According to Friedrich Hayek, the rational choice in monetary regimes is between one of two alternatives – either a free banking system with no regard to national boundaries, or an international central bank. Hayek was concerned that numerous independently regulated national currencies would be more destabilising than a situation where there is “some conformity of monetary changes in the national area to what would happen under a truly international monetary system”. An international system isn’t optimal, because bureaucrats lack the incentives and knowledge to act in the public interest. But such a system could constrain governments from inflating their currencies.
When the Bretton Woods system collapsed and capital controls and fixed exchange pegs gave way to freely floating currencies, this seemed to be a step in the direction of free markets. Milton Friedman argued that floating rates would reduce volatility, saying “under a floating rate, there cannot be and never has been a foreign exchange crisis”.
Yet exchange rate risk remains a crucial hindrance to international business, imbalances between countries with trade deficits and trade surpluses have grown, and asset price bubbles appear to have become more prevalent. Maybe short run capital flows can be destabilising in a fiat system.
The euro project was a reduction in monetary nationalism, allowing money to cross national borders in the same guise that it circulates domestically. However, its failure demonstrates that monetary statism is a worse problem than monetary nationalism. The fiat nature of the currency is the problem: debates over fixed or floating exchange rates are secondary.
When countries – or groups of countries – assert sovereignty over their currency, capital flows become destabilising. Currency crises result from a disagreement between governments and investors about the value of a currency. Governments can compel citizens to hold domestic currency to transact with the state but they cannot force them to save in it or for foreigners to demand it. Speculators tend to win, not because they’re more powerful, but because they are right.
Hayek proposed competing fiat currencies as a solution to the monetary mismanagement of the 1970s. But foreign exchange can only approach an open market when people can truly escape failing currencies. Perhaps one day the UK’s balance of payments will become as irrelevant as London’s – not because the monetary regime is international, but because it’s free.
Anthony J. Evans is Associate Professor of Economics at London’s ESCP Europe Business School, and Fulbright Scholar-in-Residence at San Jose State University. www.anthonyjevans.com