VoxEU Column Exchange Rates

What three economists taught us about currency arrangements

Richard Cooper, Robert Mundell, and John Williamson made important contributions on a variety of topics in international economics throughout their careers, particularly in terms of how we think about currency arrangements. This column reviews the work of all three, tracing their ideas and drawing lessons for policymakers today.

A generation of great international economists is passing from the scene. Richard Cooper died on 23 December 2020. An American, he was teaching his classes at Harvard until the very end. Robert Mundell, passed away on 4 April 2021. Originally Canadian; he was a winner of the Nobel Prize in economics. And John Williamson, on 11 April. Originally British, he had been the first scholar hired by the Peterson Institute for International Economics.

All three made important contributions on a variety of topics in international economics throughout their careers. Interestingly, all three coined memorable phrases that are still in common use, though not always as precisely as these scholars had originally intended.  

More specifically, all three played roles in the ongoing debate over the best currency arrangements. Should countries allow their foreign exchange rates to be determined freely by the private market, floating as the dollar, yen, pound, and most other major currencies do? Each of these three economists was unhappy with floating and made proposals for reform of the system. Should central banks fix their exchange rates, or even give up their independent currencies entirely, as the individual members of the euro have done? Or should they do something else?

Williamson and intermediate exchange rate regimes

John Williamson led the ‘something else’ camp. He believed in intermediate exchange rate regimes, that is, arrangements that give more flexibility than fixed rates but are more stable than free floating (Williamson 2000). Intermediate regimes are viable ways to achieve some  degree of partial exchange rate stability together with some degree of partial monetary independence (Frankel 2012). Contrary to common mis-interpretations of Mundell’s ‘Impossible Trinity’, this is true even for countries fully open to international capital flows (Fischer 2008).

One intermediate regime is a ‘crawling peg’, a phrase that Williamson contributed to the lexicon of international monetary economics in 1965 (Williamson 1981). Under this arrangement, especially popular in Latin America in the 1980s and early 1990s, countries decided to live with inflation by undertaking monthly mini-devaluations that kept their producers’ price-competitive on world markets. Even today, some developing countries like Nicaragua continue to use the crawling peg (Ilzetzki et al. 2019).

Williamson also championed another intermediate regime, the target zone, under which countries keep their exchange rates within pre-specified bands. He repeatedly refined and updated his proposals to apply the target zone even to the dollar, euro, yen, and other major currencies (Williamson 1987, 1994). In 1987, at the time of the Louvre Accord, a ‘reference range’ version of this proposal was secretly adopted by the G7 (Frankel 1990). But it was short-lived.

These intermediate exchange rate arrangements found their greatest popularity among emerging markets. Many of these countries mixed and matched Williamson features, falling under the rubric of Band-Basket-Crawl (or ‘BBC’) (Williamson 2001). Botswana and Singapore still do so today (IMF 2020).

Williamson’s greatest claim to fame stemmed from another expression that he coined, in 1989: the ‘Washington Consensus’ (Williamson 1993). He listed ten economic policies for developing countries that he judged had the support of the IMF, World Bank, and US administrations.  

He utterly lost control of his own invention, however. He had explicitly excluded one item from the list: the removal of financial controls. While pursuing the goal of keeping developing-country exchange rates competitive, he said, “there is relatively little support for the notion that liberalization of international capital flows is a priority objective”. Many subsequently would talk about the ‘Washington Consensus’, but most of them assumed that it entailed the opposite, the free movement of capital, typically in eager attacks on perceived ‘neoliberalism’.

Cooper, cooperation, and currencies

Richard Cooper can be judged to have favoured fixed exchange rates (Frankel 2020, Cooper 1999). His 1971 paper pointed out the adverse balance sheet effect that devaluation can have in developing economies (Cooper 1971).  

Further, he predicted that business would eventually find the high volatility of floating rates ‘intolerable’. In 1984, he made an uncharacteristically radical proposal for “the creation of a common currency for all of the industrial democracies,” beginning with the US, Europe, and Japan (Cooper 1984). To be sure, he emphasised that his plan was only a vision for the long term. But his notion of the long term was the 21st century. We are here. Yet the political appetite in each part of the world for giving up this sort of national sovereignty is even more miniscule now than it was when he made the proposal.

Perhaps Cooper was unrealistically optimistic about the practical prospects for international coordination in general. He had started the academic field of international macroeconomic interdependence and cooperation, while avoiding the use of game theory, which later came to dominate the field (Cooper 1968, 1969, 1985; Frankel 2015).   

But he drew practical lessons from the history of international cooperation in fighting contagious diseases, an especially relevant example today (Cooper 2001)). And, after all, he had accomplished the rare feat of taking his scholarly contributions and helping put them into practice on the world stage, as US Under Secretary of State for Economic Affairs in the Carter Administration (1977-1981). The most salient example was the 1978 Bonn Summit of G7 leaders, in which Cooper played an active role (G7 1978). There, Germany and Japan agreed with the US that the three would act as locomotives simultaneously pulling the rest of the world economy out of economic stagnation. In the global economy of 2021, the US and China are the locomotives.

