Leigh Harkness: An Optimum Exchange Rate System

Once again Leigh Harkness joins us for a guest post, this time on what he considers the best approach to take in regards to exchange rates for the long term prosperity for the nation. As usual Leigh’s ideas are thought provoking.

Since Leigh has been guest posting at MacroBusiness he has been contacted by some external parties interested in his research. So look out for Leigh in some other places shortly.

The two main exchange rate systems have attributes that are attractive to different sectors of the economy.  But is there an exchange rate system that suits all sectors?

The system that we are looking for should ensure stable exchange rates for the productive sectors.  Also, it should allow the market to determine the exchange rate and not require the Reserve Bank to use foreign reserves to guarantee the value of the currency.  Furthermore, it should work within a deregulated financial system and promote stable interest rates and low inflation.

For the benefit of the government, it should provide full employment and be conducive to a balanced budget.  In addition, we would require the system to be sustainable.   That is, it should provide balance of payments stability and the current account should be balanced in the long term.

Some of these targets are complementary.  To achieve balance of payments and a balanced current account, the excessive demand for imports will need to be redirected to the domestic economy.  That shift in demand will provide employment and stimulate investment that will provide additional employment.  Increased employment is conducive to a balance budget.   It reduces demand for government welfare expenditure and raises tax revenue.   Also, the increased domestic supply relative to domestic demand will lower inflation.

The current floating exchange rate system has two basic principles:

  • international receipts and payments are required to be equal; and
  • the exchange rate adjusts to achieve that objective.

The first principle means that the domestic banking system is the sole source of additional money.   To achieve our desired objectives, these principles will need to change.  The optimum exchange rate system that I propose changes all these principles.  It has two basic principles, also.

The first principle is to require banks to hold foreign reserves and link the growth in their lending to the growth of their foreign reserves.  Foreign reserves created when exports exceed imports are national savings.  This principle seeks to link bank lending to national savings.

It could be put into effect by allowing banks to lend, say, $10 for every US$1 increase in their net foreign reserves.  If banks were to lend excessively, they would deplete their foreign reserves and that would constrain them from further lending until these savings were replenished.

Banks could not add to their net foreign reserves through direct international borrowing.   However, if there were a shortage of credit, the wider finance market could raise interest rates to attract foreign capital into the economy.  Even so, bank credit from domestic savings would be a cheaper source of funds.   In the long term, interest rates would stabilise at a level that would retain sufficient national savings to meet domestic lending requirements for banks and non-bank financial institutions.  At that time, the current account would be balanced.

The second step is to manage the exchange rate so as to shift demand to domestic products to attain full employment.  To achieve that, incentives would be required to reward the financial system for attaining full employment.  For example, banks could be advised that they may lend $10 for every US$1 increase in their net foreign reserve holdings only while there is full employment.  For every one percent that unemployment exceeded the full employment target, the amount that banks may lend would be reduced by $1.  If the desired full employment level was 2 per cent and the actual level of unemployment was 5 per cent, banks would be allowed to lend $7 for every US$1 increase in their net foreign reserves.

Banks profit from holding loans rather than foreign assets.  Therefore, to maximise their lending and minimise their foreign reserve requirements, they would drive the exchange rate to a level that would achieve full employment.

In such an environment, banks may be tempted to devalue rapidly and excessively, leading to inflation.  To avoid that, incentives are required to discourage inflation.  For that purpose, the bank lending ratio could be reduced by, say, $1 for every 1 per cent of inflation above the acceptable level.  If the maximum acceptable level of inflation were 3 per cent and inflation were 5 per cent, the ratio of bank lending to foreign reserves would be reduced by $2.  Therefore, if both unemployment and inflation were at 5 per cent, banks would be allowed to lend only $5 for every US$1 increase in their net foreign reserves.  Consequently, banks would seek to attain full employment with a minimum of inflation.

This exchange rate system would meet our objectives.  It provides stable exchange rates to meet the requirements of the productive sectors.  The market determines the exchange rate and does not require the Reserve Bank to guarantee the value of the currency.  It functions within a deregulated financial system that promotes stable interest rates and low inflation.   It provides full employment which is conducive to a balanced fiscal budget, and it is sustainable.

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  1. The proposal looks promising in general.

    But for the banks, the shift in role from fueling the Current Account Deficit to that of promoting full employment and fending off inflation, is a huge turn around. From being part of the problem they become a significant part of the solution – Responsible Citizens?

