http://commdocs.house.gov/committees/bank/hba57160.000/hba57160_0f.htm
EXCHANGE RATE STABILITY IN INTERNATIONAL FINANCE

FRIDAY, MAY 21, 1999
U.S. House of Representatives,
Committee on Banking and Financial Services,
Washington, DC.

The committee met, pursuant to call, at 10:00 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding.

Present: Chairman Leach; Representatives Bachus, Ryan, Toomey, Frank, Sherman, Mascara and Inslee.

Chairman LEACH. The hearing will come to order.

On behalf of the committee, I would like to welcome our distinguished panel of expert witnesses to the second in the committee's series of hearings on international economic issues.

Yesterday the committee addressed a wide spectrum of issues associated with debate over proposals for a new international financial architecture. Today we will home in on a critical element of that ongoing discussion, the question of which exchange rate systems best promote global economic growth and stability. Page 2 PREV PAGE TOP OF DOC Until very recently, the issue of appropriate currency arrangements was missing in action from the official agenda for global reform. The existence of this gap presumably reflected the substantial divisions on this issue among economists and policymakers. In any regard, these divisions became manifest in the remarkable inconsistency of policy advice provided on exchange rates by the official financial community.

As the IMF has acknowledged, the crises in Thailand, Indonesia, Korea, Russia and Brazil were all associated with exchange rate regimes that had been more or less fixed. In Asia in 1997, the fund urged cross-hit countries to devalue or float their currencies rather than squander precious reserves in a fruitless defense of an unsustainable rate. But in 1998 it lent billions to Russia and Brazil to help them maintain their fixed or ''pegged'' rates, because those currency regimes helped provide an anchor against inflation and because international authorities feared a rapid float could have had systemically destabilizing consequences.

At long last, the U.S. and the IMF have begun to try and shape expectations about which kind of currency regimes the international community will support with exceptional official assistance. Yet here, too, the precise contours of our evolving policy remain difficult to discern. The emerging official view appears to be that flexible rates are preferable, but fixed rates can be credible, too, as long as a country is legally and politically committed to a currency board. Hybrid systems in which policymakers commit to holding the exchange rate within a band against a reference currency, pegged but adjustable exchange rates, crawling pegs and exchange rate target zones, are increasingly viewed as unviable.

On the other hand, according to Deputy Secretary Summers, exceptional official financing might still be available to countries with a traditional currency peg, except where the peg is judged sustainable or when an immediate shift away from a fixed rate is judged to pose systemic risks. Reading the Treasury tea leaves, it would appear that Argentina and Hong Kong can expect exceptional international financial support, but not most other peg rate systems, except a country like China which may, if the risks of devaluation are judged to pose systemic risks. Perhaps this is the international financial analogue to a foreign policy of strategic ambiguity. Page 3 PREV PAGE TOP OF DOC

Due to the impracticality and costliness of defending traditional fixed rate regimes, most countries would appear to be far better off to adopt policies of greater exchange rate flexibility before they are compelled to do so in a crisis.

But as we shall shortly hear from several of our witnesses, novel alternatives to floating rate approaches are getting increasing attention in the economic community. Some economists believe floating rates are too destabilizing for emerging markets to maintain in our new world of global capital mobility. For these economies, some contend, a rigidly fixed regime, which also involves establishment of a currency board, would reduce exchange rate uncertainty and help restrain domestic inflation. Other analysts want to go further still and believe the solution for small, emerging markets lies in regional currency unions, such as the creation of a U.S. dollar zone in the Americas.

Some economists believe that a more flexible form of exchange rate targeting can provide a way to limit potentially destabilizing currency volatility while reducing susceptibility to speculative attack. Those who prefer target zones to fixed rates argue that zones reduce opportunities for one-way bets against central banks while still preventing extreme exchange rate fluctuations. In other words, proponents of target zones believe them to provide a good balance between the seeming anarchy of flexible rates and the policy straitjacket of fixed rates.

In any regard, there is general consensus that whatever exchange rate approach is chosen, the only sustainable defense against inflation and potential currency instability involves creation and maintenance of a genuinely independent central bank run according to sound monetary policy principles, together with a prudently conservative fiscal policy. Page 4 PREV PAGE TOP OF DOC

The committee has today an exceptional panel of witnesses before it to help shed some light on this exceedingly complex aspect of international monetary policy, and I look forward to a stimulating discussion.

Mr. Bachus.

Mr. BACHUS. Thank you, Mr. Chairman.

I would say this to the panel. We talk about exchange rates, sound fiscal policy, pegs, all that sort of thing, but what I want to focus on is, what does devaluation do or what type of exchange rates are best for the people of these countries? In other words, we have had—the IMF claims great success in meeting this global financial crisis, but at the same time we hear that the middle class has been devastated in many of these countries, that they have lost their jobs, they have lost their savings.

In the average developing country, in a post-communist country, developing post-communist country today, the rate of growth is less than it has been since 1982. So there is no growth in these countries.

You use the word ''devastation'' but, you know, we use it so much maybe that it loses its impact. But, in fact, we have really creamed the little guy. The little guy has really been clocked in a lot of these countries. And my question for you is, what could we have done differently? Page 5 PREV PAGE TOP OF DOC In many countries, the IMF basically forced or dictated a devaluation, and people found that their money suddenly wasn't worth anything, at least that is what we are hearing. And I would like you to focus on what exchange rate regime, whatever you want to call it, what approach is best for protecting the people of those countries, for protecting their jobs, for protecting their savings, whether there is an alternative to devaluation, whether tight money would have been—whether that is an alternative.

I basically want you to put this in human terms, if you can, and make suggestions on what is the best currency approach from the standpoint of standards of living and per capita income.

So with that, I will yield back to the Chairman.

Chairman LEACH. Well, thank you very much.

Our panel today consists of C. Fred Bergsten, who has been the Director of the Institute for International Economics since its creation in 1981. Dr. Bergsten is also Chairman of the Eminent Persons Group of the Asia-Pacific Economic Cooperation Forum. He has received Master's and Ph.D. degrees from the Fletcher School.

Our second panelist is Dr. John H. Makin, who is a principal at Caxton Corporation in New York City, a major investor in foreign exchange, commodity and currency markets. He is also a Senior Fellow at the American Enterprise Institute, and he holds degrees from the University of Chicago. Page 6 PREV PAGE TOP OF DOC Our third panelist is Jeffrey A. Frankel, who served on President Clinton's Council of Economic Advisers. Professor Frankel currently occupies the New Century Chair at The Brookings Institution. He is a graduate of Swarthmore and MIT.

Our fourth panelist is Dr. Judy Shelton. Dr. Shelton is an economist who specializes in international money finance and trade issues. She is the author of ''The Coming Soviet Crash, 1989''—that had to be impressive. Is there a follow-up, ''The Continuing Soviet Crash''?—as well as ''Money Meltdown in 1994?'' She has testified frequently before the Joint Economic Committee, the Senate Foreign Relations Committee and the House Foreign Affairs Committee. Dr. Shelton holds advanced degrees from the University of Utah and has taught at the Hoover Institution at Stanford University.

Our final witness is Mr. V.V. Chari, who is Chair and Professor of Economics at the Department of Economics, the University of Minnesota. He is also an advisor to the Federal Reserve Bank of Minneapolis. Mr. Chari holds a Ph.D., an MS in Economics from Carnegie Mellon. And this committee likes to have Midwesterners, Dr. Chari; so we look forward to a perspective from the heartland.

Before continuing, let me first ask unanimous consent that all Members may place statements in the record. And let me, in turning to Mr. Frank, say that both myself and Spencer made opening statements. If you would like to have any opening, you are welcome.

Mr. FRANK. Well, since I came late and since I don't feel qualified to report sentiments from the heartland, I will waive, and maybe we will get it in a little later. Page 7 PREV PAGE TOP OF DOC

Chairman LEACH. Mr. Ryan, would you care to make any opening comments?

Mr. RYAN. No.

Chairman LEACH. Thank you. Well, then, why don't we proceed in the order in which the witnesses have been introduced.

Mr. BACHUS. Mr. Chairman.

Chairman LEACH. Yes.

Mr. BACHUS. I notice that there is a nice-looking young lady in the first row of the spectators in a red dress, kind of a maroon dress.

Chairman LEACH. Is she related to you?

Mr. BACHUS. No. She may be related to Mr. John Makin. I am not sure. Is that Jane Makin?

Chairman LEACH. We are pleased to have——

Mr. BACHUS. Pleased to have her here. Is that your daughter? Page 8 PREV PAGE TOP OF DOC Mr. MAKIN. That is my advisor.

Mr. BACHUS. Your advisor. We are glad to have her along with you.

Chairman LEACH. I have a group of advisors also here from Iowa, and we are pleased that they are with us.

Please proceed, Dr. Bergsten.

STATEMENT OF C. FRED BERGSTEN, DIRECTOR, INSTITUTE FOR INTERNATIONAL ECONOMICS

Mr. BERGSTEN. Mr. Chairman, my Midwest background is only from Missouri, but maybe it is close enough to qualify me to be part of the picture that you laid out.

I want to start by congratulating you for focusing on this issue, because you are quite correct: In most of the debate on the international financial architecture the question of exchange rates and exchange rate systems has been, as you said, missing in action. I have, in fact, raised that a couple of times with Secretary Rubin. He has acknowledged it. The issue has now come a bit more into the picture, but it still needs more focus because of its centrality, and I will try to lay that out.

Digressing a bit from my statement, though, at the outset, I want to suggest a couple of reasons why this issue has not been debated very much. Page 9 PREV PAGE TOP OF DOC

You mentioned the intellectual disagreement over what is the best exchange rate system, and I acknowledge there is something to that, but there are a couple of other institutional reasons.

One is that central banks do not like any kind of arrangements that may impinge on their institutional independence—and they believe that any kind of exchange rate regime, not just fixed rates or dollarization, but even limited variants like target zones, would put some limits on their independence of action; and they don't like it. Remember, all European central banks opposed the creation of the euro and its predecessors. They opposed the whole idea of a European Monetary System, and only after the political leaders told them it was going to happen did they get with it and devise the plans.

Central banks are institutionally against anything but free floating in most cases, particularly in industrial countries. Central banks are very powerful, and that is an element of why the issue has been rather sotto voce in the debate.

Another reason is that bureaucrats, officials, and even ministers like floating exchange rates because they enable those officials to blame all problems on the market. If the rates are floating and you can say that the market did it, then you can absolve yourself of much of the responsibility that might otherwise inure to you if you had tried to set a rate, limit the fluctuations, intervene to affect it, or taken any of the modest steps that we will be talking about today.

High officials, including of our own Government, have admitted quite openly that, ''Yes, that is true, we do like the fact that market-determined exchange rates enable us to avoid a degree of responsibility for what may happen, particularly crises or big economic costs that may emerge.'' Page 10 PREV PAGE TOP OF DOC

So, in thinking about the relative lack of discussion of the issue and why it has not achieved the place on the agenda that it logically might, keep those institutional and even bureaucratic and turf considerations in mind, because they are quite powerful.

Now let me turn to the substance. I was asked essentially to set the scene and lay out the options, and I tried to do that in my statement as well as to express a few views on what would be the best outcome. I think the issue is terribly important, because for most economies in the world, the exchange rate is the most important single price. The only contender for that honor would be the interest rate: whether the interest rate or the exchange rate is more important depends on how internationally involved the country is, and they are obviously closely related.

But for most countries, particularly smaller countries and those deeply involved in the world economy, the exchange rate is probably the single most important price, and therefore the nature of the system, as Mr. Bachus was saying, is absolutely crucial for the welfare of people throughout the country. They often don't realize it, because the impact of the exchange rate is often indirect through commodity prices, through interest rates, through financial flows, but the exchange rate is an absolutely crucial element in every country and is dominant in many.

In determining what exchange rate system to use, there are basically three choices. Countries can let their currencies float freely in the exchange markets against all other currencies, truly leaving it up to the market to determine the rates. At the other extreme, they can fix the price of their currency against a single foreign currency such as the dollar or against some basket of currencies and either permanently or until further notice try to avoid much fluctuation. And then, in what is increasingly the focus of the real action, there are a whole array of intermediate approaches where you let rates float to some extent but also intervene to some extent to limit the fluctuation. You either do that via ad hoc managed floating, or you do it pursuant to some predetermined agreements or parameters, and that is the whole idea of target zones or crawling bands. Page 11 PREV PAGE TOP OF DOC

Floating has the virtue of permitting a country to maintain a substantial degree of national control over monetary policy and other national macroeconomic policies, because if the exchange rate is floating you don't have to use the other policy tools as much to defend the exchange rate. If the exchange rate is floating freely, it gives you more freedom to devote monetary policy or other tools to internal economic considerations. That is the virtue of floating rates.

On the other hand, we know from experience that markets can substantially overshoot the economic fundamentals, thereby pushing currencies far below their underlying economic value, generating huge inflation effects that devastate the little guy and the middle class, going far more in a negative or a depreciation direction than necessary in terms of the underlying economic considerations.

Likewise, floating rates can push a currency far above the level justified by the fundamentals, hurting the country's competitiveness and throwing its trade balance into large deficit. Exhibit A is the United States. You remember back in the first half of the 1980's we had an experiment with free floating when the first Reagan Administration, led in this area by Don Regan and Beryl Sprinkel, literally pursued a policy of free floating. The result was that the U.S. dollar soared 70 or 80 percent against the yen, the mark, and the other key currencies.

