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<font size="2"><font face="Verdana" color="#002864" size="5"><strong>In Monetary Affairs, Crisis Follows Crisis</strong></font>
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<font size="4" face="Verdana">By Christopher Mayer</font>
<p class="MsoNormal"><font face="Verdana" size="2">[Posted November 6, 2003]</font>
<p class="MsoNormal"><font face="Verdana"><font size="2"><img alt src="http://www.mises.org/images3/affairtoremember.gif" align="right" border="0" width="207" height="290">"The
world is in permanent monetary crisis," Murray Rothbard</font> </font><font face="Verdana" size="2">once
observed</font><font face="Verdana"> <font size="2">(in</font> </font><font face="Verdana" size="2">Making
Economic Sense</font><font face="Verdana" size="2">),"but once in a
while, the crisis flares up acutely, and we noisily shift gears from one
flawed monetary system to another." Monetary systems built on
floating fiat currencies are fragile things. Most of the world currently
operates under this arrangement.</font>
<p class="MsoNormal"><font face="Verdana" size="2">The only thing worse, in
Rothbard’s estimation, was fixed exchange rates based on fiat money and
international coordination. Markets are fluid and changing. The government
fixed exchange rate is bound to be either too high or too low—with problems
in either case. The history of attempting to maintain some fixed exchange
rates by international agreement has a long rich history of failure, once
again illustrating that government power is no match for the relentless and
merciless forces of the market. All of which does not bode well for China’s
ability to maintain its own fixed exchange rate against the dollar.</font>
<h2 align="left"><font face="Verdana" size="2">The Bretton Woods Era</font></h2>
<p class="MsoNormal"><font face="Verdana" size="2">Our own dollar has led the
life of a tempestuous teenager, seemingly unable to stay within the bounds of
the rules laid down for it by the powers that be. The Bretton Woods Agreement
lasted from 1944 to 1971 and was a form of a fixed exchange rate system based
on international coordination. The dollar was defined at 1/35 ounce of gold;
all other currencies were fixed in terms of the dollar. Importantly, the
dollar was only redeemable in gold for foreign governments.</font>
<p class="MsoNormal"><font face="Verdana" size="2">As expected, the U.S.
government inflated the currency, as governments are prone to do. Dollars grew
rapidly; the supply of gold did not. Inevitably, as foreign governments began
to turn in their dollars for gold, Uncle Sam found out that his gold stash was
getting light. Naturally, he had to break the agreement. So, Nixon closed
the gold window in 1971. In its place came the Smithsonian Agreement, which
called for an 8 percent devaluation of the dollar, among other things. But
that could not stop the push of market forces, which like the swollen Potomac
River in the days before hurricane Isabel, simply ignored whatever man put in
its way. In February 1973, the dollar was devalued again. By March, the
Smithsonian agreement was no more.</font>
<p class="MsoNormal"><font face="Verdana" size="2">Ever since, the dollar has
been a fluctuating fiat currency with no ties to gold.</font>
<h2 align="left"><font face="Verdana" size="2">You too, Europe?</font></h2>
<p class="MsoNormal"><font face="Verdana" size="2">Europe, too, has been
unable to build a durable system based on fiat either. The European Economic
Community established one of the better-known pegged rate exchange systems in
April 1972. EEC members decided that their currencies were to be maintained
within established limits of each other. This arrangement became colorfully
known as"the snake". Market pressures also busted the snake,
as governments were unable to keep their currencies within these bands.</font>
<p class="MsoNormal"><font face="Verdana" size="2">The next step was the
European Monetary System, in March 1979. Here currencies were held together by
the European Currency Unit, (ECU) a unit of account based on a weighted
average of the exchange rates of member countries. That went bust in the fall
of 1992, after experiencing severe problems and despite the attempts of
numerous European Central Banks to maintain it by intervening directly in the
foreign exchange markets. Again, government dictates held up like straw houses
in gale force winds—which is to say, they didn’t.</font>
<p class="MsoNormal"><font face="Verdana" size="2">The latest system created
the euro, which began in 1999. The euro is relatively young even by monetary
standards. There are not yet actuarial tables accurately devised for the
life expectancy of paper money, but, theory and history agree that it’s
something less than permanent. </font>
<h2 align="left"><font face="Verdana" size="2">The Tequila Crisis of 1994-95</font></h2>
<p class="MsoNormal"><font face="Verdana" size="2">Pegged rate systems are
great for fueling crises, like oily combustibles lying around in a garage; a
small flame can start a great fire and take down a house. Another instructive
case is the peso meltdown in 1994-95, or the so-called The Tequila Crisis.</font>
<p class="MsoNormal"><font face="Verdana" size="2">Before the crisis, Mexico
linked the peso to the dollar, but allowed a band within which it could float.
