As we were recently reminded, with a very delicate financial system, extreme exchange rate fluctuations can wreck havoc on trade policies worldwide. As neoliberalism gained traction in the “developed” and then “the developing” world, the financial system received the prerogative over other economic and social objectives. Inefficiencies in the industrial and labor markets were seen as preferable to those existing in the financial markets.
Low interest rates and an indiscriminate opening of financial markets was seen as the solution for developing countries. Quick financial gains are popular politically, and require far less skill to implement than well conceived economic development planning.
Grieves Smith (2003) imagined a scenario where exchange rates were fixed among economic regions. Stated parities and bands would exist within each zone, and automatic stabilization arrangements would be agreed upon ex-ante (3). John Williamson (2003) also was a proponent of pre-established parties and bands accompanied with automatic stabilization agreements. In contrast, Williamson discussed how each nation state would determine their own targets for exchange rates, according to desired economic and industrial goals. He mentioned the nth country problem since there are only (n-1) degrees of freedom for setting the exchange rate targets. The largest country with the global reserve currency would be the only state to passively accept a floating exchange rate (11).
It is unrealistic to believe that the United States would unilaterally assume a passive stance towards setting targets for exchange rates. This is because, when used correctly, exchange rate bands can help countries carry out ambitious industrial development policies. Williamson discusses the Development Strategy Approach for exchange rates and uses literature from Bela Balassa to support his claims. According to Balassa, it is important to have a competitive exchange rate in order to motivate entrepreneurs to begin to export goods outside of of the traditional export commodities (4). If a country passively observes its floating exchange rate, too much easy capital can crowd out non-traditional, capital-intensive production.
Financial controls can also help maintain the feasibility of exchange rate band targets. Excessive speculation and large sudden inflows of capital pressure the domestic currency to appreciate. This changes the balance-of-payments position of a county. Imports increase because they become relatively less expensive for domestic consumers (Chang and Grabel 2014, p. 192). According to Chang and Grabel, neoliberalists only advocate corner solutions for exchange rate management. The first-best solution is a floating exchange rate. Second-best solutions are currency substitution and currency boards, with currency substitution being a superior alternative to currency boards (167).
There are real benefits to be gained from financial stability. Less pronounced capital inflows also translate into hedges against sudden withdrawal of foreign investment and subsequent currency depreciations. Countries can implement financial controls to mitigate these risks. Foreigners can be prohibited from maintaining bank accounts or receiving loans. Governments can also stipulate what types of investments foreigners can make, encouraging medium to long-term commitments that align with economic development goals. They can seek to avoid portfolio-type investment, since these can be converted into other currencies most easily, and in effect as the most prone to capital flight (169).
It should be remembered that between 1945 and 1976, many of the “industrialized” countries had pegged exchange rates (177). Exchange rate management was used as an effective policy tool to implement and continue economic growth in key industrial sectors. The costs of convertibility restrictions, potential for black market trading, corruption, and invoice mislabeling were seen as lesser concerns than waste in currency speculation and the economic and social costs of financial instability.
Williamson depicts a S-curve model with an optimum exchange rate and level of investment. Exchange rates greater than the optimum are beneficial because investment is squeezed out by a lack of savings (6). An undervalued exchange rate would require the central bank to race to acquire and sterilize reserves faster than the incoming net capital flows. He concludes that a floating exchange rate does not naturally find this pareto optimum. It would only “a matter of luck” is the exchange rate ends up maximizing growth (6).