Sunday, June 19, 2011

Beware of 'Peg the Dollar to the Euro' Proposals

In a cure for what is being forecast as a recession after the end of the Federal Reserve's latest targeted quantitative easing binge (QE2), Nobel Laureate Robert Mundell has proposed that the Treasury fix the exchange rate of the dollar to the euro. Mundell believes that a sure sharp rise in the dollar post-QE2 will lead to deflation in the U.S., and then recession. His prescription for this scenario is to stabilize currency exchange rates, given his view that exchange rates transmit inflation or deflation into economies by raising or lowering prices for imported items and commodities. By targeting a peg of the dollar to the euro, the world's two leading currencies, greater economic stability will be achieved.

I say that this is an absurd idea. Fixing the exchange rate of the dollar to the euro does not equate to currency stability. I also take issue with the dynamics that Mundell may be using in his argument: commodities don't always correlate with the eurodollar, so fixing the dollar to the euro won't necessarily affect commodity speculation and hot money flows across borders and back. The problem is with mismatched credit expansions and interest rate policies between borders - causing money to flow preferentially to the highest yielding opportunities at that moment. We have a very fluid and liquid global system now, and swing trading based on these mismatches in policies is quite obvious. We live in the realm of the carry trade, wherever it can be found.

Would an international gold standard help? Not if it isn't supported by a commitment to maintaining its stability, and I doubt that commitment exists at present. For one, it would mean credit could not expand or contract too drastically, and I do believe there are some highly placed who want such a turbulent environment. The other issue is interest rates, which are already monopolistically fixed by sovereign central banks - this is another control not likely to be easily ceded. A stable international gold (or hard money) standard and "free banking" are ideals for the distant future, and the benefits are worth continued extolment.

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