  2. “The first principle is to require banks to hold foreign reserves and link the growth in their lending to the growth of their foreign reserves. Foreign reserves created when exports exceed imports are national savings. ”

    Can you please make sense of this for me?If every country in the world wanted this, it would be impossible to achieve.

    • Good question. Maybe it would result in global balance, so countries with deficits would have negative credit growth, which might rapidly reduce imports and the exchange rate. Countries in surplus would see the opposite.

      My understanding of the historic international settlement schemes were always based on achieving balance, e.g. The gold standard in use before Bretton Woods.

    • If we initially exclude bank lending, national savings are created when the income from exports exceed the expenditure on imports. When bank lending is included, that lending increases imports. The initial national savings are used to pay for those additional imports. The net effect is that exports and imports are equal or close to being equal (if we exclude consideration of capital flows).

      The graph at the bottom of the blog is Figure 14 in a paper on formulas for the current account deficit (http://www.buoyanteconomies.com/CAD_Formula.htm ). It shows that as bank credit rises, foreign reserves fall as they are used to pay for the imports that the bank credit has created.

      Therefore, the optimum exchange rate system does not rely on building up national savings. National savings are used to pay for the imports generated by bank lending; thus making bank lending sustainable in the long term. This system is one that every country could use and attain a balanced outcome.

      This is very different to the floating exchange rate system which relies on some countries to be massive savers to finance bank lending in other countries that have growing foreign debts which are unsustainable.

        • It does not imply that all countries have balanced current accounts. Not all countries would adopt such a system.

          Even those counties that do so may have times of current account deficits and others times of surpluses. However, the system will be sustainable and it will ensure monetary stability in the long term.

  3. The banks will simply use some kind of ‘special purpose vehicle’ to get around the foreign reserves requirement. Also, you cannot have a floating exchange rate where you ‘control the exchange rate to allow for full employment’. This is what China is doing, and now they discover that their monetary policy is ‘made in USA’.

    • The proposed guidelines on bank lending do not preclude bank lending. They are like the prime assets ratio or capital requirements. The banks can simply buy foreign exchange and that will enable them to lend. There is no major constraint that is worth manipulating to get around. These guidelines have been derived from a similar approach that has been successfully applied in a small country. The bankers appreciated it because they knew how much they could lend and they understood the effect of their lending on the economy.

      The exchange rate is not controlled in the proposed system. Note that China is successfully using the fixed exchange rate system to increase prosperity, as we once did. We now use the exchange rate to constrain our income, undermine many of our industries and drives our country into debt. Whose system is sustainable and contributing to their economic welfare?

      • “The exchange rate is not controlled in the proposed system. Note that China is successfully using the fixed exchange rate system to increase prosperity, as we once did.”

        Ours is clearly more sustainable than China’s. Their system has led to a complete misallocation of growth towards fixed asset investment.

        Was that a trick question? Anyone who argues the opposite is in a dream world.

        • So our massive focus on fixed asset investment (Housing mostly) is not a complete misallocation?

          Globally banks prefer lending to purchase assets not business or otherwise. These unproductive loans are encouraged by common elements globally in tax systems to promote capital gains (rent) over actually earning money.

          • Ours has nothing much to do with the exchange rate whereas China’s problem does.

            You have in fact simply reinforced my point.

      • BK,would you say that your computer is more stable than mine because it has a better printer? Of course not! But you have said something similar about the economy.

        Like a computer, the economy contains hardware (the real resources and products) and software (the monetary system including exchange rates, money, prices, interest rates, banking etc.).

        The stability and sustainability of the economy’s software has little to do with the quality of its hardware. China has prospered, despite having very poor hardware. America’s industries have declined and the country has become burdened with debt, despite having very good hardware.

        One of these countries has a monetary system that has the effect of stimulating the economy with additional money when it increases exports. The whole country prospers from its export growth.

        The other country has a monetary system that prevents exports from stimulating the economy. When exports rise in that country, its monetary system makes people shift their spending from domestic products to imports.

        Which of these systems is going to make a country prosperous and which is going to make the country stagnate? Does the quality of the hardware have any significant effect in determining the outcome?

  4. Ask yourself, now if these are the rules, how would game this?

    We already have a problem with underemployment, and hidden unemployment.

    For starters, banks would strive to capture or corrupt the reporting process of unemployment.

    I mean, even with today’s inflation targetting system, if this figure HAD of been reported correctly, there would have been a diffrently vastly set of numbers in terms of borrowing between 1992 and 2007.