Do we need a single nominal anchor in today's tripolar world?

Abstract

The recent volatility in currency markets has prompted calls for a return to gold as a nominal anchor for the international monetary system, and implicitly for a return to a fixed exchange-rate regime. Using a gold or other commodity standard as a strict policy guide, it is argued, would force policymakers to pursue noninflationary economic policies and thus restore market stability. On the surface, that argument has some appeal. The current international monetary system, involving three reserve currencies and managed floating, allows participants latitude to pursue inflationary or otherwise destabilizing policies. By contrast, a system with a single firm nominal anchor appears to avoid such moral hazard. This article reaffirms that calls for a nominal anchor such as gold are really calls for the “right” monetary and fiscal policy. Ironically, recent exchange-rate volatility more reflected market responses to economic and political surprises than to inappropriate, inflationary economic policies. The desire for greater currency stability is understandable, but more stable currencies will be the result of, rather than an instrument for, such policies. Two developments reinforce this conclusion: First is the growth of nondollar financial markets that afford investors alternatives among reserve currencies in the event that policies deviate. Second, market participants quickly punish policymakers for their mistakes with a weak currency and sinking bond markets. Such reactions force policy authorities to adopt policies aimed at price stability. The recent experience in Europe and in the dollar bloc illustrates these points. The turmoil in the ERM indicates how vulnerable are fixed exchange rate systems when economic fundamentals diverge. By contrast, the convergence among dollar-bloc yields underscores the positive role played by fundamentals even absent any effort to stabilize currencies.