The U.S. shifted from running a current account balance, where it was when I left office, Mr. Chairman, to the largest deficit any country had ever run in history. The dollar's rise converted the U.S. from the world's biggest creditor country to the world's largest debtor country—where it remains today, at least in part because the floating exchange rate regime enabled or even pushed the dollar to a hugely overvalued level. And you will remember the pressures on trade policy that were generated as a result, to apply all sorts of import barriers and the like, which in fact the Reagan Administration did on autos, steel, and a number of other industries. Page 12 PREV PAGE TOP OF DOC

So we have had an experience in free floating, and it didn't come off very positively, I would say, in terms of our own experience, let alone smaller countries.

The second alternative, fixed exchange rates, can avoid those overshooting costs and others if—and this is a big ''if''—the authorities can successfully set the rate at a sustainable level and convince the market of both their ability and their will to keep it there.

Fixed exchange rates reduce the transaction costs of international trade and investment. They can provide a useful anchor for price stability, particularly for a small country linking its currency to that of a bigger country such as the United States or Germany. And the option of adjusting the fixed but adjustable rate provides a country with an additional policy tool that can be used to help correct an excessive external deficit or surplus.

In practice, however, the problem is that governments often set or try to sustain a so-called fixed rate at an unsustainable level, one that doesn't reflect the fundamentals either. Private capital flows then eventually force devaluations or revaluations that can be extremely costly, and those, too, can then lead to huge overshoots, as we saw in the Asian crisis.

Successfully defending a fixed rate can also be quite costly. Mr. Bachus asked, ''Are there alternatives?'' Well, you can defend a fixed rate if you are willing to push interest rates to 20 percent, 50 percent, 100 percent or if you are willing to push the economy into a recession, but those are huge, costly steps. Countries usually aren't willing to do it; and, as a result, they may get the worst of all worlds—huge costs in trying to defend the fixed rate and then it is still knocked off by speculation, and all sorts of crises result. Page 13 PREV PAGE TOP OF DOC

With those heavy costs, then, there is a clear trend away from fixed rates and, indeed, in the present world economy of huge private capital flows, a growing consensus that countries can enjoy the benefits of fixed rates only by maintaining extensive capital controls, which also have costs, or by adopting such a credible commitment that the markets will believe them through thick and thin—and that is dollarization or a currency board, which my colleagues, I am sure, will talk about.

In the real world, I think the debate therefore largely goes to the intermediate options. Because floating rates have been tried and found wanting, and because fixed but adjustable rates have been tried and found wanting, the real issue, including for the United States, I believe, is the degree of currency flexibility and the policy under which that degree of flexibility will be managed.

The practical policy issues are as follows, as I indicate on page six of my statement:

What range of fluctuation is consistent with the underlying fundamentals and hence acceptable?

What policy tools can be effectively deployed to keep rates within those ranges?

Should the ranges be decided in advance? Should they be announced, or kept secret, or should they be simply applied in an ad hoc manner? Page 14 PREV PAGE TOP OF DOC

And should the country in question pursue managed floating on its own, or in tandem with other countries, like the Europeans do?

There are a whole range of alternatives within that spectrum, but I think it boils down to two. I don't know if Larry Summers has said it to this committee, but he frequently says he believes that the current regime, like Churchill said about democracy, is ''flawed and terrible, except compared with everything else.'' He characterizes the current regime of ad hoc intervention in the markets as ''guerrilla warfare'' that the officials wage against the markets. They keep it all secret, they don't tell you what their ranges are, they may not even have any ranges, and they do it all on an ad hoc basis.

My view is that this has been very ineffective. They have come in with too little, too late. Huge costs have emerged. It is a bad alternative.

The alternative that I like is called ''target zones'' for the industrial countries or ''crawling bands'' for the developing countries. The reason I advocate that is because currency gyrations in recent years, particularly among the big industrial countries, have far exceeded any conceivable shift in economic fundamentals.

The dollar rose by 80 percent against the yen and 40 percent against the mark in less than two years in the recent past. One result is that our trade deficits are again at record levels, cutting our exports and hence our income levels and generating strong protectionist pressures despite a 25-year low in our unemployment rate. It is also probably setting us up for a sharp fall in the dollar at some early point that would be extremely disruptive to our own economy and the world economy as a whole. Page 15 PREV PAGE TOP OF DOC

In addition, we've got to keep in mind that the sharp swings in the dollar-yen exchange rate were a very big cause of the Asian financial crisis. Many of the Asian countries were pegged to the dollar. When the dollar rose 80 percent against the yen in three years, up went the Asian developing country currencies with it. That contributed importantly to their huge trade deficits, which helped to lead to the crisis. So we get big global effects from these huge currency movements.

I think it may get worse with the creation of the euro for reasons that I am happy to talk about if you want.

It seems to me that the goal of currency reform should thus be a ''third way,'' to use the popular political term, between the two extremes, both of which have been found wanting. For the G–7, I think that goal can best be pursued by maintaining substantial flexibility but modifying the method by which it is managed. For the past decade, the G–7 has intervened periodically on an ad hoc basis without prior announcement. That can surprise the markets. It has sometimes succeeded, but, as I say, it has almost always come long after large misalignments have set in and severe damage has resulted.

A better approach, in my view, would be to announce limits on the extent of permissible swings, starting perhaps as much as 15 percent on either side of agreed currency midpoints, as in the European Monetary System since 1993. The objective of the exercise would be very simple: to avoid the huge swings in floating rates that have deviated tremendously from underlying equilibrium, caused major economic problems and trade policy problems, and set up big reversals that cause huge financial instability. Rates would still float virtually all the time, and if there were long-term shifts in inflation rates and such, you could alter the ranges themselves to take account of that. Page 16 PREV PAGE TOP OF DOC

Within the wide limits envisaged, I believe the G–7 governments could surely agree on ranges that would reflect underlying economic reality and be credible to the market. The crucial point is that, if they could do that, private speculation would then become stabilizing rather than destabilizing. The reason is simple. If there is a credible band, as a rate moves toward the edge of the band, the markets know that there is not much money to be made in pushing it further, because the officials are going to resist effectively. The money is to be made moving back toward the middle of the range and therefore achieving what is called ''mean reversion.'' You move back toward the middle. The empirical evidence on regimes of this type, such as the European Monetary System, shows that they do tend in that direction, they do stabilize in that direction, and therefore the system works.

The final point is that it is true that a rate may occasionally reach the edge of a zone, and then the governments have to do something to defend the zone. My argument is that they can usually do that by direct intervention, by jawboning the markets and by intervening directly to buy and sell foreign exchange. In most cases, they would not need to alter monetary policy.

Occasionally they might. Paul Volcker has testified that for the United States, that would usually be a good idea. We would have been better off had we listened more often to the exchange rate signal rather than not. But it is true that on occasion you might have to do it

It is also true that, on occasion, that might not be what you want for domestic monetary policy. But in assessing whether the whole regime is a good idea, you have to compare it not to an abstract notion of perfection but whether it is better or worse than the current regime of ad hoc episodic, too little too late, and I believe it is. Therefore, I think that is the best way to go, and I hope we have a chance to discuss it at some length this morning. Page 17 PREV PAGE TOP OF DOC

Thank you.

Chairman LEACH. Well, thank you very much.

Dr. Makin, and if you want one of your advisors to join you at the table you are welcome as well.

STATEMENT OF JOHN H. MAKIN, RESIDENT SCHOLAR & DIRECTOR OF FISCAL POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE

Mr. MAKIN. I think I will do it solo for now.

Mr. Chairman, I appreciate the opportunity to talk to the banking committee on this important subject.

You know, Fred sitting next to me here reminds me that this topic has been one of discussion and I guess disagreement between us for nearly 30 years. So you will get to hear a range of views here.

Now, the basic thing I want to say about the issue is that fixed exchange rates seem like a good idea, but they never work out that way. And what I want to do this morning is briefly review some post-war events that will suggest that that is the case and then focus on the experience in emerging markets since 1997 and today in Japan as examples of the unworkability of exchange rate targets. Page 18 PREV PAGE TOP OF DOC

Broadly speaking, it would be nice to fix exchange rates. The problem is that I don't know what the exchange rate should be. I don't know what currencies are over or under value. It is people who are buying and selling the currencies who decide. So the notion—my basic point today will be that to suggest to people that we can fix exchange rates is perhaps misleading.

So, I want to make five points.

First, I favor a regime of currency flexibility as a practical way to deal with the need for differing monetary policies and different national economies. While in theory either fixed or flexible exchange rates can work, in practice fixed rates mean that you lose control over your money supply. The quantity of money flexible rates means that you lose control over the price of money. Probably it is best to pick one or the other.

Exchange rate targets, however, have been counter-productive. This is because fixed exchange rate regimes tend to impose the same monetary policy on different economies whose differing needs may require different monetary policies. Some specific examples of difficulties over the last 30 years serve to reinforce the point.

Second point and the first example: the Bretton Woods system. The struggle to preserve the Bretton Woods system of fixed exchange rates in the late 1960's until August of 1971 illustrated well the problems with pegged currencies for advanced industrial countries. During the late 1960's, when the United States pursued more inflationary policies than Europe and Japan, the dollar became what seemed to be overvalued. That is, the attempt to peg the dollar required counterproductive restrictions on U.S. capital flows. Page 19 PREV PAGE TOP OF DOC

The final, disruptive collapse of the Bretton Woods system in August of 1971 ushered in a period of flexibility among the exchange rates of most G–7 countries. The attempt to re-peg currencies in December of 1971 under the Smithsonian Agreement was unsuccessful. The pegged exchange rate regime ended with the abandonment of currency pegs in February of 1973, just in time to avoid the currency chaos that would have ensued in financial markets if fixed rates had been in place when the oil crisis hit in the fall of 1973.

Moving up two decades to Europe, in 1992, you will recall that it proved unworkable to maintain fixed exchange rates within the European currency system. The British pound, the Italian lira and the Spanish peseta were allowed to float down after Germany was forced to follow tighter monetary policies to avoid the inflation associated with currency union between East and West Germany. Despite the dire predictions of inflation that would follow, the trio of European countries that devalued their currencies prospered without inflation. Spain and Italy were able to join the European currency union on schedule, while Britain's economic performance was enhanced by the freedom to pursue its own monetary policy separate from that of Europe. And, of course, Britain today continues to maintain or to allow its currency to fluctuate against the euro.

I might add in terms of this—slight digression from my prepared testimony—think about what was being said about the euro at the end of last year. Most people suggested that the euro was going to be a stronger currency, that we should be prepared for its appreciation against the dollar. And, of course, the authorities in Europe were forced to pick an exchange rate. As it turns out, so far it has been a weaker currency and, had the currency been pegged, Europe would be forced to follow tighter monetary policies today while, in fact, Germany and Italy are economies that are slowing down. Page 20 PREV PAGE TOP OF DOC

So the problem is, again, it seems like a good idea to peg currencies, it would be nice to have fixed exchange rates. Reality doesn't usually permit it, and the commitment to peg exchange rates forces central banks to do things that seem to hurt the local economies and hurt the individuals in them.

Today in Europe, excluding the United Kingdom, the European Monetary Union is imposing a single monetary policy on all of Europe. I have covered that.

I will skip on to my fourth point, which focuses on the experience in emerging markets since 1997.

One of the most dramatic illustrations of the danger of pegged exchange rates came with the Asian crisis that emerged in the spring of 1997. Pegging the currencies of emerging Asian markets like Thailand, South Korea and Indonesia to the U.S. dollar created the illusion of fixed exchange rates and tempted business to borrow heavily in dollar-denominated loans. As Chairman Greenspan emphasized in his testimony yesterday, too much borrowing and too much investment led to excess capacity in those countries and an inability to service debts. When the links to the dollar collapsed, as they did in most of emerging Asia, the excess capacity and heavy dollar borrowing proved a lethal combination for emerging markets. As a result, the Asian crisis was far more intense and prolonged than many expected.

Pegging currencies in an environment of excess capacity and deflationary pressure adds to that deflationary pressure. In other words, if a country is pegging a currency and trying to prevent a weakness of the currency, those policies are deflationary and those are very harmful and create some of the problems that Representative Bachus was referring to earlier. Page 21 PREV PAGE TOP OF DOC

The IMF's initial approach to the currency crises in emerging Asia, which was tighter monetary and fiscal policies, proved disastrous since it exacerbated the conditions of excess capacity. In fact, tighter monetary and fiscal policies left a weaker currency as the only way to stimulate demand in those economies.

You recall the experience before most of the devaluations in this emerging market crisis. The IMF's typical stance is to say the currency has to be defended. We will give them a package of IMF support in exchange, essentially, for putting a gun to their heads and blowing their heads out—that is, following more deflationary policies.

The experience with Russia was another case. We were told that if Russia didn't get a large loan from the IMF, the Russians would be lobbing nuclear missiles at us. In fact, the Russians got their loans, stole the $5 billion, didn't lob missiles, defaulted and devalued, and the IMF took a bow.

The lessons from the Asian crisis—returning to the earlier phases of this situation—as Secretary Rubin has acknowledged in an April, 1990, statement, are that IMF's efforts to peg currencies of emerging economies by enforcing tighter monetary and fiscal policies are counterproductive, as I have suggested. In Secretary Rubin's view, currencies should either be allowed to float freely or irrevocably pegged through the use of a currency board.

In my view, the currency board solution is a dangerous one for emerging economies, especially in a world of excess capacity, as it tends to force deflationary policies on countries trying to satisfy the conditions necessary to maintain a currency peg to the dollar. These policies will be deflationary if the dollar is strong, as it has been over the past several years. Page 22 PREV PAGE TOP OF DOC

Argentina, with its currency board, is currently suffering from the deflationary policies necessary to maintain its rigid currency peg to the dollar. Wages and prices in Hong Kong and in China are also falling sharply due to currency pegging. And, in fact, as I called into the office this morning, there is a modest flight away from Argentina because markets are beginning to wonder if Argentina can stand the pressure of maintaining a currency peg that is implicit in a currency board.

