You might think it’s no big deal that exchange rates becomes more volatile after the end of Bretton Woods—after all, Bretton Woods was a fixed exchange rate regime. Actually, it’s a huge deal, as you’d expect the real exchange rate to be unaffected by a purely monetary change, like switching from a fixed to a floating exchange rate regime.
Read the whole post. Sumner makes his points powerfully. I am not sure that anyone has an easy explanation for this volatility change.
1. An old-fashioned pure monetarist view of the Mark/Dollar exchange rate is that its movements are inversely related to movements of the relative money supplies. Hold the supply of dollars constant and print 10 percent more marks, and the mark should depreciate by 10 percent. In that case, you in order to arrive at the volatility depicted in the chart in Sumner’s post you have to imagine the two central banks at their respective printing presses randomly alternating between flooring the accelerator and slamming on the brake.
2. A modern monetarist (Sumner?) might not focus on relative money supplies, but the inclination would still be to attribute the variation in exchange rates to the actions of central banks. But it is difficult to imagine a central bank policy reaction function that would generate the swings observable in the chart.
3. The Dornbusch overshooting model would tell you to keep your eye on relative interest rates. If the American interest rate in dollars is higher than the German interest rate in marks, then the dollar has to become overvalued relative to its long-term equilibrium rate, so that the expected depreciation of the dollar equates the expected return on German bonds and American bonds. My problem with that model is: what is this “long-term equilibrium rate” of which you speak? The model treats this as if it were some widely known and agreed-upon benchmark. In my view, there was no such thing, especially after Bretton Woods broke down.
4. My view of money and inflation is that they are consensual hallucinations. If that term bothers you, think of them as conventions. We explicitly agree to accept currency as payment, and then we tacitly agree on what other forms of payment are acceptable. We tacitly agree on how we expect prices to behave as measured in terms of currency.
The Bretton Woods agreement fostered the consensual hallucination that inflation would be gradual and that exchange rates would be stable. These beliefs were self-reinforcing up until the late 1960s. When the U.S. started losing too much of its gold reserve trying to maintain the Bretton Woods exchange rate, something had to give. In August of 1971, President Nixon took us off Bretton Woods and left the dollar unpegged. My interpretation of the chart is that for the next dozen years or so people did not have any consensus on where values belonged. Inflation rates started to vary widely across countries and over time. Exchange rates fluctuated wildly. People’s expectations had no anchor.
As Sumner points out, the end of that episode makes a great case for monetarists. Fed Chairman Paul Volcker said he was going to do something to restore sanity, and sure enough, sanity was eventually restored. I am left waving my hands and saying that somehow sanity was restored, and it was coincidental that it happened while Volcker was Fed Chairman.
Remember: I think that the Fed is just a bank. Yes, I know that the liabilities on its balance sheet are an accepted form of payment. But there are a lot of accepted forms of payment.
Arnold: just one point on your last paragraph. Even if you think the Fed is just a bank, it is more important than all the other US banks. Because all the other US banks fix the exchange rates of the dollars they produce to the dollar the Fed produces. So if the Fed decides to make its dollar more or less valuable, all the other US banks will follow along and make their own dollars equally more or less valuable. The Fed is the alpha leader; the other US banks are beta followers.
The “sticky wages and prices” Scott referenced in his post, are also part of the price making mechanism for professionals (particularly healthcare), who are part of the now dominant services sectors as supported via fiat money. Price making in excess of price taking, creates more demands on equilibrium, but the relative inflation this suggests is not being expressed. Think of government subsidy for intangible services as a form of IOU, and that IOU is also positioned as a secondary part of wealth creation in that it is counted in GDP without an immediate point of resource reconciliation. Hence it is in a secondary market position that relies on already existing wealth. This secondary position is presently being reinforced by the fact the Fed is not presently allowing full representation of the IOUs of service sector activity in the marketplace, instead the Fed attempts to support asset wealth through interest on reserves.
I disagree with your point 2. One example: suppose both countries have central banks that target domestic inflation, and there are country-specific shocks to Domestic Absorption (or Net Exports). The real exchange rate adjusts so that both countries stay on their inflation targets.
I think of your view and Sumner’s as more compatible than contradictory.
If money is just a collective agreement, and expectations are a major factor in inflation, then, as Sumner suggests, the Fed’s promise to “do whatever it takes” to achieve some level of inflation works insofar as people believe that it has the ability and willingness to follow through.
On point 1: is it the relationship between money supplies alone or the relationship between M times V in each country? MV = PT is the identity not M is strictly proportional to P.
Sure, there are a lot of accepted forms of payment, but the Central Bank’s liabilities are the form of payment in which goods are denominated. Remember, for Sumner and other neo-monetarists, the important effect is on the medium of account, not the medium of exchange. The availability of other media of exchange is irrelevant.
The Bretton Woods agreement fostered the consensual hallucination that inflation would be gradual and that exchange rates would be stable.
1) In 1944 Bretton Woods made a lot of sense because nobody had any idea what was going to happen next as Europe was broke and bombed out. We way under-estimate the concerns of Post WW2 economy and just assumed everybody become Father Knows Best by 1948. Not True and the late 1940s were hard years. (And in 1944 many people saw the relationship, although exaggerated of WW1 & The Great Depression.)
2) The problem with Bretton Woods it lasted 10 years too long but the economic system of 1961 was working for most First World nations so nobody would stop it. (Sort like the US market in 2001 where we did not need higher values.)
3) I still say the breaking 1970s the Oil Embargoes when the Middle East want to make more on oil.
4) The longer I live the more I accept the 1970s inflation was bad combination of historic Baby Boomers entering the workforce and other nations needing more income so inflation was the poison between 1971 – 1982.
I speculate that a regulatory channel opened up requiring that, after Bretton Woods, one of the parties was required to adjust required reserves for exchange where as before that was not need for fixed rates. Hence we get the periodic adjustment of accounts to meet quarterly and monthly government rules.
Not all banks are equal. Not all accepted forms of payment are equal. Try paying in bitcoin.