The Mexican government would frequently have to intervene in the market to
enforce this band. Mexico experienced a large trade deficit in 1994, perhaps
indicating that the pegged peso was stronger than a peso would have been
without government intervention. Money supply growth was brisk in the years
preceding the crisis, and 20% or more per annum throughout most of 1994.</font>
<p class="MsoNormal"><font face="Verdana" size="2">As always seems to happen
in these types of systems, the Mexican government could not control the
growing supply of pesos, nor could it bolster the weakening demand for pesos—while
at the same time trying to maintain the peso’s value in terms of the dollar.</font>
<p class="MsoNormal"><font face="Verdana" size="2">In December, the endgame
began for this arrangement. Mexico’s central bank finally devalued the peso
by 13% on December 20. By the end of December, the peso floated freely and
fell another 15%. In the four-month period beginning on December 20th, the
peso lost 50% of its value.</font>
<h2 align="left"><font face="Verdana" size="2">The Asian Crisis of 1997</font></h2>
<p class="MsoNormal"><font face="Verdana" size="2">Who can forget the Asian
Crisis of 1997? Originating in Thailand, it spread throughout Southeast
Asia—the Malaysian ringgit, Singapore dollar, Philippine peso, Taiwan dollar
and Indonesian rupiah all declined. The Asian Crisis sent ripples across
financial markets all over the world.</font>
<p class="MsoNormal"><font face="Verdana" size="2">Prior to the Asian Crisis,
Thailand had a pegged exchange rate tied to the dollar. Again, the Thai baht
became weaker in the marketplace and investors exchanged the baht for dollars.
The Thai central bank spent more than $20 billion trying to maintain its
pegged rate but ultimately had to lift it. Quite simply, the supply of baht
exceeded the market’s demand for it and the government’s intervention only
delayed and exacerbated the crisis. Over a five-week period, the Thai baht
lost more than 20% against the dollar. Other Southeast Asian countries also
had to surrender their fixed exchange rates.</font>
<h1 align="left"><font face="Verdana" size="2"><em>The Yuan-Dollar Peg</em></font></h1>
<p class="MsoNormal"><font face="Verdana" size="2">This brings us, in a
roundabout way to the current feud surrounding the yuan and dollar. As we have
blazed through a selective short history of currency blow-ups, it should be
clear that maintaining a peg not in harmony with market forces is a recipe for
a costly disaster.</font>
<p class="MsoNormal"><font face="Verdana" size="2">For ten years, the Chinese
have maintained a fixed exchange rate of about 8.28 yuan to the dollar. As has
been well documented, the U.S. has been a great importer of Chinese goods. We
take their merchandise and they take our dollars. According to James Grant,
"the dollars pile up on the balance sheet of the People’s Republic of
China at the rate of $10 billion per month." Such trends are
unsustainable. At some point, the Chinese are going to have to stop acquiring
dollars at the fixed rate. The yuan, it seems, is too cheap at that rate and
the Chinese money supply is booming. People are eagerly swapping their dollars
for yuan.</font>
<p class="MsoNormal"><font face="Verdana" size="2">Meanwhile, money and credit
are booming in China. As Grant writes,"It is therefore no accident that
the Shanhai real estate market is on fire, that Chinese loan growth is
burgeoning or that frightened Chinese monetary authorities have been unable to
keep the lid on Chinese money-supply growth. By making the yuan too cheap,
they have also, necessarily, made it too plentiful."</font>
<p class="MsoNormal"><font face="Verdana" size="2">The resulting artificial
boom in China is no good for the Chinese. A bust follows every such boom. If
allowed to float, the yuan would presumably get stronger, and some of the
money flows would slow or even reverse. It may be too late for China, whose
government seems just as intent on destroying their currency as American
officials seem bent on destroying the dollar—whether knowingly or not.</font>
<p class="MsoNormal"><font face="Verdana" size="2">Count the yuan dollar
fiasco as just another chapter in the long saga of man’s futile struggle to
master paper money. The unattainable dream is to be able to produce as much of
it as possible at near zero cost and yet also have it maintain its purchasing
power in the real world of things.</font>
<h2 align="left"><font face="Verdana" size="2">The Only Successful Fixing of
Exchange Rates</font></h2>
<p class="MsoNormal"><font face="Verdana">Murray Rothbard wrote"Governments
don’t know, and don’t want to know, that the only successful fixing of
exchange rates occurred, not coincidentally, in the era of the gold standard."
The reason is easy enough to understand. It worked because monetary units,
like the dollar, were fixed in terms of their weight in gold. Gold has to be
extracted, manufactured within the market, and cannot be created out of thin
air. But government planners don’t like gold. It ties their hand. They
can’t spend so freely because they know they have to redeem their monetary
issues in gold. It checks their inflating ways.</font>
<p class="MsoNormal"><font face="Verdana">It’s easy to be depressed when you
look around and see the state of monetary affairs. But, as Rothbard noted, and
as the short historical vignettes above show, we have one great force in our
favor. As Rothbard cheerfully noted"Free markets, not only [in] the long
run but often in the short run, will triumph over government power." The
inability of governments to maintain fixed exchange rates in the face of
opposing market forces is only further proof of their impotency.</font>
<p class="MsoNormal"><font face="Verdana"><span class="728180114-06112003">____________________________</span></font>
<font face="Verdana">Christopher Mayer is a commercial lender for Provident
Bank in the suburbs of Washington, D.C. <span class="728180114-06112003">
</span>Send him </font><font face="Verdana" color="#000080">MAIL</font><font color="#000000"><font face="Verdana"> and
see his </font><font face="Verdana">Mises.org
Articles Archive</font><font face="Verdana">.
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