A currency board is a pretty drastic solution. It is the equivalent of tying yourself to the mast heading into a serious storm. You had better make it through. Otherwise, it is going to be very painful.

One by one the currency pegs in emerging markets, Asia, Russia and Latin America, have given way. In fact, the experience of countries like Mexico that have maintained a flexible currency policy since 1995 and Australia, with its floating currency, have both suffered less from the problems of excess capacity that have plagued emerging market economies since 1977.

I am going to skip over to what I think is one of the most serious problems today that is related to the currency regime since I see I am short on time.

Chairman LEACH. Let me say, I am going to be lenient with the time.

Mr. MAKIN. Well, in that case, OK. OK. Returning then to the emerging markets situation. Page 23 PREV PAGE TOP OF DOC

The IMF's approach to forcing currency fixity on developing economies is especially disruptive in emerging markets. I am skipping over to the top of page 3 here. Beyond forcing deflationary policies on those countries, it forces IMF officials to make dire statements about the consequences should the currency pegs be broken.

And then I am going through the comments I made about Russia already.

Skipping down to the next paragraph, the latest example of an ill-advised effort to peg the currency of an emerging market came in the case of Brazil. In November of 1998, a Brazilian package was put in place that included a commitment by the Brazilians to maintain a currency peg. In January of 1999, the Brazilians were forced to allow their currency to be devalued in the face of heavy deflationary pressure. Since then, the Brazilian situation has stabilized somewhat due partly to the accommodative monetary stance of the Federal Reserve at the time and its favorable effect on global financial markets.

China is the remaining developing country that has maintained a currency peg at the expense of rising deflationary pressure. Since the Chinese currency is not convertible, it is feasible for China to maintain a quasi-currency peg. Its currency really isn't traded in markets, but it is not advisable. China continues to suffer from considerable excess capacity and a broad set of problems associated with too much state lending to nonviable, state-owned enterprises. Again, while all of these problems would not be addressed by allowing the currency to float, insisting on maintaining the peg of the Chinese currency to the dollar has made China's deflationary problem worse. Page 24 PREV PAGE TOP OF DOC Now, I turn to point five, Japan. Today's most serious deflationary problem, Japan, could be somewhat alleviated by a viable policy of easier money that would include a sharp depreciation of the yen. This would help Japan in two ways. It would avoid the deflationary consequence of a shrinking export sector, which, by the way, produced a drag of 1.2 percentage points on Japan's negative 3.5 percent growth rate during the fourth quarter of last year. The ill-advised U.S. policy to push up the yen last June resulted in increased deflationary pressure in Japan and in the global economy and contributed to the difficulties in Asia and the rest of the world over the balance of 1998.

A second reason to allow a weaker currency associated with a reflationary monetary in Japan would be to accelerate restructuring there. Many valuable franchises exist in Japan that foreign investors would buy at an accelerating pace given a cheaper yen. Japan desperately needs to accelerate the restructuring of its economy, but domestic managers appear reluctant to follow this course. A weaker yen that accelerates purchases by American and European businesses of Japanese enterprises would accelerate the restructuring process and help Japan start to contribute to world economic growth.

Pressures for a return to exchange rate fixity continue unabated in many official circles in today's economy. G–7 ministers, especially those in Europe and Japan, constantly propose efforts to re-peg currencies as a means to stabilize capital markets. The experience of the last 30 years, some of which I have touched on here today, demonstrates that pegging currencies where monetary policies are not fully coordinated is, in fact, destabilizing.

The only way I can account for the official preoccupation with pegging exchange rates in much of the global economy today is to suggest a confusion in the minds of many policymakers whose primary preoccupation in the post-war period has been fighting inflation. Today, 20 years after the battle against global inflation was being fought, many of these central bankers at the IMF and elsewhere have replaced the productive goal of avoiding inflation during an era of excess demand such as prevailed through the early 1980's with the deflationary goal of presenting currency devaluations during an era of excess supply that has emerged late in the 20th Century. Page 25 PREV PAGE TOP OF DOC

The prevalence today of excess capacity has meant that the battle of currency devaluations has been lost in the developing countries of the world with the list of losers extending from Thailand, Indonesia and South Korea in 1987 to Russia in 1998 and Brazil in 1999. In fact, after deflation most of these countries have experienced relief from the deflationary pressures that attempting to maintain currency pegs have brought on, although the problems of Indonesia and Russia go well beyond those associated with a currency regime. Still, currency devaluations have proved preferable to currency pegging in the deflationary world that has emerged in the late 1990's.

Mr. Chairman, I have appended to my testimony a longer paper which examines the experience of countries after they have allowed their currencies to adjust; and, generally, it has been favorable. This is not to suggest that devaluations are a cure-all but merely to suggest, in effect, that to say that currencies can be pegged has proved highly misleading, both in the financial markets and to individuals trying to operate in the economies where the currency has been pegged.

Thank you.

Chairman LEACH. Thank you, Dr. Makin.

Dr. Frankel.

STATEMENT OF JEFFREY A. FRANKEL, VISITING FELLOW IN ECONOMICS, BROOKINGS INSTITUTION Page 26 PREV PAGE TOP OF DOC

Mr. FRANKEL. Thank you, Mr. Chairman. It is a pleasure to be here.

The international financial policymaking community has, over the last eight months, made a variety of reforms to try to reduce the frequency and severity of international financial crises—steps to improve transparency, strengthen financial systems, and involve the private sector more fully in rescue packages. Some critics have pronounced these steps too small to merit the title ''new financial architecture'' and have said they are more like remodeling the house or, at most, redoing the wiring and the plumbing. Whether or not that characterization is right, I consider these steps to have been useful.

There are several areas where reform would be so fundamental as to merit unquestionably the appellation ''new financial architecture.'' One is the question of whether there should be a global lender of last resort and how big it should be. Another is the question of further liberalization of international capital flows and how rapid it should be. But in this session we are concentrating on the third question, exchange rate regimes and how flexible they should be.

My overall theme is no single currency regime is right for all countries or at all times. The choice of exchange rate regime should depend on the particular circumstances facing the country in question. And that proposition may sound obvious, but I think it needs to be said. There are some who have drawn lessons from recent experience that they are in danger of overgeneralizing, of applying to all countries regardless of the particular circumstances. Page 27 PREV PAGE TOP OF DOC One proposition is a country should generally move to increased exchange rate flexibility. I hear this from policymakers who have tried to help fight speculative pressures against exchange rate targets in recent years and countries where the attempt ended in a costly crash—Thailand, Korea, Indonesia, Russia, Brazil, Mexico five years ago.

When exchange rates float, there is no target that needs defending. On the other hand, a diametrically opposed proposition is that all countries should move toward enhanced exchange rate fixity. After all, none of those crisis-impacted countries had been literally or formally fixed to the dollar.

Enthusiasts point to currency boards that have successfully weathered the storm in Hong Kong and Argentina. Some go even further and suggest official dollarization, taking encouragement from the euro-eleven's successful move to a common currency on January first, a project that has gone more smoothly than most American economists forecast as recently as a few years ago.

I think we have on this panel proponents for each of the three alternatives—float, fix and intermediate. What is the right answer? My own position is that it is indeed appropriate that some countries, including the crisis currencies, for the time being, float. It is also appropriate for some other countries, such as small countries in Central America and perhaps even Argentina, to dollarize.

It might sound like I am going to next subscribe to a proposition that has become quite popular recently, that countries in general must move to the extremes, either direction of free floating or firm fixing, but that the intermediate regime, such as the target zones that Fred Bergsten favors, are no longer tenable. Page 28 PREV PAGE TOP OF DOC

I believe that that proposition, too, is in danger of being overgeneralized. Each exchange rate regime, including the intermediate ones, is right for some countries and at some times.

By my count, there are nine major exchange rate regimes. I am going to list them quickly, ranged along the continuum from the most flexible to the most fixed. The definitions appear in my written testimony on page 3. I am not going to define them here.

First is free floating. Second is managed float. Third is target zone or band. Fourth is basket peg. Fifth is crawling peg—and I should mention that some of these can be combined. Sixth is adjustable peg. Seven is a really truly fixed peg. Eight is the currency board. And nine is monetary union, which includes the special case of official dollarization.

Economists believe that most decisions involve tradeoffs. The choice of exchange rate regime is a tradeoff between the advantages of fixing and the advantages of floating. The main advantages of each can be stated succinctly. The two big advantages of fixing the exchange rate for any country are, first, to reduce transactions costs and exchange rate risk which can discourage trade and investment; and, second, to provide a credible anchor for noninflationary monetary policy.

The big advantage of a floating exchange rate, on the other hand, is the ability to pursue an independent monetary policy. When an economy suffers a downturn, it may want to soften the impact via a monetary expansion and/or a devaluation; and, for either response, it needs an independent currency. For some countries, perhaps a majority, the exchange rate regime that optimally trades off the advantages of stability with the advantages of flexibility is probably somewhere in the middle in between firm fixing and free floating. And on the list that I read of the nine, I would classify regimes three through six as the intermediate regimes as distinct from the extreme corners. Page 29 PREV PAGE TOP OF DOC

But what are the characteristics that make a country more suited for fixity rather than flexibility? There is a classic list which goes as follows: small size, openness to trade, high labor mobility, availability of a fiscal mechanism to cushion downturns, and a high correlation of the local business cycle with that of the country to which a currency peg is contemplated. These attributes are well-known among economists as criteria for political units to join in a so-called optimum currency area. Countries that have these characteristics are likely to see big benefits from exchange rate stability and are also less likely to have need for monetary independence in the first place. Easy examples are the Panamanian link to the dollar and Luxembourg's link to the euro.

As a result of recent history, I would be inclined to modify the list of criteria, particularly if we are talking about prerequisites for the most rigid institutional arrangements—a currency board or full dollarization or monetary union. Argentina, for example, is not an especially small open economy, but it has had a currency board since 1991 that has been largely successful in the face of severe challenges. The Argentine government announced in January that it was considering going even further, abandoning the peso altogether in favor of full and official adoption of the U.S. dollar as legal tender.

I would add to the list of criteria for firm fixing several things. First and foremost, a strong need to import monetary and financial stability, perhaps even a desperate need, due to a history of hyperinflation, or an absence of credible public institutions, or unusually large exposure to nervous investors. The willingness of Argentina to give up monetary independence derives from its past history of hyperinflation and the domestic political consensus that the experience must not be repeated. Page 30 PREV PAGE TOP OF DOC

The next requirements are access to an adequate level of reserves and a strong well-supervised financial system. Otherwise, the country might simply convert currency-crisis vulnerability into banking-crisis vulnerability.

Finally, the existence of the rule of law is a necessary condition for a currency board, though not necessarily for dollarization. Proclaiming a currency board does not, as sometimes implied, automatically guarantee the credibility of a fixed peg. Little credibility is gained from putting an exchange rate peg into the law in a country where laws are not heeded or are changed at will. A currency board is not credibility in a bottle. It is unlikely to be successful unless accompanied by solid fundamentals.

In the case of full monetary union, another desirable characteristic is a willingness of the foreign country whose currency is used to allow input into monetary policy, or at least to share seigniorage as the Europeans are doing. Now, Argentina understands that it is not going to be given a vote on U.S. monetary policy. In that sense, dollarization in Latin America differs quite fundamentally from the sort of monetary union that has taken place in Europe. The Argentines would like some sort official agreement with the United States if they were to decide to go ahead and dollarize, including some sharing of seignorage revenue. This is a perfectly reasonable request. For the U.S. to get all the seignorage would amount to a de facto transfer from Argentine citizens to our Treasury, but my reading is that we are unlikely to give it to them.

Even so, it might be worthwhile for Argentina or, especially, some smaller countries located closer to the United States to dollarize unilaterally, provided they have sufficient political support domestically to abandon all monetary sovereignty. In the past, giving up the domestic currency has been a complete political nonstarter for virtually all countries, regardless of the economics, but the world has changed, as illustrated by the fact that talk of dollarization in January was said to have actually earned the current Argentine president positive political popularity, rather than the reverse. Page 31 PREV PAGE TOP OF DOC

The case in favor of currency boards or dollarization for some of these countries is somewhat stronger than in the past, in light of recent experience. What I have in mind is that emerging market countries have found that an independent monetary policy has not, in practice, been a useful instrument. A standard argument against rigidly fixing the exchange rate in terms of the currency of a particular partner is that it requires that the country be subject to the same monetary policy as that of the partner. Now, it is true that when the Fed raises interest rates, that increase is rapidly and fully passed through to Panama, Hong Kong and Argentina, even though it may not be appropriate to local economic conditions. But the situation is even worse than that for countries such as Brazil and Mexico that have only loose links to the dollar. There an increase in U.S. interest rates has a big negative effect on capital inflows and, on average, causes the local interest rates to rise by even more than the U.S. increase.

International investors are nervous without the airtight currency peg. They require an extra premium to compensate them for perceptions of risk. Well, if monetary independence is not a tool that emerging market countries currently can use effectively, then they are not giving up very much if they give up their currencies.

All right. So fixing is right for some countries. It is not right for all countries. To begin with a case at the opposite extreme, the United States clearly meets the criterion for an independent free-floating currency. We have a large economy. Thus, the States of the Union are more highly integrated with each other than they are with the rest of the world. There is more movement of trade, labor and fiscal transfers within our borders and a higher correlation of a business cycle within our borders than across our borders. Page 32 PREV PAGE TOP OF DOC Fluctuations in the exchange rate are simply not as important to us as they are to most countries. Furthermore, we have a strong and well-functioning central bank, and we have the confidence of international investors. We do not want to have to subordinate our monetary policies to conditions abroad. Thus, the advantages of floating overwhelm the advantages of fixing.

I have got a page more on U.S. policy and intervention, but I think our focus here is a little more on the emerging markets; is that right?

