Flexible exchange rates can't hide profligacy forever

Most people use the dollar standard because not only is it the most convenient, but also because by and large it has been a good store of value, at least relative to other currencies.

You will find it difficult (at times impossible) to exchange other local currency in many parts of the world. But that will not be the case with the U.S. dollar. The greenback is the reserve currency standard because it meets all the conditions of an international unit of account, means of payment and store of value.

But with the U.S. running unsustainable current account deficits and its net foreign debt growing, its dollar faces structural depreciation, creating uncertainty on a global scale. The real problem stems from the fact that all foreign exchange rates are relative and not absolute values. Value is relative not only against real goods, but against other paper currencies too.

If we use a metal as standard, such as gold, and the quantum of gold remains static as the global demand for liquidity increases, then prices will be deflationary. The gold standard was found to be too strict to adhere to, because if all currencies were linked to gold, you could run a fiscal or trade deficit without huge outflows of gold.

The advantage of using a paper currency is that the supply can be adjusted to the national or global needs. As monetarists claim, inflation is basically a monetary problem of printing too much money. Money can be printed through growing fiscal debt, growing bank credit or inflow of foreign funds.

You can print domestic currency notes, but not foreign ones. In other words, you can ask your fellow countrymen to bear an inflation tax by printing money, but foreigners (and today locals) could run through capital outflow. They stop investing and lending money and you end up with a fiscal or currency crisis.

The bottom line is that in the long run, you cannot spend more than what you earn. Thus, when conventional economists say that flexible exchange rates help with monetary policy, they think there is an easy way out of this problem.

Flexible exchange rates may help a little in day-to-day adjustments in prices, but ultimately, there is always the temptation to use the exchange rate to devalue your way out of the fundamental problem of spending more than you earn.

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