The first section explores the importance of seigniorage in financing the government budget in Southern European countries. It is shown that too low a rate of inflation, for a given budget deficit, implies excessive debt accumulation. It is concluded, therefore, that it would be useful to break up the EMS into two separate clubs. One would be organized around the German minimal inflation target. The second group of countries, for whom seigniorage is more important, would entertain a moderate, say 8% inflation rate and would use a crawling peg mechanism to maintain stable real exchange rates.
The second issue concerns real interest rates. The paper argues that real interest rates remain at exceptionally high levels and that this is a source of financial instability and poor investment performance. Budget deficits, financial engineering and insufficient nominal money growth are singled out as the leading explanations of these high real rates.
The third obstacle to exchange rate stability is the continuing, sizeable overvaluation of the dollar. The paper discusses the reasons for and likely size of the overvaluation. The paper also explores the reasons why, despite this overvaluation, the dollar has not yet experienced a further decline in value.
The paper also discusses excess capital mobility and the rationality of exchange markets, and endorses the Tobin proposal for market segmentation. Such a dual exchange rate system might be a practical and constructive solution to the differences over exchange rate policy between the US and Japan. Flexible exchange rates are, however, appropriate between Europe and the United States.

Are current levels of exchange rates sustainable? Can the EMS continue to operate with its current institutional structure over the coming decade? In this paper I argue that the international monetary system now faces a number of serious difficulties which are likely to create major exchange rate problems in the coming years.
The first difficulty arises from the combination of high real interest rates and rising debt/GDP ratios, which in the past decade have seriously weakened public finances throughout the world. The growth of the ratio of public debt to GDP can be decomposed into three components. The first is obviously the primary (non-interest) budget deficit. The second reflects interest payments on the debt and depends on the difference between the real interest rate and the growth rate of GDP. The third factor is the portion of the deficit financed by money creation: an increase in monetization slows the rate of public debt growth. The extent of monetization depends on inflation, the rate of GDP growth and the behaviour of the demand for money (or on velocity). For a given velocity of high-powered money, a higher rate of GDP growth, for example, increases the portion of the deficit financed by money creation, since the private sector's demand for money rises with income. A reduction in the growth rate of output therefore reduces scope for seigniorage at a given rate of inflation: the magnitude of this effect depends on the ratio of high-powered money to income and is therefore particularly important in financially underdeveloped countries. Velocity, however, is not constant, but reflects the demand for high-powered money, which depends on inflation and real interest rates. Higher real interest rates therefore increase the rate of debt accumulation via two channels: they directly raise the growth of debt by increasing the interest burden and they also reduce the potential for financing the deficit through money creation by reducing the demand for high-powered money.
The demand for high-powered money therefore has an important effect on the behaviour of public debt. In countries where the ratio of high-powered money to income is very low there is scope to finance a relatively large budget deficit by relatively moderate rates of inflation. Tight monetary policy designed to reduce inflation, however, reduces the revenue from money creation. Without an offsetting correction in the budget the result is a more rapid growth of debt. This loss of seigniorage through the single-minded pursuit of low inflation is compounded by lower rates of real output growth. This problem is particularly evident throughout Southern Europe, where the quest for disinflation has been pursued without recognition of its long-term fiscal consequences. To put it simply, the public finance role of inflation has simply been ignored in the past decade.
For moderate rates of inflation therefore an increase in the rate of inflation reduces the rate at which the ratio of debt to income rises. If debt accumulation is a problem then choosing the appropriate rate of inflation is particularly important: countries with a debt problem should most definitely not seek near-zero inflation. Inflation also has implications for optimum currency areas and the EMS. Countries in which taxes can be raised most efficiently through an inflation tax should not merge with others for whom zero inflation is the principal policy objective. Recognizing the role of public finance leads one to argue for a crawling-peg EMS. Real exchange rates should be maintained within the EMS by continuous depreciation rather than by the current mix of excessively low inflation (for example in Italy) and recurrent realignments. It may therefore be useful to divide the EMS into two separate clubs. One would be organized around the German minimal inflation target. The second group of countries, for whom seigniorage is more important, would entertain say an 8% inflation rate and use a crawling peg mechanism to maintain stable real exchange rates.
International monetary stability is also likely to be threatened by the persistence of exceptionally high real interest rates. The real interest rate on US Treasury bills was on average zero between 1928 and 1980, whereas today real interest rates (calculated on the basis of producer prices) are near 3%. How can these high rates be explained? It seems unlikely that they are the result of a world capital spending spree: the boom in the stock markets before October was not accompanied by a commensurate accumulation of physical capital. It is also incorrect to argue that today's high nominal interest rates merely reflect high rates of expected inflation. Examination of the money market equilibrium condition indicates that an increase in expected inflation, given output and real balances, cannot explain a rise in real interest rates. An increase in expected inflation, if it has any effect at all, reduces real money demand and hence must lower the nominal interest rate, and therefore real rates as well. Inflationary expectations can only be a reason for high interest rates if output increases as well: the level of economic activity must increase, typically via an investment spending boom, for this explanation to be tenable.