Chairman LEACH. It is. I have a little flexibility in time. I would rather you wouldn't go massively over, however.

Mr. FRANKEL. I will——

Chairman LEACH. All of your statements in full will be placed in the record.

Mr. FRANK. Think of the time as a crawling peg. It is not fixed, but it is not free-floating either.

Chairman LEACH. But don't think members of this panel are appropriate members of the currency board. Please go ahead.

Mr. FRANKEL. I will. Page 33 PREV PAGE TOP OF DOC I want to cover one more topic, intermediate exchange rate regimes, like crawls and bands. Most countries are somewhere in between the United States and Luxembourg. Until recently, many experts believed that countries that were intermediate with respect to size, openness and the other optimum currency area criteria were probably suited to intermediate exchange rate regimes. Suddenly the view has become common that such regimes are not sustainable in a world of large-scale financial flows and that countries are being pushed to the corners of either firm fixing or free floating.

Recent history makes it understandable that some would flee the soft middle ground of the intermediate regimes and seek the bedrock of the corners. Monetary union and pure floating are the two regimes that cannot be subjected to speculative attack. Most of the intermediate regimes have been tried and failed, often spectacularly so. Mexico, Thailand, Indonesia, Korea, Russia, Brazil were all following varieties of bands, baskets and crawling pegs when they crashed.

Perhaps when international investors are lacking in confidence and risk tolerance, the conditions that have characterized emerging markets during the last two years, governments can reclaim confidence only by proclaiming policies that are so simple and so transparent that investors can verify instantly that the government is doing in fact what it claims to be doing. Market participants can verify the announcement of a simple dollar peg simply by looking up today's exchange rate and seeing if it differs from yesterday's.

An alternative interpretation is that the search for a single regime that will eliminate currency speculation as an issue is a search that cannot be successful, short perhaps of restrictions on international capital flows. The rejection of the middle ground would then be explained simply as a rejection of where most countries have been recently, with no reasonable expectation that the sanctuaries of monetary union or free floating will, in fact, be any better. The grass is always greener at the corners of the pasture if you previously have been grazing in the middle. Only when you have spent some time in the corners does the middle start to look good again. Page 34 PREV PAGE TOP OF DOC

To conclude, I suspect many countries are fated to switch back and forth among various regimes over time. If this is right, the only recommendation that one can give most central bankers in vulnerable countries, excepting those whose country characteristics suit them for a corner solution, is to keep alert to any serious signs of overvaluation. A blanket recommendation to avoid the middle regimes in favor of firm fixing or free floating, one or the other, would not be appropriate. Thank you, Mr. Chairman.

Chairman LEACH. Thank you.

Dr. Shelton.

STATEMENT OF JUDY SHELTON, ECONOMIST AND AUTHOR OF ''MONEY MELTDOWN: RESTORING ORDER TO THE GLOBAL CURRENCY SYSTEM''

Ms. SHELTON. Mr. Chairman, Members of the committee, I consider it a great privilege to have this opportunity to express my views on the subject of international monetary relations, so I will try to be brief and focus on just those key points I would hope to convey this morning.

I must say to Mr. Bachus that your concern about the human impact of currency instability goes to the heart of the problem. Monetary regimes are not created in the cosmos. They are invented by people. And presumably monetary regimes are meant to help people carry out those other economic transactions they engage in for their daily survival and to build their dreams. Page 35 PREV PAGE TOP OF DOC

Citizens are generally a captive audience to the legal tender laws of their country. Therefore, I believe governments have a moral responsibility to deliver stable money. Remember, money is meant to serve as a reliable unit of account and as a meaningful store of value.

Mr. Chairman, you made reference to the continuing saga in the former Soviet Union. That is an issue that still pains me very much. I think the lack of credibility of the ruble contributes greatly to their problems. After my work in that area, I subsequently started focusing on the economic and financial problems caused by our lack of a rational international monetary system.

In early 1995, I received an offer to become Professor of International Finance at a graduate business school in Mexico, in Monterrey, which I accepted. I think it is important to personally witness the impact of devaluation on people's lives and their dreams. I can tell you that it is very discouraging. You see these bright young entrepreneurial MBA students in Monterrey; they believe what we tell them about the magic of Silicon Valley. We teach them that if you develop an innovative idea, if you have a good plan, you will be able to contribute to society and improve economic welfare. Of course, the financial capital will be made available to you to carry out the plan.

It is not so in countries such as Mexico. To get a venture capital loan is almost impossible. If you can get it, you have to pay 28 percent; even a brilliant plan that in Silicon Valley would find angels to support it is not going to prove profitable when the cost of capital is so high. The reason it is so high in Mexico—and I testified at the Senate Banking hearing last month on this dollarization issue—is because you must pay a premium to investors to supply financial capital. Why? Because the currency lacks credibility. Page 36 PREV PAGE TOP OF DOC

There is a sense in Mexico, part of the political psyche, that every six years there will be a devaluation. They have a presidential election coming up next year. In my mind it is not coincidental that people are talking about dollarization in Mexico. They are saying: ''Don't let this happen again.'' It is so disillusioning to the human spirit to have the monetary rug pulled out from beneath a society. It is so discouraging.

The committee showed great foresight in scheduling this hearing on exchange rate stability just the day after your hearing on the architecture of international finance. By the way, I listened to it on C-SPAN radio from 10 to 4:30 yesterday. So I know you were hard at work all day. I certainly believe currency chaos has been a major factor in recent global financial turmoil. Establishing an orderly international monetary system would be a tremendous boon to global financial stability and would contribute significantly to productive economic growth around the world.

There are three main observations I wish to emphasize today. One, the world is in a critical transition phase of monetary relations with many emerging market countries openly debating their various currency options; two, the United States is in a strong position to exercise leadership toward the design and implementation of a new exchange rate regime or monetary order to serve the needs of an open global economy; and three, the continued expansion of free trade, the increased integration of financial markets and the advent of electronic commerce are all working to bring about the need for an international monetary standard, a global unit of account.

This last observation has a crucial bearing on the likely direction of exchange rate relations in the future. Regional currency unions seem to be the next step in the evolution toward some kind of global monetary order. Europe has already adopted a single currency. Asia may organize into a regional currency block to offer protection against speculative assaults on the individual currencies of weaker nations. Numerous countries in Latin America are considering currency union or dollarization to insulate them from financial contagion and avoid the economic consequences of devaluation. Page 37 PREV PAGE TOP OF DOC

Now, an important question is whether this process of monetary evolution will be intelligently directed or whether it will simply be driven by events. In my opinion, political leadership can play a decisive role in helping to build a more orderly, rational monetary system than the current free-for-all approach to exchange rate relations. So I would urge Congress to help ensure that the United States take the initiative on this crucial economic issue.

The evolution of monetary relations may proceed largely on its own, propelled by the desire of some nations to replace their national money with the local dominant currency or by technological innovations offering new forms of private electronic money that could potentially outperform government-issued currencies. In any event, it is imperative that the United States begin to develop and put forward its own global monetary vision for the future.

What exchange rate regime or currency order would best facilitate international trade and the most productive use of global financial capital? What kind of international monetary system is most in keeping with U.S. economic principles to support entrepreneurial endeavor and free markets?

My own view is that a fixed-exchange rate system or common currency provides the optimal monetary platform to maximize the benefits from free trade and improve global living standards. Floating rates, while appealing in theory, have proved damaging in practice. Governments too often seek to manipulate the value of their currencies, and the resulting dirty float serves to disturb pricing signals across borders.

But in recommending a fixed-exchange rate approach or common currency, let me be clear in saying that only a strict mechanism based on a universal reserve asset and guaranteed convertibility for individuals would be desirable and prove sustainable. An exchange rate regime predicated on the oxymoronic notion of controlled flexibility that would attempt to maintain pegged rates or target zones through central bank intervention and currency markets is highly undesirable and unworkable. Page 38 PREV PAGE TOP OF DOC

Our overall objectives should be to facilitate free market capitalism, which works best when the monetary unit of account conveys the same information to both buyers and sellers. The doctrine of comparative advantage is the rationale for free trade. All participants are better off when they produce those goods and services most appropriate for their economy and then have the chance to offer those products or investment opportunities in the international marketplace.

As Professor Robert Mundell of Columbia University has observed, ''the only closed economy is the world economy.'' The world economy today is rapidly becoming a global common market. As we have seen in Europe, the sequence of development is first you build a common market; and second, you establish a common currency. Indeed, until you have a common currency, you don't truly have an efficient common market. Instead you have a fragmented market with participants relying on different units of account to provide a crude monetary frame of reference for assessing value. Moreover, those units are constantly fluctuating against each other.

Remember that the ultimate purpose of floating rates was to stabilize exchange rates. The goal of any monetary system is to provide a stable frame of reference for evaluating the relative appeal of goods and services for investment opportunities wherever they may be available. When a premium must be paid to compensate investors for the risk of foreign exchange loss, or where competitive depreciation permits some sellers to underprice their goods at the expense of others, markets are compromised. Financial instability results when market participants recognize that currencies do not accurately reflect the true value of competing products and investments in the global marketplace. Page 39 PREV PAGE TOP OF DOC In short, the United States should seek to guide the process toward a stable global monetary system. What we can already glean from Europe's bold experiment is that while a common currency helps to realize the economic gains to consumers and producers from transparency and competitive pricing, integrity of the currency itself cannot be merely vouchsafed by officials from the European central bank. Meanwhile, the United States offers the world's best brand of money in terms of its performance as a unit of account, store of value, and medium of exchange, but the perceived integrity of our money is highly dependent on one very competent chief central banker.

Ideally every nation should stand willing to convert its currency from a fixed rate into a universal reserve asset. That would automatically create a global monetary unit based on a common unit of account. The alternative path to a stable monetary order is to forge a common currency anchored to an asset of intrinsic value. While the current momentum of dollarization should be encouraged, especially for Mexico and Canada, in the end the stability of the global monetary order should not rest on any single nation. Thank you.

Chairman LEACH. Thank you, Dr. Shelton.

Dr. Chari.

STATEMENT OF V.V. CHARI, CHAIR AND PROFESSOR OF ECONOMICS, DEPARTMENT OF ECONOMICS, UNIVERSITY OF MINNESOTA; ADVISER, FEDERAL RESERVE BANK OF MINNEAPOLIS

Mr. CHARI. Mr. Chairman, Members of the committee, I am very glad to bring a Midwestern perspective to the thinking. I should start by saying that this is not actually a Midwestern perspective. It is very much my own. In particular, it doesn't reflect anything, any views of the Federal Reserve Bank of Minneapolis or the Federal Reserve System of which I am associated. Page 40 PREV PAGE TOP OF DOC

We in the Midwest like to flatter ourselves that our distance from the turbulence of everyday policymaking allows us to be more reflective and somewhat more intellectual in thinking about issues, and so I will take a somewhat more reflective attitude this morning.

I think we should start by recognizing that exchange rate regimes are not an end. The end, as Representative Bachus suggested, is presumably the well-being and economic prosperity of our citizens and the people of the world. Exchange rate regimes are not even the means to an end. There is no particular virtue, for example, in fixing the exchange rate between goods bought in dollars and that bought in pound sterling. Rather the view I want to take is that exchange rate regimes are the means to the means to an end.

Exchange rate regimes are desirable to the extent that they impose discipline and impose constraints on the conduct of monetary policy. In taking this perspective, it is actually useful to start with a simple observation about monetary policy. Monetary expansions, especially when they are larger than was generally expected, tend to raise employment and economic activity in the short term and tend to raise prices and inflation and thereby dislocate economic activity over the longer term.

This observation implies that there are strong incentives for policymakers to pursue unduly expansionary monetary policy and let future policymakers bear the costs of the resulting inflation and dislocation in economic activity. These temptations often become irresistible in economic downturns and in times of extensive extreme economic distress. Unless monetary policy is constrained in some fashion, markets and economic actors in the private sector come to expect erratic and inflationary monetary policy, and employment economic activity in general can be severely reduced on average. This is the cost of unconstrained discretionary monetary policy. Page 41 PREV PAGE TOP OF DOC

Over the course of the last 100 years or so in both the developed and the developing world, countries, societies, have understood this problem and have attempted a variety of ways to rein in discretionary monetary policy. During the gold standard era, for example, monetary policy was constrained by the commitment to exchange domestic currency for gold at a fixed rate. During the Bretton Woods era immediately after World War II, monetary policy was constrained by agreements that exchange rates would not be altered unilaterally.

Over the last 25 years, countries, especially in the developing world, have looked for a variety of other ways to discipline monetary policy. The principal challenge here is to devise mechanisms that would convince markets that monetary policy will be conducted responsibly now and in the future.

Why exchange rate regimes? One reason is that fixed exchange rate regimes are relatively transparent and easy to monitor for private citizens. All you have to do is to slap the pesos on the table and watch to see if you get dollars at the promised exchange rate. You don't have to delve into the arcana of reserve requirements of various stances of monetary policy, of monetary aggregates and so on. In short, you don't have to be an expert economist. All you have to do is to see if they are willing to exchange pesos for dollars at the promised rate. That is one of the attractive features of fixed exchange rates, that it is a transparent form of committing oneself to monetary policy.

On the other hand, one should remember that the incentives to deviate from some promised monetary policy are also often large. The fact that those incentives are large implies that absent some other commitment device, monetary authorities, especially in the developing countries, will have strong incentives at some point to deviate from the promised policy. Page 42 PREV PAGE TOP OF DOC

The experience with monetary policy has been a fairly unhappy one in most developing countries and arguably even in most developed countries. As far as developed countries are concerned, Milton Freedman for one has argued pretty convincingly, I think, that the Great Depression was a consequence of bad monetary policy. There is essentially unanimous consensus in the economics profession that the great inflation of the 1970's and the early 1980's was a consequence of bad monetary policy. So it is clear that bad monetary policy in some sense can impose substantial severe costs on the citizens of the world. And so it is, I think, a critical issue to find ways of disciplining monetary policy.

