What the world needs now: greater surveillance on exchange rates

The world needs to move back to a rules-based system of oversight over currencies and enhanced global surveillance of national macroeconomic policies, according to a leading Professor of Economics at the University of Oxford, UK.

A mish-mash of floating and fixed currencies contributed to the global financial crisis of the past two years, according to a paper by Professor David Vines, of the University of Oxford’s Department of Economics and Balliol College.

Vines spoke to the paper this week at a conference organised by the Paul Woolley Centre for Capital Market Dysfunctionality, a research unit based at the London School of Economics and associated with the University of Toulouse and the University of Technology Sydney (UTS).

Vines said three features of the world led to the instability precipitating the crisis: domestic policies in advanced countries targeted only inflation; exchange rates were floating in some countries and managed in others; and the financial system in advanced countries had a high degree of leverage.

The combination of undervalued exchange rates in East Asia and the use of monetary policy in the US to ensure steady growth in demand led to the big fall in interest rates. Because of leverage the interest rate fall helped continued growth but it was built on fragile foundations, Vines said.

He was not advocating a return to the Keynsian system of adjusting managed exchange rates, but nevertheless one which was more rules based and involved greater global surveillance of national policies.

It was important to ensure that fiscal policies did not support outcomes in which exchange rates remained away from the levels necessary to ensure more balanced external positions in the longer term.

“To this must be added a new element: stronger global surveillance of national financial systems,” Vines says in his paper entitled “The Financial Crisis, Global Imbalances and the International Monetary System”. “The aim of this would be to limit the fragility of national financial systems and limit the international transmission of shocks through financial means.”

There needs to be some limit over the ability of countries to pursue managed exchange rates which are far away from their equilibrium position and which can cause excessive interest rate movements elsewhere in the world.

There also needs to be a provision of international reserves which are not dependent on the US dollar.

The Paul Woolley Centre was established in 2008 by former funds manager Paul Woolley, who headed up the UK operation of GMO, to sponsor research into market behaviour. It held its second annual conference at the UTS campus in Sydney October 28-30.