Musing exchange rates and all that jazz

Jazz is the quintessential music of America, coming from its African folk roots and melding with European classical tradition. One tends to forget that the best African-American jazz players like Miles Davis and Wynton Marsalis were all classically trained. But jazz has become global and you can today get good jazz coming out of Poland, Brazil and Johor Bahru, where the late Sultan of Johor was a great fan.

The attraction of jazz is that it is free flowing, not bound by formal rules. The lead player starts with a simple theme and improvises on it until it becomes a complex fugue, with different players and instruments piling on the same theme, like waves in the sea, sometimes calm, other times violent. It can sound beautifully harmonic or just chaotic noise, but jazz is always personal, from the player to the listener.

So why are exchange rates like jazz?

Many academic economists treat exchange rates like classical music that must fit into a theory. In the last 20 years, when almost all countries went through exchange rate crises, the Washington consensus was the corner solution — either stick to fixed exchange rates or freely floating regimes and try not to manage the float. In practice, almost all countries went on managed floats when they realized that it was too painful to stick to fixed exchange rates.

In Hong Kong, which runs a currency board regime that pegs the Hong Kong dollar to the U.S. dollar, I learnt that exchange rates are actually a discipline. A fixed rate means that the whole economy must adjust to the exchange rate. You must avoid fiscal deficits and your exporters can't try to persuade the government to depreciate in order to compete. Under a fixed rate, you improve your productivity or you are out of the market.

The arguments against fixed rates are well known. First, you cannot run independent monetary policy, because you have to follow the monetary policy of the reserve currency that you are pegged against. Second, holding a pegged exchange rate is an invitation to speculation, especially if the country is running a large fiscal or current account deficit. Mr. Soros and others have made fortunes punting against governments maintaining policies inconsistent with their exchange rates. Third, for large countries like China, competitors argue that maintaining fixed rates would give them a price advantage against their trading partners.

However, maintaining flexible exchange rates has also disadvantages. When you are a small economy, like New Zealand, you may have no control over the exchange rate. The more you try to control inflation through higher interest rates, the more hot money flows in, the currency appreciates and the export sector suffers. Hedge funds and currency speculators love making money through the carry trade, punting currencies like the Australian and New Zealand dollars. Retail players like the proverbial Japanese housewife Mrs. Watanabe invariably get caught when the carry trade reverses.

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