In my view, I think one of the main reasons why our experiences with monetary policy in both the developed and the developing world have been so unhappy is that monetary authorities have been unwilling to be precise and clear about the kinds of rules that they would follow in the future. It is not enough to say, ''I promise to maintain the exchange rate at a particular level as long as I feel like it.'' What you really do need to say is what you are going to do in a variety of different kinds of circumstances.

Typically it is simply not credible to say, ''I will maintain this exchange rate forever.'' Especially in developing countries, all too often the practice has been the following: The government says it will peg the exchange rate of domestic currency to the dollar. Nobody really believes that this commitment is indefinite or will be adhered to regardless of circumstances. Inevitably when pressures in the exchange rate rise, the government is forced to devalue, so the problem is that by not committing to an explicit rule for the future conduct of monetary policy, confidence is undermined in monetary policy and in institutions in general. Page 43 PREV PAGE TOP OF DOC Currency boards are an example of a particular kind of commitment device and can serve a useful role. I must say, though, that I think, quite frankly, most developing countries would be far better off, given the experience that they have gone through, to give up the use of their currencies altogether. For far too many developing countries, currencies of their own are a lot like national airlines. It is a vanity they cannot afford, but one that they feel compelled to possess.

Given this vanity, let's ask ourselves how we can live with this political reality. Currency boards can be useful precisely because they constrain monetary policy so severely. The constraint on monetary policy implies necessarily that the monetary authority's ability to act as a lender of last resort is constrained. That is the whole point, and that is the purpose of having an institution like that.

The question is how necessary is it that central banks must act as lenders of last resort, especially in developing countries. The conventional defense of the need for a lender of last resort comes from the observation that in a world with fractional reserve banking, banks can be subject to a variety of runs, panics, and the like, and that having a central bank that acts as a lender of last resort might help to stem these panics when they do occur.

The thing is that for a vast majority of developing countries, it is not obvious that you need a lender of last resort or that alternatives do not exist. One alternative, which is available to a number of these countries, is, in fact, to allow for relatively free and unfettered access to financial markets. If domestic banks can borrow from abroad or can sell their assets to foreigners, then in the event of a panic or a run on their deposits, they may be able to sell their assets to foreigners and thereby be able to pay off their depositors and thereby stem the possibility of a panic in the first place. Page 44 PREV PAGE TOP OF DOC

This observation leads to the implication that countries that wish to use currency boards as mechanisms to discipline and constrain their monetary policy in the future probably should also adopt relatively unfettered access to international financial markets. Failing to do that means necessarily setting up currency boards up for disaster.

The bottom line then is that economic theory and economic history tell us that discretionary monetary policy framed in the notion that somehow central bankers know best what to do is too often a recipe for disaster. It is essential for us to devise mechanisms to constrain the conduct and performance of monetary policy.

Pegging exchange rate systems typically do not impose the kinds of constraints on monetary policy that seem necessary and desirable. Currency boards perhaps go one step in the right direction. They do open themselves up to a variety of serious risks, but those risks, in my view, can perhaps be circumvented.

Thank you.

Chairman LEACH. Thank you all very much. There isn't a great deal of consensus here, but there is one circumstance where I think there is consensus—and I particularly tip my hat to Dr. Bergsten. I think for as long a period of time as I have been in public life, Dr. Bergsten has emphasized the importance of currency relationships, and I think that is an underpinning that everybody has—that currency values do matter. They matter to big countries. They matter to small countries. They have enormous macroeconomic effects. Page 45 PREV PAGE TOP OF DOC On the other hand, I happen to think that Dr. Makin is correct in his assumption that if you judge floating rates versus fixed-rate regimes in a traditional way, the floating rate argument is absolutely compelling. And I see no defense of fixed-rate regimes in the traditional sense.

Then the interesting question that the economics community and some of you reflected today is are there new approaches to fixed-rate regimes that might have some attractiveness to one country or another or groups of countries. And here there appears to be some differences of opinion, but lots of new ideas. I am intrigued from a political point of view. I frequently argue that one of the wisest decisions of the century was the devolution of monetary control from Congress to a central bank, and yet we have reflected here some concerns about giving central banks too much discretion. And one of the things that I think Dr. Makin has pinpointed is when he says, ''I don't know what the right relationships are between currencies at any given point in time,'' it is pretty self-apparent that nobody does, and that therefore, if one believes in free markets, it is hard to argue against floating circumstances and you let the markets dictate. But we all recognize there are problems in globalization that put some whims in the market.

But I was impressed in the Brazilian circumstance where the Brazilians in a very unnoted way caused a great deal of investment from the outside, that is, from the international financial institutions, to protect their currency without giving up any of their own. They took advantage of the IMF, but that the second they announced a flexible exchange rate, stability appeared on the scene, and that it appeared that flexibility was stabilizing and rigidity was destabilizing, which was not totally intuitive, and therefore I think that fits well in the Makin argument. Page 46 PREV PAGE TOP OF DOC

But what I would like to ask Dr. Makin is, as you listen to several of these alternatives, none of which are defenses of old-fashioned fixed rates, but rather are new constructs of attempts to devise a more orderly system, if you find any of these arguments compelling, or each loaded with the same kinds of problems that exist with an old-fashioned fixed-rate regime?

Mr. MAKIN. Thank you, Mr. Chairman. As I listened to each of my colleagues testifying, I was struck by how much I agreed with the objective, which is to create a stable monetary system that works globally and serves the interests of the people who are living under the system. I suppose my point has been that while it is very appealing to suggest that stable exchange rates are desirable, it is misleading to suggest that they are possible, and that is based on the experience that we have seen since 1971. Prior to that, a period of fixed exchange rates, at least through the 1967 period when the British were forced to devalue, served us reasonably well because of the dominance of the United States in post-World War II. But since then, central banks have simply not in practice been prepared to accept the constraints on their own activities that are implied by pegging a currency.

Of course, we are left with the question of pegging to what. Today it seems to be that most people suggest if they are in favor of pegging, pegging to the dollar, because our own central bank has done such a good job, but that might change again.

So the thing that strikes me is I certainly admire—I share the goals that everyone has put forward here, but my reading of the last 30 years is that the reality is that probably the kindest and most realistic thing we can suggest is that currencies will fluctuate. Page 47 PREV PAGE TOP OF DOC

I want to make one second point, and that is that in the past several years, the pressure in the global economy has been coming from excess capacity and deflation. We are so used in the postwar periods of dealing with inflation and the problems that go with that. In a deflationary world with excess capacity, defending a currency peg is often itself deflationary and very damaging to economies, very damaging to the well-being of people within those economies, and I think we saw that adequately demonstrated in Asia, partly in Russia, in Latin America as well.

So that I think it is necessary to recognize that defending a currency, defending a peg which may seem desirable as a deflationary exercise and could be dangerous, and there I point specifically to the case of Japan where the need for reflationary activity would suggest a weaker currency that some would oppose on the idea that the currency ought to be stable, but I am afraid that argument is an argument for deflation that Japan can't stand right now. Thank you.

Chairman LEACH. Let me turn to several of the other panelists on this question, but first to Fred, because you were able to follow Fred. I think Fred ought to be able to respond to you in one sense.

Fred, I will tell you one of the things you said that I am not sure is not wrong-headed is you indicated that by going to a free-floating currency, government officials then could take less responsibility. It is my assumption that when you have flexible rates, that that forces accountability on central banks and fiscal policymakers, not the reverse; that is, that trying to keep some sort of rigid currency relationship with somehow outside groups, the IMF or your own reserves coming in, is a defense of the irresponsible, and that flexible rates is another way to put accountability into both the fiscal and monetary authorities, not the reverse. That is my assumption, but you have come to the exact opposite conclusion, and I am not sure just why. Page 48 PREV PAGE TOP OF DOC

Mr. BERGSTEN. The reason is that officials, including heads of state, have almost always preferred to blame problems on the speculators and the markets rather than taking responsibility for what they have done—from British Prime Ministers of the 1960's, when sterling was devalued, to Richard Nixon, when he took the dollar off gold in 1971 here, or Mohamad Mahathir in Malaysia most recently. If rates are floating, they can more easily blame it on the speculators, or on the markets, for carrying the rates to levels that they abdicate responsibility for.

Think back to when the dollar soared in the first half of the 1980's and made even the most competitive American firms very uncompetitive in world markets, threw us into huge trade deficit, threw us into huge protectionist trade measures that you all felt here on the Hill and changed us from the world's largest creditor to the world's largest debtor country in three or four years. When one asked the Reagan Administration, and particularly the Regan Treasury, how this could possibly be happening and what were they doing about it, they shrugged their shoulders and said, ''Don't look at us. It is the markets.'' That is the point I am trying to generalize.

I agree that you can read it different ways in different circumstances, but that, I think, is a handy cop out for people—running from heads of states down to the bureaucratic level—who want to fend off pressure that otherwise might healthily be put on them by one of these regimes we are talking about.

Chairman LEACH. Fair enough. Page 49 PREV PAGE TOP OF DOC Let me give the other panelists a chance to respond, and then I want to turn to the other questions. Part of the assumption of going to anything that is fixed at all is that there are people that can intervene to defend the fixations, and that the intervention has to come from governments or collections of governments. Is there enough money in the governments of the world to defend against all the private capital flows, and if there isn't, is this all an idea that is just idealistic and not practical?

Mr. BERGSTEN. Could I just say one more thing, Mr. Chairman? I think some of the differences between us in part at least, are semantic. John Makin, in his original remarks at least, tended to characterize target zones as a variant of fixed exchange rates when he said targeting doesn't work. That is just conceptually wrong.

Jeff Frankel, in his nice taxonomy, listed target zones as on intermediate regime, but if you want to think of it as closer to one or the other, I think it is a flexible-rate regime. My target zones have very wide bands—plus or minus 10 or 15 percent. Rates would float almost all the time. The only issue is whether you set some predetermined and maybe preannounced points at which you would intervene.

Jeff Frankel said, for the United States, the U.S. should intervene from time to time. I regard that as putting him in my camp. I am not talking about narrow bands with frequent intervention, but rather something quite wide, where the only goal is to avoid the big misalignments.

Now, Makin asks, ''How do you know whether rates are right or not?'' Well, you have to make some judgments as to what is sustainable in terms of trade balances and effects on your domestic economy. The IMF does that every day now. They make estimates. The methodology has been well developed. It would be applicable, and it would be workable in the real world. Page 50 PREV PAGE TOP OF DOC

Chairman LEACH. Fair enough.

Let's let Dr. Frankel respond.

Mr. BERGSTEN. The question is, is there enough money. Fair enough.

Mr. FRANKEL. Let me just answer your quite correct point that although intervention can have some effect sometimes, if you are going the opposite direction from the direction that the financial markets want to go, there is just a lot more money on the other side, that modern capital markets are so deep and so big that ultimately you can't fight them purely with intervention unless you ultimately are prepared to back it up with monetary policy, which, as Fred says, at some stage is necessary if you want to pursue exchange rate targets or more fixed relationships.

More generally let me try to comment on how we on this panel keep starting at the same point and arriving at different finishing conclusions. I think we all agree, to answer the initial question from Congressman Bachus, that the best way to serve the interests and promote the prosperity of people of any country is, to the maximum extent possible, to rely on free market principles and to limit government intervention when it is not absolutely necessary.

The problem is that the choice of exchange rate regime is just not one of those questions that simple adherence to free market principles or desire for accountability of the monetary authorities is able to solve. The choice between fixing and floating depends on other things. You can take the most fervent pro-laissez-faire economists, and they divide evenly on the issue. Page 51 PREV PAGE TOP OF DOC

I am not going to try to characterize my fellow panelists, but consider the label ''supply-siders'' versus ''monetarists.'' They agree on lots of things. Neither one takes a back seat to the other in their devotion to free market principles. But supply-siders think of the exchange rate as a promise—as Judy Shelton was saying—money is a solemn commitment by the government, they think free market principles imply that the government should to intervene to maintain the exchange rate.

Monetarists come to the exact opposite view. They view the exchange rate as a price, and they think the government shouldn't intervene to set the price. You shouldn't intervene to buy and sell euros to influence the price, just like you shouldn't intervene to buy and sell wheat to influence the price of wheat. You should leave it to the private market. This difference in views is simply something that economic philosophy is not able to settle.

Where that leaves me, as I indicated in my testimony, is that the best regime depends on the circumstances of the country involved. In some cases one is appropriate, and in some cases another.

Chairman LEACH. Thank you.

I think I ought to turn to other panelists, and then we will come back.

Mr. Frank.

Mr. FRANK. Thank you, Mr. Chairman. Page 52 PREV PAGE TOP OF DOC

I thought that last point was very useful, but I should say in the world in which I live, you gave a false analogy when you said people who believe in the free market for wheat. I have been in Congress nineteen years. Apparently there is a footnote in all of the free market economics texts that says, ''this does not apply to agriculture,'' and it can only be read by erstwhile conservatives who believe that the free market works everywhere except in agriculture. Apparently Adam Smith didn't know about agriculture. It was a later development that his principles failed to apply to.

I found this very useful, and, Ms. Shelton, you said you heard it on C-SPAN radio yesterday. I don't understand why C-SPAN isn't here today. The only thing I can think of is they are saving this topic for sweeps week and will be asking us to redo it so they can show it. It does unfortunately confirm one of the most depressing ratios, in my judgment, and that is the inherent importance of public policy discussions is inversely proportional to the amount of attention they generate in the media. This is an extraordinarily important subject to which the media is paying virtually no attention. I say virtually. We have some representation, but it really is too bad, because it is so important, and I have found it very useful.

