Comments on J. Williamson: “A worldwide system of reference rates”

Abstract

“A worldwide system of reference rates” is a fascinating article. It provides a bold proposal for reorganizing the international monetary system on the basis of globally agreed upon exchange rate “reference” parities, supported by central bank interventions. As Williamson emphasizes, this proposal runs counter the widespread consensus that the major industrial countries should utilize a combination of inflation targeting and floating exchange rates. According to this majority view, central banks would be better off without a commitment to defend any particular exchange rate, for interventions do not work or at least, commitment to an exchange rate target only heightens the likelihood of a speculative attack. With this in mind, central banks should not risk their reputation on a foreign exchange target, and concentrate instead on domestic targets, such as the inflation rate where they can achieve better results and build a track record. The exchange rate will have to take care of itself. Such a view, Williamson forcefully argues, is irresponsible at best. Putting the burden of adjustment in the hands of the market ignores the deep flaws that are known to plague its operation. This includes the persistent mis-adjustments that have been observed since generalized float prevailed in the 1970s, as well as the problem of excess volatility. Day-to-day changes in the exchange rate between leading currencies are out of line with changes in underlying fundamentals. Economists have discussed extensively these problems in the abundant literature documenting the extreme inefficiency that characterizes floating exchange rates (see MacDonald 1988 for an early survey). They are encapsulated in the famous results by Meese and Rogoff (1984) according to which no popular model of exchange rate determination achieve better results than a mindless random walk model. Currency traders have a name of their own for the erratic movements in the foreign exchange market: the exchange rate is for them a “lost cause”. IEEP (2006) 3:353–357 DOI 10.1007/s10368-006-0067-z