This analysis leads us to ask why despite high real short-term interest rates, real aggregate demand remains strong. One reason, at least in the United States, is the low level of taxation and hence the high level of current real disposable income. Budget deficits, therefore, offer a plausible explanation for high real rates. Financial innovation and liberalization are also a very plausible source of strong aggregate demand. By raising the value of consumer wealth or removing credit constraints on households, they have boosted aggregate demand at each level of the real interest rate. For a given real money stock this will tend to raise interest rates.
The large US external deficit poses another challenge to the stability of exchange rates: the current value of the dollar is such that a large external US deficit will almost certainly persist into the 1990s. The Morgan Guaranty measure of the real exchange rate of the dollar (which reflects US trade with developed and newly industrialized countries) indicates that the dollar has not returned to the level of 1980 and continues much above the average of the period 1973-80.
Most observers who believe that the dollar is now correctly valued argue either that US trade is adjusting slowly to the dollar's depreciation of the past two years and that patience is required to await the return to equilibrium, or that there is no need for US current account balance because external deficits can be financed almost indefinitely.
The slow adjustment argument does not sustain detailed scrutiny. Simulations of US net exports, on the assumptions that real exchange rates are maintained at the level of the early 1980s and that growth in the US and abroad proceeds at the same pace, indicate that the deficit will decline up to 1989, but that a $100 billion (and growing) deficit will remain. Only if the rest of the world experiences a major spurt in demand could this gap be closed.
Does the US have an unlimited ability to finance current account imbalances by selling off its assets? It is true that the rest of the world holds as yet a small share of its portfolio in the form of US assets and that accordingly there are years' worth of savings from all industralized countries available to finance a continuation of the deficit, even at $100 billion levels. In 1987, however, central banks rather than private savers have been financing the US current account and it is not clear that private portfolios will continue to absorb enough US assets to finance the trade deficit.
There are other factors which suggest that the US dollar is still overvalued. The emergence of NICs as suppliers of manufactures in world trade has had its largest impact on US markets, which are larger and more open than those of Europe or Japan. This suggests that over the next decade it is the US which will absorb a large share of NIC exports. America is therefore bound to suffer a widening trade deficit with these countries. This creates a need for further US depreciation relative to Europe and Japan to provide the room for increased net exports from the developing world.
James Tobin and others have identified international short-term capital flows as an obstacle to efficient performance by the world economy. A dual exchange rate system offers one possible approach to this difficulty. Under such a system there would be a fixed commercial rate and a flexible capital account rate. The fixed commercial rate would prevent portfolio shifts from affecting the stability of trade flows or price levels. The flexible capital account rate would serve as a shock absorber for asset market disturbances, fads, and other motives for portfolio shifts which may under present arrangements result in excessively large or persistent exchange rate movements.
A dual exchange rate system has been applied in many countries, but often with only mixed success. Dual rates are often criticized as impractical: either the premium is small and hence serves little purpose or it is large and leakages between markets become an important source of resource misallocation. Exactly the same argument was raised when income taxes were first introduced, namely that evasion would be widespread, but clearly this has not occurred. Moreover since most international transactions are carried out by audited institutions, a comprehensive system of dual rates among industrial countries, with appropriate legal sanctions, should reduce evasion to levels lower than those experienced in income tax collection.
The principal advantage of a dual exchange rate system is to insulate the goods markets from the vagaries of exchange rate fluctuations provoked by asset market disturbances, which do not necessarily reflect economic fundamentals. This insulation is not costless, of course. All the problems of a fixed current account exchange rate remain: there must be enough flexibility to adjust to persistent real changes and also to allow for divergent inflation trends. Moreover, once the capital account rate is detached from the anchor of trade flows it might cease to reflect fundamentals altogether. The potential gain lies in monetary policy being freed to pursue domestic objectives, and more importantly, the isolation of trade flows from asset market disturbances. A dollar overvaluation, such as that which took place in 1982-5 as a result of the US monetary and fiscal mix, would not have occurred under a dual exchange rate system.
There is a sense in which Europe, and to a much more limited extent the US, already have such a dual exchange rate system. The European economy is relatively closed and has adhered to relatively stable exchange rates: it resembles a fixed current account regime. By contrast the capital account rate - in effect the $/DM rate - has been flexible. Indeed, it is because the rate mattered so little that it could fluctuate so much.
This suggests that in fact we are already part of the way to a dual exchange rate system. The question which remains concerns the merits of fixing the current account rates more firmly. On balance there appears little merit in fixing rates between the US and Europe: trade flows are limited and the uncertainty about policies and the need for real exchange rate adjustments makes market solutions preferable, even if they contain excess noise introduced by the capital account.
For the United States and Japan the evidence points in the opposite direction. Misalignments of the dollar/Yen rate increasingly carry the threat of protectionism and also have important spillover effects on countries like South Korea. Given the importance of trade flows and of political relations there may be a case here for moving towards stable real exchange rates for commercial transactions and towards the accompanying policy coordination which must accompany such fixed rates. Unlike Europe, Japan may be small enough to prefer US macroeconomic leadership to the threat of protection.