I want to ask a set of questions that didn't get explicitly touched on, but one of my concerns has been the tendency historically, and by that I really mean the postwar period, post-World War II, to look at international economics in countries or entities, whole and undivided, and the distributive impact of countries has come to our attention. For a long time that didn't make a lot of difference, say, here because I think the United States was almost an entity unto itself. Clearly in recent years people of the United States have become more concerned about the economic impact internally on distributor effects. Page 53 PREV PAGE TOP OF DOC

It is also relevant in the sense—and it goes to the colloquy that the Chairman had with Mr. Bergsten, which is in addition to the—well, we have been pursuing a couple of goals since World War II, one of which, with a great deal of success, has been to democratize many other countries. And public opinion now counts for a lot more in a lot more countries than when we started out with the Bretton Woods agreements, which means that when you are deciding about policy, you have to factor in the ability of the authorities to sell this to electorates much more than we used to, and that is the discussion the Chairman quite reasonably began with Mr. Bergsten, and that also feeds back into the whole distributor effect.

My question is, do the various choices that governments get to make here as to the degree of fixity versus floating in the exchange rates, do they have distributive effects within countries? What is the impact? Is it going to differ from time to time?

I realize that is a whole large subject, but I would like to begin on that because I think that is important to me both in terms of the equities and public policy, but also the question—obviously, some countries have to sacrifice is what we are saying. Does the type of exchange rate regime you have affect who sacrifices more or less, what the affects are on income distribution? I would be interested in the distributive effects.

Mr. Bergsten, let's just begin and go down the line.

Mr. BERGSTEN. The exchange rate itself certainly can have a big distributive effect. I go back to the case I keep referring to because it is familiar here. When the dollar strengthened so greatly in the 1980's, that trashed the tradable goods sector. Much of manufacturing, much of agriculture, which was dependent on exports, were severely hit and, indeed, really didn't come out of the early 1980's recession for a long time because of the huge overvaluation of the currency and the massive trade deficit. Page 54 PREV PAGE TOP OF DOC

At the same time, that overvalued dollar, or strengthening of the dollar, was very helpful to big parts of the nontradable sector. There was a huge capital inflow coming into the country. It pushed our interest rates lower than they otherwise would have been. The strong dollar kept inflation lower than it would otherwise have been. That was good for housing, it was good for a lot of services, and so one big impact of the strong appreciation of the dollar was to redistribute U.S. income away from steelworkers and auto workers to home builders, retailers, and so forth.

The question of whether the exchange rate system affects that would then depend on whether the system had a bias by pushing currencies to be overvalued or undervalued, and I don't think there is such a bias. I, however, would argue that free floating—because it produces these big overshoots both up and down—will exacerbate swings in income distribution that will be destabilizing and anxiety-creating on exactly the grounds that you raise, and therefore adds to trade policy problems. If you have an exchange rate system that permits prolonged misalignments, meaning currency values out of kilter with the underlying economics, then those disadvantaged by that prolonged misalignment are clearly going to look for some kind of compensation, be it trade restrictions or something else, such as agriculture subsidies.

So I think your point is an extremely important one in both economic and political terms. It adds to the case for trying to minimize the instability and particularly prolonged misalignments of exchange rates. That is, frankly, why I search for an intermediate regime such as target zones, which I think try to minimize the problems of the two extremes, both of which go to your problem. Page 55 PREV PAGE TOP OF DOC Mr. FRANK. Could I just go down the line, Mr. Chairman.

Mr. Makin.

Mr. MAKIN. Thank you, Congressman.

Obviously exchange rates have important distributional effects. I agree with Fred on that point. I just have to say parenthetically that although I am flattered, I don't mention target zones in my testimony, and I don't think they are a good idea.

But turning to recent experience in emerging markets in Asia, I mean surely the attempt to peg the Thai baht, for example, or to hold the exchange rate there, to hold the exchange rate in Korea, had tremendous distributional effects; that is, it required, in order to get help from the IMF, some very stringent monetary and fiscal policies that were very disruptive and very harmful to the traded goods sectors in those countries.

My conclusion, however, is the reverse of Fred Bergsten's; that is, it was the desire to maintain the currency peg, especially in situations where there was too much capacity in place, as there is still today in Asia, that the harm comes from trying to maintain a peg that is not sustainable. We are still seeing that problem in China. Every month that goes by sees weaker production figures and lower price data in China and more and more pressure on individuals who had been involved in the traded goods sector.

Indeed, one of the major concerns in China today is that the effort to maintain current policies could lead to widespread disruption. There is a huge unemployed labor force in China partly because of their desire to move away from the large state-owned enterprises, but the currency regime has a tremendous impact. Page 56 PREV PAGE TOP OF DOC

My point in my testimony is simply to suggest that making believe that a peg exchange rate is going to work and then imposing stringent monetary and fiscal policies at the behest of the IMF in the name of keeping the currency peg can be very damaging and actually accentuates the painful redistribution that comes from problems that are being generated elsewhere.

Mr. BERGSTEN. I am not trying to retain pegs. I said it once. I will say it again.

Mr. FRANK. OK.

Mr. Frankel.

Mr. FRANKEL. I do agree completely with Fred Bergsten that a weak currency helps agriculture and much of manufacturing because their products are internationally traded; that a strong currency tends to help services, banking, construction, some other sectors. So there are redistributional effects across sectors to some extent, across regions. But there are also respects in which the distributional effects are not that relevant. First, you can't really divide it into rich and poor. It doesn't have any obvious implications for the distribution of income in that sense.

And second, there is Fred's point regarding direction up and down. The choice of regime fixed versus floating doesn't have any particular bias with respect to that. Page 57 PREV PAGE TOP OF DOC In this case my suggestion, Congressman, would be to keep your eye on the aggregates. In my view, the key criterion is promoting overall growth and prosperity, and the means to that end are monetary stability, openness to trade, minimizing the effect of shocks. Those are the goals.

Mr. FRANK. We will try that out as a mobilizing slogan, ''keep your eye on the aggregates.'' I think that will fit on a bumper sticker.

Ms. SHELTON. I would disagree with that. I think in Mexico after the devaluation, there were very sharply defined distributional effects. The wealthy people didn't suffer. That was part of the scandal. They've got their money to Miami and Dallas, and they were largely unaffected. It was the poor and the middle class who felt the brunt of the economic impact. Inflation always hurts the poor the most because it affects the cost of food, and that is a huge part of their daily budget.

The resulting high interest rates hurt what was a budding middle class in Mexico that had increased social stability. The rates hit 150 percent at one point, within a year of the devaluation, for mortgages on homes and automobiles. People had bought their first homes, their first cars; now keys were being dropped off at the banks. The interest payments were simply too high. The devaluation hurt small business because a lot of those small businesses import their capital equipment from the United States. Suddenly it costs twice as much to pay for them, because it takes twice as many pesos, which is how they receive revenues from the business, to pay off the loan on the equipment from the United States.

So I think deregulation is very much a human issue, a social problem, because it imposes unfair effects on different segments of the population. Page 58 PREV PAGE TOP OF DOC

Mr. FRANK. Thank you.

Dr. Chari.

Mr. CHARI. Exchange rates are not determined in a vacuum, nor are they determined on Mars. Exchange rates reflect to a substantial extent economic fundamentals, in particular fundamentals of monetary and fiscal policy. We are kidding ourselves if we think somehow in the early 1980's, given the combination of U.S. and worldwide monetary and fiscal policy, we could somehow have maintained some other exchange rate system. I think that is just kidding ourselves. Therefore, if we are thinking about the determinants of income distribution, I would suggest that we look at the determinants of policy.

So policy can affect and does affect distribution of income. The question is is there an independent effect through exchange rates? Not much.

Mr. FRANK. Let me just ask a question that might be suggested by the disagreement with Mr. Bergsten and Mr. Makin. Does deciding you are going to allow them freely to float, and you will do nothing to try to policy-influence them, does that remove one of the policy tools you might rely on to deal with the effects?

Mr. CHARI. It actually gives you an additional policy tool; that is, fixing an exchange rate in effect reduces your feasible set of policies to some extent because it imposes a constraint. You can't do certain things that you might otherwise have been able to do. Page 59 PREV PAGE TOP OF DOC

Mr. FRANK. What about trying to influence it, not fixing it but trying to influence it, trying to buy it down or build it up? What about some kind of a middle position?

Mr. CHARI. Any middle position like that is going to affect the distribution of income and is going to affect aggregates, but my guess is the direct effect of whatever policy they are doing, whether it is reducing interest rates or running budget surpluses or deficits, that would be for a starter, and the indirect effect through the exchange rate and through the effect on trade and capital flows and so on is going to be relatively minor.

Mr. FRANK. I am out of time. I would love to continue this at some future time. I think the Chairman has indulged me quite enough.

Chairman LEACH. Mr. Bachus.

Mr. BACHUS. Thank you.

Mr. Chairman, Mr. Ryan first suggested this hearing on exchange rates and its effect on stability. He has a plane to catch. I am going to ask that he go first.

Chairman LEACH. Sure.

Mr. Ryan. Page 60 PREV PAGE TOP OF DOC Mr. RYAN. Thank you, Mr. Chairman. Thank you, Spencer.

This is a fascinating hearing, and I agree with my colleague from Massachusetts that this should be better attended. I cannot think of a more important hearing and more important subject on the issue of international economic policy than this, because all is predicated upon a solid foundation of monetary policy.

I would like to pull back and ask you about what really is at stake here. I think, Dr. Frankel, you really hit the nail on the head, between laissez-faire economists it is either a free float or a full fix, and, Mr. Chairman, you mentioned the free float versus the full fix. It seems at the heart of this is a political philosophy which is in the policy vacuum a free float works very, very well in the vacuum absent meddling personal, political, discretionary behaviors. A full fix usually displaces those things. Everything in between, the intermediates, the pegs, the floats, all these other things have one degree or another of political meddling, personal discretion. And we have not seen this century a truly individual-based fixed exchange rate system.

Judy, in your book ''Money Meltdown,'' and correct me if my paraphrasing is wrong, it has been a few years since I read it, the standard we had at the time the Nixon Administration pulled this off was one that was controlled by governments, not by individuals. Convertibility was directed and controlled by central governments, not by the individual, and the gold windows were violated because of political hedging and meddling.

Ms. SHELTON. Only foreign central banks—— Page 61 PREV PAGE TOP OF DOC Mr. RYAN. Right, foreign central banks controlled the windows. The individual could not do the conversion. So what we are at here is what is the stored value? How do we preserve the stored value? The key issue for all human beings involved is can they get a leg up in society, and can they do so relying on a currency, a trading vehicle that has a reliable store of value? So that ought to be our foundation, price stability.

Now, it is interesting that we are sitting in this room talking about different exchange rate regimes when some of these regimes have nothing to do with price stability, and that is something that I think we ought to keep our eye on. What is price stability?

It seems that human nature is such that in any kind of currency regime, when you have it filtered through a discretionary entity run by a handful of individuals, whether it be international, IMF type of organizations or domestic central banks, whether it is taking central banks, as you mentioned, Mr. Chairman, making them more transparent, more autonomous, which is a good step, you still have a degree of discretionary political decisionmaking. Do you think that that is important? Do you think it is important that we remove the decisionmaking and monetary policy in terms of the long-run picture from central banks, individuals in governments making the decisions, to a point where individuals in society, all individuals, make the decisions on the store of value of a currency? Aren't we always looking at a different degree of political meddling in all of these systems, even many fixed exchange rate systems?

Now, what is the crux of this, then, if we are always looking at a different degree of political meddling, whether it be a government-controlled fix, a float, dollarization pegged on the U.S. dollar, which is still politically meddling? We have a wonderful Federal Reserve Chairman who, because of his ability to focus on price stability possibly following an implicit price rule today that we may not know about, gives confidence in our stored value with the U.S. dollar, but there is the post-Greenspan era, and that is coming sometime down the road. Page 62 PREV PAGE TOP OF DOC

What is the heart of this issue on a philosophical ground? And is there an answer to getting rid of political meddling, discretionary decisionmaking at the international government level, at the central bank Federal Government level, and shouldn't that be our core direction, and anything short of that is going to be bound by human behavior, which will be pursue the short run, bow to the insurmountable political and economic consequences in the short run?

It seems that the reasons we are decrying and criticizing an ultimate fixed exchange rate system is because of short-run concerns. And all the anecdotal evidence I have been hearing from some of the witnesses against fixed exchange rates seems to be short on concerns, but looking at the long-term horizon, isn't the key point that individuals can have a stored value that is perfectly reliable, and that institutions, central institutions, should be taken out of that situation whereby they do not have the political meddling ability to change that stored value? I would like to ask the witnesses starting from Dr. Chari on down that point.

Mr. CHARI. It would be nice to be able to devise a system whereby world monetary policy in some sense is run on autopilot. I don't believe that kind of system is in our near or even in our distant future.

Mr. RYAN. Do you think that ought to be the ultimate goal?

Mr. CHARI. There are reasons to suspect that. If you had what we technically in our profession call an ability to commit yourself never to meddle ever again, never to pursue discretionary monetary policy, that would not be a desirable system. So the tradeoff always is between a system run well or very well but with an ability to commit yourself to future actions and a system that runs more imperfectly but does not have any ability to adjust to changing circumstances. Page 63 PREV PAGE TOP OF DOC

I am somewhat more hopeful that we can devise mechanisms that involve central banks which will allow us to pursue sensible monetary policy even in environments where we don't have this ability fully to commit ourselves to the future.

We have been through a fairly painful learning process over the last 70 or 80 years. My guess is that we are pretty far along. I think there is a much clearer understanding amongst central bankers across the world about ways to find mechanisms to commit them, to tie their hands, in effect, in the future.

