. JC – just for clarity on this issue of fixed versus pegged. When I say fixed I mean what Steve Hanke means in the definition as quoted in comment 45.

    And as I said in the first place if Australia fixed it’s exchange rate with the USA (using the Steve Hanke definition of fixed) we would not have 30% interest rates. Our interest rates would tend towards US interest rates plus a minor risk premium. If you use the definition that I use for fixed exchange rates (the definition Steve Hanke also uses) then do you accept this point? Please say yes!

  45. I think the stuff Steve missed about Argentina was that the Argies weren’t prepared to make the necessary adjustments in the internal market to allow maximum flexibility when aligning monetary policy with another country. What they should have done was to dollarize completely as dollarization would have simply forced the reforms on them.

    The problem with the Argentinians was that they ran the domestic economy like they always did… a socialist slag heap. Some of the states or provinces (whatever they called them) have up to 30% of the workforce in government jobs. So adopting a peg (which later became a dishonest peg) was always going to end up in trouble.

    The point about a peg is that the pegging country must allow equal or more flexibility in the labor markets as the country they are pegging to or it won’t work otherwise they will end up with a mess. Argentina is a case study in how not to do it.

    Mexico was interesting after they came off their fixed exchange rate in the early 90’s. they followed money supply targeting to crunch inflation (under Friedman’s) advice as quite a few of the Bank of mexico’s senior economists etc. came from the university of Chicago. I would argue that policy alone helped Mexico industrialize at a rapid pace and move into first world living standards…. also helped by NAFTA.

    the 80’s and 90’s were a very interesting period in watching all this unfold. I made some really decent money for the bank I worked for with devals after the Australian experience.

  46. I think Steve was pretty spot on regarding Argentina. I’m glad you put me onto him. As I skim his stuff it all looks like the same sort of stuff I have been trying to promote for years. However he has better letters after his name so in future I’ll chuck in some quotes by him.

    So are you backing down on the 30% interest thing?

  47. re 53. Yes of course.

    I don’t think we should be following US monetary policy though as they have basically fallen off the cliff as far as I’m concerned. The system is rooted and I think it will wreck Obama’s presidency in the same way it wrecked Carter’s.

    Eventually we will have to see another Volker like Fed chairman and hopefully a free market president who leaves everything alone while the economy is repaired.

  48. So are you backing down on the 30% interest thing?

    Back down?

    If we ran the same monetary policy with a fixed exchange rate system of the 80’s we would be done for.

    If we ran a pegged rate (Hanke’s definition) no, we wouldn’t have of course as our interest rates would have been basically US rates + or – credit spread.

  49. I was truly amazing watching Indonesia though the crisis as it toyed backwards and forwards with Hanke’s proposal to peg the Rupia.

    Every time the Indonesian authorities spoke about pegging the currency (on Hanke’s suggestions) the currency would strengthen and interest rates would fall. The opposite happened when they talked against the idea. This happened several times for it not to be a pattern so the market would have much preferred to have a currency board set up after the crisis.

    A currency board with full convertibility would have also helped the poor as the poor are the ones that hold most of their money in straight cash. Devaluation in poor countries really screws poor people. The rich nearly always hold their wealth in hard assets and outside the country so they a lot less effected by devaluations etc. of the type we saw in Indonesia.

  50. I think you should go back and read Hankes definition of fixed rates and pegged rates. You seemed to have missed the fact that I was using the term fixed rate the same as Hanke. And it is fixed rates (Hanke’s definition) that would cause our interest rates to have been basically US rates + or – credit spread.

    Anyway thats enough semantic wrestling for one day. Thanks for the exercise. Hopefully in future when I say fixed exchange rates you will know that like Steve Hanke I mean a system where a fixed exchange rate is the sole target of monetary policy.

  51. Generally in history, once the gold standard is returned it seems the interest rate soon falls to 3% or so. Terje is right about this. The gold standard means low interest rates.

  52. Some comments by JC have been release from moderation and so I am only now aware of them.

    For the record I am not a f$#king liar. In the context of a discussion about fixing the Australian dollar to gold JC said:-


    If we had been linked to the dollar in he current climate domestic interest rates could have easily gone to 30% or even higher sending us in the worst depression for a generation.

    Careful what you wish for.

    I made a mistake in reading this. On first reading I thought JC said if we had linked to gold in the current climate. However he didn’t, he said if we had linked to the US dollar. I apologised for that mistake in an edited version of the article but my apology seems to have been subsequently edited out of the main article (presumably by John Humphreys) along with a correction to my original assertion. As such perhaps my apology got missed.

    As I said in my original qualified retraction I don’t think my mistake was overly material. A link to the US dollar would not cause interest rates to go to 30% either. Fixing to gold or the US dollar would cause our interest rate to converge towards the gold interest rate or the US dollar interest rate.

    JC also suggested that I used the term “fixed” incorrectly. However his prefered expert on this topic, Steve Hanke, uses the term “fixed” exactly the way that I use the term. To be fair Hanke does use the term pegged differently to me but I hardly every used the term pegged in any case.

    * A fixed exchange rate means that open market operations are used to target a specific market determined exchange rate by moderating the supply of currency.
    * If we fixed the Aussie dollar to the US dollar we would inherit their interest rate plus a risk premium.
    * If we fixed the Aussie dollar to gold we would inherit the gold interest rate plus a risk premium.
    * I am not a f%$king liar.
    * I am sorry I misinterpreted JCs comment on first reading or if in refuting the substance of his comment I made the discussion unnecessarily personal.

    I hope all wounds mend and we now mostly agree.

  53. Graeme – it also means low consumer price inflation and relatively stable commodity prices and if widely adopted it means extremely stable exchange rates. The gold standard produces a sea of stability and reveals capitalism at it’s best.

  54. Dear ex-banker, truly I don’t know when you wrote all this mumble. If you knew anything about soft and hard currency then part of high interest and low interest is out the window. In 1990 there was only one main stream currency and all others branched of it in calculations and so on. You could never buy the yen in eastern Europe. But the dollar you’d find in Kenya Africa (they hardly had water there that time). Now the gold then, well to lock a currency to a commodity is crazy.. you had the Arabs (no offence) they’d about to buy the world thanks to rising oil prices.. well they waited to looong and now they are back on same square just because they had their currency stuck to oil and nothing bought oil more than futures and they are not in the money anymore. It’s a batch however you twist it, and that’s why you are an ex-banker too 🙂

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