Indeed, Cooper in this episode gave the world the phrase ‘locomotive theory’, which refers to fiscal expansion that is coordinated across countries in periods when the global economy is suffering from a deficiency of demand. The story is that Cooper on a visit to Japan described the three big economies as ‘engines’ pulling the global train; the word ‘locomotive’ came from a translation back into English of coverage in Japanese sources.

Mundell and the postlapsarian desire for exchange rate stability

When Bob Mundell was awarded the Nobel Prize in 1999, the committee specified two contributions that still remain indispensable tools for thinking about the advantages of fixed versus floating exchange rates (Nobel Prize 1999). One was the 1962-63 Mundell-Fleming model –  so christened by Rudiger Dornbusch (Mundell 1963, Fleming 1962, Boughton 2003). The model was far ahead of its time in assuming high cross-border financial integration. A key finding was that monetary policy attains high power to influence income if the country’s exchange rate is floating, but loses power if the exchange rate is fixed. Even though Denmark retains its own currency, for example, its peg to the euro means that it has little control over its own monetary policy.

What happens when a country or region gives up its own currency altogether, thereby renouncing monetary independence by definition?  Mundell’s other prize-winning article was his 1961 “Theory of Optimum Currency Areas” (Mundell 1961). The phrase is another that is prominent in the lexicon of international macroeconomics. Mundell’s analysis began with the observation that there was no reason why national political boundaries should necessarily coincide with the boundaries between independent currencies. 

Luxembourg, for example, is too small and its economy too dependent on its neighbours to justify having its own monetary policy. It should instead, tie its currency tightly to one or more of its neighbours, as Luxembourg has indeed historically done. It is content to have its interest rates set in Brussels or Frankfurt. It is like one of the 50 US states, which is sufficiently integrated with its neighbours that the benefits of sharing a common currency outweigh the costs.

Countries like the UK or Norway, on the other hand, are more likely to experience different macroeconomic conditions from mainland Europe, and to need the freedom to respond by cutting their interest rates and depreciating their currencies independently of what monetary policy is set in Frankfurt. These two northerners never joined the euro.

As Paul Krugman has pointed out, it is absolutely essential to distinguish between pre-1971 Mundell and post-1971 Mundell (Krugman 1994, 2021). 1971 was the year that the Bretton Woods system of pegged exchange rates broke down, and the year that Mundell left the University of Chicago. His post-1971 ideas were broad-brush, and at odds with the ideas in his pre-1971 writings (Mundell 1971).  

He is sometimes called the intellectual father of two big and consequential ideas: supply-side economics, which bore fruit in Ronald Reagan’s 1981 tax cuts; and a common currency for Europe, which came to life in the form of the euro in 1999. The two movements were very different. But both were associated with a relatively unconditional faith, which Mundell had not shown before, in the virtues of restoring the exchange rate stability that the world had lost in 1971. 

His fundamental change of world view was most likely due to a new belief that the prices of goods and services were so flexible as to equilibrate markets automatically, regardless of currency policy (Wanniski 1975).

From the viewpoint of post-1971 Mundell, the Optimum Currency Area concept that he had invented has been misused by others. Many American economists liked his framework for judging the advantages and disadvantages of a common currency, but argued that European countries did not meet the OCA criteria (Jonung and Drea 2015, Bayoumi and Eichengreen 1992). They found that individual European countries generally had greater need for monetary autonomy, in that their business cycles had relatively low correlations and their unemployed workers had low ability to adjust to shocks by moving to where the jobs were (compared to US states, for example).

Mundell’s first choice was a single global currency. His second choice was currency unions within Europe or within other regions (Mundell 2003, 2012; Mundell and Clesse 2000). He felt that, since he had originated the Optimum Currency Area criteria, he should get to say whether proposed unions qualified. But subsequent events seem to confirm others’ warnings that even Europe is too large to qualify, if taken as a whole, let alone the entire world.

Intellectual influence

Let’s take stock, as of 2021. Freely floating rates suit most large countries better than Mundell, Cooper, and Williamson felt (G7 2013). Call the three ‘the Bretton Woods generation’. But at the same time, some countries do well with firmly fixed exchange rates, especially economies that are small and highly integrated with neighbours (Frankel 1999).

At least half the countries of the world fall in between the two poles. But in most cases, their intermediate exchange rate regimes don’t obey such well-defined rules as Williamson’s BBC plans. Many of the larger Emerging Market countries – including Korea, India, and China – follow ‘systematic managed floats’ (Frankel, 2019). The central bank regularly responds to changes in total exchange market pressure by allowing some fraction to be reflected as a change in the exchange rate and the remainder to be absorbed as a change in foreign exchange reserves.

As we mourn the passing of these three giants, their careers serve as a reminder of a famous Keynes admonition: “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist”. But perhaps the quote needs to be amended to reflect that the influence of powerful ideas can exceed what their originators foresaw. 

Editors' note: A shorter version of this column appeared on Project Syndicate.


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