And all we can do to promote that, to promote the idea that it is important for central bankers to choose policy rules which describe how they are going to act in the future and then find ways of tying themselves to the mast, so to speak. Whatever we can do to advance that viewpoint and that kind of conduct will be desirable. I think we are making slow progress in that direction.

I have hope that we can do it, but I must say that I have a lot of sympathy for the view, as I said during my spoken testimony, that central bankers have committed large errors in the past, and there is no assurance that they will not. So this is one of these areas where I think it is best to proceed somewhat tentatively rather than definitely.

Ms. SHELTON. I am just enthralled with that framework for analysis because I think exchange rate regimes are closely connected with basic issues of political philosophy. Page 64 PREV PAGE TOP OF DOC I should mention, in 1966 our Chairman of the Federal Reserve, Alan Greenspan, wrote an article called, ''Gold and Economic Freedom.'' It was very interesting. He still speaks admirably of the gold standard as a means to depoliticize control over the money supply. His references today are more muted than they were in that article, which was quite radical in terms of its political implications.

It is ironic that, as often as we invoke the importance of rule of law over rule of men, that we don't apply that same standard to money. The unit of account, the money, is one of the most critical componnents of free markets. But the value is largely controlled today, not just for this country but throughout the world by a rather small group of men. Central banks are less secretive than before, but certainly they attempt to calibrate through micromanagement what the value of money should be.

It is interesting that you raised this issue. If you could depoliticize money totally, not just with price rules and constraints on central bankers or through varying levels of independence, but through fixed-rate convertibility, you could vastly improve the international monetary system. For example, one system that the world has known, a system that worked very well, was the classical international gold standard. The key to that approach, and it is the same thing that makes a currency board effective, is that when an individual who uses the money, starts to become concerned about inflation, that person has a choice. He can turn in the money for the reserve asset at a pre-established rate of exchange. In other words, there is a contractual arrangement which allows people to convert paper money into some other financial asset—whether it is the U.S. dollar in the case of Argentina, or gold as under the old gold standard. Page 65 PREV PAGE TOP OF DOC The point is, it is not up to a small group of individuals to decide whether the amount of money is perfectly calibrated to the needs of the economy. It is that individual at the margin who asserts his right to say: ''I am suspicious about the integrity of this money. I will turn it in. I would rather have the reserve asset.'' And it is that choice in currencies that really underscores the integrity of a system. That is the democratic approach to money.

And I think that in discussing some kind of a future global system we should keep in mind that the reason gold is invoked is because it is universally recognized and historically acknowledged as a store of value. In a very forward-looking way, it is the most neutral of assets. It is nonpolitical. It is objective; every country knows what it is.

Indeed, China is a big buyer of gold. India is a big buyer. Every country understands that gold represents a monetary store of value. In contrast, what if every country in the world went on a currency board using the dollar? Would they ultimately resent the United States if we wanted to raise interest rates at a time when other countries didn't? Of course. Or what if we abused the privilege and created too many dollars? That is what happened under Bretton Woods. Countries resented that the United States acted irresponsibly in its role as the only key reserve currency country. We were the anchor. We blew it, and they suffered. We exported our inflation.

The reason that Europe does not rely on the Bundesbank to anchor its single currency, as they did earlier under the exchange rate mechanism, is because of this same political problem. Other European countries were angry when Germany did what was in its own best interests, forcing other countries to eat the same damaging monetary policy through the exchange rate with the German mark. That is why ultimately I think it is good to have an objective reserve asset as opposed to the currency of a single country. You must take the politics out of it. Page 66 PREV PAGE TOP OF DOC

Mr. FRANKEL. My view is somewhat different. In many countries like the United States, there is no possibility of getting away from human decisions in making monetary policy. The Federal Reserve does have discretion, and they have used it quite well recently. That is not the same as political meddling. The Fed is independent and pretty well insulated from political pressures and has done a good job recently. Of course, that doesn't mean that they will always do as good a job.

Judy Shelton mentioned the alternative of the gold standard. The theory was that having a fixed supply of gold and having the quantity of money tied closely to it would give price stability. That is not what actually happened. That was not the reality. There were huge swings in the price level. There were deep recessions, and much of this was the result of vagaries in the gold market.

In the middle of the 19th Century when you had the California Gold Rush and a lot of gold coming on-stream, there was monetary ease, and then there was inflation. Then there was a gold drought for half a century or so in which there was a drag on growth and deflation. This is a period when the Midwestern farmers were getting crucified, to use a word used by William Jennings Bryan, leader of the populist movement—''We will not be crucified on a cross of gold''—because it was leading to deflation.

Then they discovered gold again in Alaska and South Africa in the late 1890's, and it led to another increase in the money supply. So the gold standard way eliminated decisionmaking, but it does not guarantee monetary stability. Page 67 PREV PAGE TOP OF DOC Mr. MAKIN. First, Congressman Ryan, let me thank you for deeming this an important subject, although I guess the press doesn't.

You know, I think the issue of the exchange rate regime and the issues that you have raised in your remarks are ones that people have struggled with for centuries. The idea of a kind of arbitrary choice of a metal versus the discretion of central bankers has been one that has come and gone for a long time.

As Jeff Frankel has mentioned, the experience with the gold standard in the 19th Century was mixed because it was very difficult to predict what would happen to the supply of gold, and when it was not forthcoming in great quantity in the latter part of the 19th Century, had deflationary problems which led to the cross of gold speech, as Judy Shelton suggested, it is important that people be able to register a vote when the central bank, if there is a central bank, is misbehaving.

I would argue that in today's system there is. If you are uncomfortable about monetary policy—and, traditionally, what people begin to do is exchange their money for goods at an accelerating rate which creates inflation. Inflation triggers the central bank to take action against inflation. Again, this is frequently stated by the Federal Reserve and has been their policy and will continue to be their policy.

The other recourse, of course, is if people are taking action against bad monetary policy, that leads to inflation by converting into goods and the central bank isn't responding, then I would argue that the exchange rate is another means, that is, individuals convert the local money into foreign money, the currency depreciates and provides another clear market signal that the central bank isn't doing their job. Page 68 PREV PAGE TOP OF DOC

So in my own view—and it is certainly an open question, but the lessons of history over the past 150 years suggest that allowing individuals the freedom to convert money into goods and allowing them the freedom to convert their money into some other money at a flexible exchange rate is a signaling mechanism that essentially forces central banks to do the right thing.

Mr. BERGSTEN. Mr. Ryan, I strongly agree with your focus on rules versus discretion, and I stress throughout my statement that distinction. I disagree with what Mr. Makin just said, that the way to the best result is letting individuals have the freedom always to buy and sell currencies—because we know markets make errors, are irrational at times, overshoot, and all that.

But I am with you on limiting discretion of decisionmakers and government. Note that my target zone proposal embodies exactly what you are saying. You let rates float freely but with broad limits around them. You announce those limits. You tell the market what the limits are. And when the rates hit those limits—which you have predetermined, preannounced, agreed with the other major countries—then you come in to limit the fluctuation because going beyond would be bad for the economy. But it is a rules-based system. If you want to characterize the debate between the current Administration, say, and me, that is the debate.

Mr. RYAN. Let me ask you this, Mr. Bergsten. Mr. Frankel mentioned how some dirty floats or floating pegged spans didn't work. You have mentioned a number of examples. How is your proposal different from that? And with bands isn't there always an incentive to be the first guy to break the rules? Page 69 PREV PAGE TOP OF DOC

Mr. BERGSTEN. The main difference is that the bands that I am talking about are very wide bands. Somebody characterized the old European Monetary System of plus or minus 2 percent as a target zone system. I don't call it that. That is a fixed rate system with very narrow margins. I am talking about wide bands of 10 percent or more on each side. Therefore, it is mainly a flexible rate system but with some limits as to how far you could flex.

Mr. RYAN. We have tried that in the past, haven't we?

Mr. BERGSTEN. The European Monetary System has tried it since 1993, and it has worked like a charm. Since 1993, when they had their crisis, which was a fixed-rate crisis, they widened their margins to plus or minus 15 percent, and since that time it has worked like a charm. Indeed, it was a transition to the euro, contrary to something somebody said earlier. So the wide band systems do, in fact, work.

Having said that, you can still get the band wrong. Even with a wide band, you could still get it wrong. You could be subject to attack. I don't rule that out.

Mr. RYAN. Wouldn't you agree that there is a high degree of political and economic incentive to in the short run go to the corner of the band like we have seen in so many different band operations? Isn't there always built inside a band system a political incentive in the short run to bow to the pressures, to rush to one of the corners of the bands and to break the rules? Be the first person out of the gate breaking the rules to get ahead of that advantage? Which seems that it still incorporates at the core of it the incentive to, in the short run, if you are a central banker, if you are controlling the band for your country, to break the rules and to go to one of the corners of the bands? Page 70 PREV PAGE TOP OF DOC

Mr. BERGSTEN. No, I don't think there is such a set of officials in countries. Some people argue that there is an incentive for the market players to try to go to the edge, to defeat the central bank and get a speculative profit. My view on that is, if you get the bands right, which I believe is within the state of the art, if you are credible in defending the bands the first couple of times they are tested, and if you have international cooperation in doing that, the bands can and will hold, and that is the experience of the European Monetary System since 1993.

Mr. RYAN. But if you agree with me that we ought to get rid of political meddling and discretionary decisionmaking, isn't that exactly what a wide band encapsulates? Isn't a wide band involving political discretion, discretional decisionmaking within the wide band?

Mr. BERGSTEN. No. You make a political decision at the outset in setting the band. What is the midpoint? What is the range? But once you do that, then if you live up to what you have agreed to, there is no more political discretion. The rates float. If the edge is hit, you then come in to stop the rates from going outside the band. So there is a decisionmaking process at the outset: A, to go to that system; B, where you locate the bands. But after that, then I am with you; and I think at that point you have a nice mix of market orientation most of the time but limits around it to avoid big, costly misalignments, adverse distribution effects, and so forth.

Mr. RYAN. I have been told I have to go catch my plane. Sorry. I would love to stay and chat, but I apologize. Page 71 PREV PAGE TOP OF DOC

Chairman LEACH. Before you leave, you should recognize there is a Midwestern answer to all of this.

Mr. Frank was very concerned about the footnote and agricultural policy, but if we just move to a golden standard, and by that I mean we will have corn which is, after all, renewable, and we produce it here as the base of value, we can solve two problems at once.

Mr. RYAN. Well, serving southern Wisconsin, one of the larger corn-producing areas in the country, next to Iowa, I would endorse that.

Chairman LEACH. We are reaching more consensus than we thought.

Mr. BERGSTEN. There is too much discretion on the part of you politicians.

Chairman LEACH. Thank you, Mr. Ryan.

Mr. Bachus.

Mr. BACHUS. Mr. Chairman, I remember last year there was an article in one of the newspapers in one of the small counties I represent, and on the front page it had my picture with several members of the Farm Bureau delegation in Washington, and under that it said: ''Congressman Discusses Wide Range of Farm Issues''. And what was that? They were asking for about eight different funding things and controls. Page 72 PREV PAGE TOP OF DOC

And then on page 3 of the same newspaper it had the president of the Farm Bureau, the same guy that was in the picture with me, opposing a local school tax, saying, when was the government going to get out of their pocket? They just wanted to be left alone.

It happened to be in the same paper, so I have noticed that the agricultural community sort of does get a little schizophrenic on those issues.

I am glad this isn't televised.

Let me ask you this to the panel. Here is the basic question, and I have one question for you, and then I am going to give you four reasons why I am asking this question.

Should the IMF attempt to influence the monetary policy or the exchange rate policy of debtor countries? In other words, should the IMF attempt to influence the monetary policy or the exchange rate policy of debtor countries or even push their foreign exchange policies or dictate those policies? And I ask you that in light of these things, the first of—and if there is an argument to this point maybe you can sort of say I disagree with it. But the devastating effects that sharp, sudden devaluations have on most of the population of those countries, in other words, the social implications on the people, the economic implication, what we talked about, the loss of savings and the loss of jobs and the loss of—somebody said dreams.

Two, this is something that I pick up on more and more. When a country goes to the IMF and seeks help for an economic crisis, the world market, the financial market immediately assumes devaluation because the IMF has almost become synonymous with a devaluation of currency, at least in my mind I have seen that. Page 73 PREV PAGE TOP OF DOC

And so the market I think begins to put pressure on the currency the minute they perceive that a country—and maybe the country is already in trouble, but I can tell you that a country when you start talking about IMF bailout to a country, the currency problems are going to get worse, because there is a perception there that IMF is going to seek devaluation.

Third, the IMF doesn't consider social policy. I don't see that they consider the welfare of the people so they are trying to influence—we said here today that the exchange rates and the currency policy has a tremendous direct benefit on standards of living on people's savings, on their everyday life. Is the IMF in a position to make those decisions?

We had actually—one of our panelists yesterday headed up the IMF's surveillance team for several years. He came in here yesterday, and I didn't get a chance—he left for a plane early, but my question to him was going to be—he was here to testify that the IMF did a lousy job on their surveillance and in predicting what was about to happen, and he was in charge of it. So that is a pretty good—the guy that is in charge of it and says we don't have the ability to do it.

And the fourth thing is, should they seek devaluations when, as I think we have all said that the currency ought to be a store of value, we ought to—savings rates are important. If people get to thinking that they might as well not save money, they might as well spend it because there is going to be a devaluation.

And, Ms. Shelton, you mentioned that in Mexico, why should people save it if it is going to be worth less tomorrow? So back to my original question. Page 74 PREV PAGE TOP OF DOC

But I give you those four reasons why I might tend to think that they shouldn't influence those policies, but I don't know. And we will just start and go up.

