Floating Exchange Rates: Unworkable and Dishonest [goldseek.com]


By Keith Weiner

Milton Friedman was a proponent of so-called “floating” exchange rates between the various irredeemable paper currencies that he promoted as the proper monetary system.  Many have noted that the currencies do not “float”; they sink at differing rates, sometimes one is sinking faster and then another. This article focuses on something else.

Under gold, a nation or an individual cannot sustain a deficit forever.  A deficit is when one consumes more than one produces.  One has a negative cash flow, and eventually one runs out of money.  The economy of a household or a national is therefore subject to discipline—sooner or later.

Friedman asserted that floating exchange rates would impose the same kind of forces on a nation to balance its exports and imports.  He claimed that if a nation ran a deficit, that this would cause its currency to fall in value relative to the other currencies.  And this drop would tend to reverse the deficits as the country would find it expensive to import and buyers would find its goods cheap to import.

Friedman was wrong.

To see why, one must look at the concept known to economists as “Terms of Trade”.  This phrase refers to the quantity of goods that can be purchased with the proceeds of the goods exported.  For example, country X uses the xyz currency.  It exports xyz1000 worth of goods and it can thereby pay for xyz1000 worth of imports.  But what happens if the xyz drops relative to the currency’s of X’s trading partners, because X is running a trade deficit?

The country exports the same goods as before, but they are now worth less on the export market.  So X can pay for fewer goods than before.  Buying the same amount of goods will result in a larger deficit.

At this point, one may be tempted to say “Ahah, Friedman was right!”  But remember, we are not talking about a gold standard.  We are talking about an irredeemable paper money system.  Money is borrowed into existence. Looking at the trade deficit from the perspective of Terms of Trade, we see that trade deficits lead to budget deficits, which leads to a falling currency, which leads to increased trade deficits.  It is not a negative feedback loop, which is self-limited and self-correcting.  It is a positive feedback loop.

There is no particular limit to this vicious cycle until the country in question accumulates so much debt that buyers refuse to come to its bond auctions. And this is not a correction or a reversal of the trend; it is the utter destruction of the currency and the wealth of the people who are forced to use it.

And, of course, Friedman had to be aware that America was likely to be biggest trade deficit runner in the world.  Its currency, the dollar, was (and is) the world’s reserve currency.  That means that every central bank in the world held dollars as the asset, and pyramided credit in their own currencies on top of the dollars.

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