Mr. BERGSTEN. Mr. Bachus, I think you make the key point when you say the IMF comes in because a country is already in trouble, by definition, or else the IMF would not come in. So then the question is whether the IMF coming in helps or hurts, and whether the nature of its policy, advice, and requirements is correct.

My own view is that the IMF almost always helps the situation. The IMF as the bearer of bad news and the guy who requires the country to take strong medicine to get out of its own problem often gets a lot of blame, but the country is in difficulty at the outset. It is going to have to take some corrective measures.

The IMF, I think, does two things that are helpful. It brings money in most cases that helps smooth out the adjustment period. This enables the country not to have to take such draconian measures as it would without the extra financing. That at least cushions to some extent the impact on the little guy. If a country had to do it in most cases totally without the IMF or outside help, they would have to default and devalue much more. They would put controls on all imports, for example; and all food imports for hungry people would be cut off. So the IMF, I think, by providing some transitional funding, helps, including by reducing the draconian impact on poor people.

Second, it brings advice, which I think on the whole is usually good advice. But then comes the big question you raise. Do they overemphasize devaluation of the currency? And there is a legitimate debate on that in any given case of adjustment that is required. Page 75 PREV PAGE TOP OF DOC

In the recent crisis in Asia, it is probably true that the IMF at the outset of the crisis brought policy advice and conditions that were based on its past experience in Latin America and elsewhere that were not perfectly calibrated to the Asian problems. The Asian problems were not the traditional macroeconomic problems—big budget deficits, excessive money supply, hugely overvalued currencies. There was some of that, but it was more weak banking systems, corrupt governments, and all that.

I think the IMF made a quick correction over the first six months or so and got back on track, but there probably was some excess emphasis at the start on fiscal tightening, and maybe on currency changes. But remember that in this case what was basically done was to get the countries to move to floating exchange rates, and then it was the market moving those floating exchange rates that pushed the currencies down way too far, and in fact most of them bounced back about 50 percent from the lows they reached.

So, in a way, it would have been better not to go to floating rates. It would have been better to have a more controlled intermediate solution, and that is what the IMF should have pushed.

I think the lesson coming out of what has happened is in that direction. I think John Makin is off-base when he said at the outset that the world is trying to move back to fixed rates. I think there is a consensus coming out of what has happened that we need greater flexibility of rates—not total free floating, but greater flexibility. The question is how you define that. That is why I think the real debate is in that area. Page 76 PREV PAGE TOP OF DOC I do think that the IMF itself is chastened by the past experience. They will counsel countries in the future to avoid rigidly fixed rates in order to avoid the big crises of the type that they trigger, but they will in the future also try to gauge their advice to produce less devaluation, although, still, in most cases you are going to need some change in currency values to get the country's trade performance and overall economy back in equilibrium.

Mr. MAKIN. Congressman Bachus, your question I think was should the IMF try to influence the monetary or exchange rate policy of debtor countries. My answer is, no, because I think the performance of the IMF over the past two years suggests that an alternative mechanism would probably be better and perhaps a totally revamped IMF, which was probably discussed yesterday, or a different institution, which would be far more attuned to the realities of today's markets.

First of all, debtor countries raise the question of debtors to whom? In the 1980's when we had the Latin American debt crisis, most of the debts were by governments, a few governments, to banks.

In the 1990's, the crisis was debts of private sector institutions to a widely diverging set of banks. The IMF's advice, as Fred has suggested, early in the Asian crisis was off-base and made the problem worse. I would suggest that their problems continue.

The IMF's approach to the problem in Russia was to try to supply $5 billion extra to the Russians. The Russian problem is really not a monetary problem. Russia simply has government obligations that it cannot finance because it doesn't have the means to collect taxes. And so the IMF money was simply used—was stolen, frankly, by the Russians; and now the IMF this year has loaned the Russians $5 billion to pay back what the Russians owe the IMF. Page 77 PREV PAGE TOP OF DOC

So I don't think that the IMF has distinguished itself as an institution that can deal very well with these problems, and that is not too surprising. The IMF is an institution that is bound by practices that were developed in a period when most emerging countries had to come to the IMF because there was excess demand and they were spending too much money. The situation where there is a large excess supply, because fixed exchange rates have led to the illusion that countries like Thailand can borrow at dollar interest rates, is something that the IMF has demonstrated itself totally unable to manage. So the alternative I think was actually what happened.

Take the case of Korea. The IMF put a package in place late in November of 1997, and Korea went into a free-fall in December. What solved or at least maintained the situation in Korea was not the IMF, it was Treasury Secretary Rubin's gathering of commercial bankers at the New York Fed in January of 1998 where he asked and received an additional $24 billion in short-term bridge financing for the Koreans.

Here again the suggestion of the crises of the past several years has been that the banking system—the real institution that has made or got through the worse part of these crises has been the U.S. Treasury.

The IMF goes in—has typically gone in and made the situation worse, and the Treasury has come in and cleaned up the mess, in some cases doing well and in other cases not doing so well. The problem has been, however, that markets now assume that there is some kind of underwriting process by governments, including the U.S. Government and the Treasury, for their investments in emerging markets. In my view, many of the risks in those markets are underpriced by the so-called moral hazard problem. Page 78 PREV PAGE TOP OF DOC

Looking forward, I think there is going to be no substitute for a case where the institutions that invest or encourage investments heavily in emerging markets will have to absorb some of the risks rather than, as Goldman Sachs did in June of 1998, encourage heavy investment in Russia and then walk away from the problem after those investments collapsed.

So I guess, to answer your question, I am not sure the IMF should be doing anything in these circumstances.

Thank you.

Mr. FRANKEL. My answer is different to the question should the IMF attempt to influence monetary and exchange rate policies. My answer is, yes, when it is appropriate; and it often is appropriate.

Four points: On the question of influencing versus dictating, there is an important distinction regarding who the country is, whether it is a debtor and whether it is already in crisis. There is a distinction between surveillance versus the rescue programs, which are appropriately conditional on policies. But even then, the letters of intent are negotiated between the country and the IMF, and it is not quite the case that the IMF dictates completely a specific policy.

Second, Congressman, you said that the IMF is synonymous with devaluation. I have heard that perception before. To me, it is not accurate. Page 79 PREV PAGE TOP OF DOC Just to give one example, in the Tequila crisis that followed the Mexican devaluation of December, 1994, Argentina was directly hit because it seemed to have some characteristics in common, or for whatever reason. The IMF's help made it possible for Argentina to hold the peg, to maintain the convertibility plan which they otherwise might not have been able to make. And there are other examples as well.

The IMF comes in for a lot of criticism. I have a theorem that for every attack on the IMF there is a symmetric and opposite attack from the opposite direction. There are plenty who think that the IMF has been too aggressive in urging exchange rate flexibility; and there are plenty who think that the IMF has been too slow to urge exchange rate flexibility, that the only problem is they didn't urge Mexico to devalue sooner or Thailand to devalue sooner. My own feeling is that on average they get it about right.

My third point is that when you are talking about a country like Thailand in July of 1997, at that point there is no choice. You can't maintain a peg if you don't have reserves, and they had already used up their reserves. So, whether you think that it is right or wrong that they should have devalued earlier, to say that the IMF forced or urged Thailand to devalue in July 1997, misses the point. There is no choice when you have run out of exchange reserves, because that is the only tool that a country has, to intervene to maintain a peg.

Finally, just to come back for a moment to the distributional question that Congressman Frank raised, I know there is a tendency when a whole country is in serious trouble appropriately to focus in particular on the poor. This is understandable. But I think it would be too broad a generalization that devaluation particularly hits the poor. It depends on the circumstances. Page 80 PREV PAGE TOP OF DOC

If you are a poor farmer, devaluation is usually good for you, to come back to agriculture. And to come back to William Jennings Bryan, when he said ''We will not be crucified on a cross of gold'', he was talking about the policy of an overly strong dollar tied rigidly to the gold standard, which was causing deflation in commodity prices, and he wanted devaluation because he wanted to get prices to poor farmers up.

Ms. SHELTON. I think that the IMF is generally associated with devaluation policies because they go into a country and push for a cheapened currency as a quick fix; the idea being if you can export and gain from competition, those benefits will flow back to the domestic economy. The problem is that is not competing, it is cheating. I think such policies foster a backlash of protectionism from suppliers and those foreign markets are now forced to compete against exports from cheap currency countries.

The irony is that the IMF was established for one purpose: To oversee a fixed exchange rate system anchored to the dollar, which was in turn redeemable in gold. Logically, when we ended the Bretton Woods system in August 1971, there was no reason to continue the existence of the IMF. But they transmogrified into whatever the international financial community needed, including taking on the role of global debt collector, and more recently attempting to play a formal surveillance role.

I likewise was struck to hear the IMF department head say that even when doing surveillance the organization couldn't enforce anything because these countries were its clients. Michel Camdessus, Managing Director of the IMF, now acknowledges that he was telling officials in Thailand that they should devalue several months before July 1997. But he wasn't saying that to the rest of the world. A surveillance role that cannot be communicated to financial markets ends up confusing those markets. They don't push for more information from governments, because they assume such data is being supplied to the IMF. They assume the IMF is indeed overseeing the economies of client nations. So, in fact, I would suggest that the IMF inhibits what would normally be appropriate market discipline exercised by foreign investors demanding to see precisely the kind of information that might discourage them from continuing to invest in countries that might end up in trouble. Page 81 PREV PAGE TOP OF DOC

Since the subject has come up a couple of times today regarding the gold standard, and since Chairman Greenspan was here yesterday, let me quote something he said six months ago: ''A key conclusion stemming from our most recent crises is that economies cannot enjoy the advantages of a sophisticated international financial system without the internal discipline that enables such economies to adjust without prices to changing circumstances. Between our Civil War and World War I when international capital flows were as they are today, largely uninhibited, that discipline was more or less automatic. Where gold standards rules were tight and liquidity constrained, adverse flows were quickly reflected in rapid increases in interest rates and the cost of capital generally. This tended to delimit the misuse of capital and its consequences. Imbalances were generally aborted before they got out of hand.''

So instead of the situation we have today where distortions build up because there is no rational, logical international monetary system, the gold standard was imposed automatic discipline. It is true rates would sometimes go up, but that prevented the huge dislocations that result when individuals aren't in a position to make more rapid adjustments because imbalances are obscured by faulty exchange rate relations.

Mr. CHARI. One of the attachments to my written testimony reproduces in substantial part an essay that I wrote along with Patrick Kehoe of the University of Pennsylvania which appeared in the Federal Reserve Bank of Minneapolis Annual Report for 1998. There we argued that there is a substantial case, basically, for abolishing the international monetary fund, so I guess my answer about whether we should intervene is that they shouldn't be around in the first place. Page 82 PREV PAGE TOP OF DOC But at a more serious level, I think it is important to recognize that exchange rates and exchange rate movements are a symptom of the underlying problem and are not typically the problem themselves. They are typically a consequence of the specific kinds of policies that were followed and are expected to be followed.

As Jeff Frankel emphasized, and I think this is exactly right, how are you going to maintain exchange rate when you don't have the reserves and you are unwilling to raise taxes dramatically when times are bad in Thailand or any other country to defend the exchange rate? It is, in some sense, not possible. So if you are going to commit to pegging an exchange rate, then that imposes strong discipline on monetary and fiscal policy and you have to be willing to live with the kind of discipline that is imposed upon you.

Typically when these countries run into trouble, it is because they have, for very good reasons, been unwilling to live under the constraints that the system imposed upon them. So there is no point in blaming the symptom for the underlying problem. We should instead look at the underlying problem.

Regarding a more general issue about alternative monetary regimes, gold standard or exchange rates or anything else like that, we should recognize that the last half of the 21st Century was a fine period, but it wasn't as though things in the monetary area, as Jeff Frankel emphasized, functioned marvelously. We had lots of dislocations. We had lots of problems. We have had lots of problems in the 20th Century, and so therefore it is not like there is some magic bullet that is going to solve all of our problems.

To the extent that we can solve our problems, I think we really ought to recognize that the central and analytical issue is one of devising ways to commit ourselves about the conduct of future monetary policy in ways that we will not eventually deviate from those kinds of rules, and that necessarily means that it makes no sense whatsoever to commit to a rule or a mechanism which you know will be abandoned. Page 83 PREV PAGE TOP OF DOC

The gold standard is an example of that. Routinely throughout the gold standard whenever a country got into a war they went off the gold standard. That was part of the operation of the mechanism. Everybody understood that. I would argue that those kinds of escape clauses ought to be an integral part of any monetary policy exchange rate regime.

Mr. BACHUS. Thank you. Thank you to the panelists. Thank you, Mr. Chairman.

Chairman LEACH. Thank you, Chairman Bachus.

Let me just conclude by saying that we have made an effort today to get as wide a panoply of economic perspectives as we can on this issue and to present views that are on the cutting edge of innovation. I am not sure personally that the Administration doesn't have it about right at this time and that one of the great questions is where we move in the future.

But what is clearly the case is that concert relationships are central to the whole issue of the new architecture, and it could well be that the United States' economic community is going to be leading, but for many countries these are very sovereign decisions. And one aspect—and I think the advice from our Government at this time that I am very sympathetic with—is that we should be very careful from a governmental perspective of pushing answers on others if others choose to move in the direction we might like in terms of dollarization. It should not be up to us to insist upon. And I think for some countries that is probably a pretty good answer, but they have to reach that decision themselves. Page 84 PREV PAGE TOP OF DOC Anyway, I thank you all. I think this testimony presents a panoply from which we can all draw conclusions, and I certainly think each and every view that is the opposite of the other contains a grain of truth and that one of the great aspects of economic theorizing today is that the conclusions are not always self-evident, but the observations may well be very prescient. And I think all of you have provided a background of significant thought, and so I thank you all.

The hearing is adjourned.

[Whereupon, at 12:45 p.m., the hearing was adjourned.]