It is ironic that the strongest disciples of free markets are often the messiahs of currency pegs, fixed exchange rates and currency target zones. Those who believe the market should set the price for everything reject its decision on pricing international economic input and output.
Of course, fixed exchange rates and currency pegs can play a role at certain moments in history. They're useful when tackling hyperinflation (Latin America), or when a country's financial system is close to meltdown and policy makers lack all credibility (Bulgaria). Fixed exchange rates even provide a "permanent" anchor for small city states (Hong Kong).
But when it comes to big, populous countries and economic blocs, the market must be allowed to price all economic factors, as well as to punish policy errors and political uncertainty. The only way to ensure exchange-rate stability is to pursue the right policies. It is impossible, in today's world, to match the "right" exchange rate to the "wrong" policies - as Brazil has now found to its cost.
So the current talk of target zones for yen, dollar and euro will come to nothing. The mismatches between economic cycles (and what is required for economic health) are too great in each bloc. Japan will be condemned to print yen or enter a deflationary spiral. Either outcome will send the yen to ¥160 to the dollar before the year-end. Europe is entering a deep recession with rising budget deficits, while backing away from essential reform. And the US is booming. The big surprise this year will be the weakness of the euro versus the dollar.
There are three reasons why an attempt to build a new global exchange rate mechanism would be doomed to failure. The first is that the world's central bankers won't agree to it. They share nothing like a common vision. The US Fed wants to sustain a rapid rate of economic growth and stable financial markets - just as long as this doesn't risk big inflation. The nascent European Central Bank prudently focuses its sights on an inflation target of 0% to 2%, keeping an equally close eye on broad money growth. And the Bank of Japan? Well... when it comes to the yen exchange rate, the BoJ does what the Ministry of Finance tells it to.
The second flaw is a lack of consensus between policy-makers. Exchange rate targets are fine. But which country should defend them at the margin? Some argue that the dollar should trade far below its current parity with the yen, based on the two countries' current-account imbalance. Perhaps the BoJ should raise short-term interest rates? After all, the Fed has cut the cost of borrowing dollars three times since September.
Others say the trade imbalance is just a reflection of US households' low savings rate and insatiable appetite for consumption financed by Japanese thrift. So maybe Washington should impose a massive fiscal tightening to raise the natural savings rate as Tokyo attempts stimulus? It's doubtful whether either response would be economically expedient or politically attractive.
The third argument against currency targets is that they can do a lot of harm. Sterling's membership of the exchange rate mechanism at an overvalued exchange rate cost the UK economy dear. In September 1992 UK interest rates soared to 15% to defend sterling's ERM parity, causing a deep recession.
If exchange-rate parities aren't credible investors will speculate against them. Capital moves with such vigour that policy makers can rarely "beat" the markets - even if they wanted to. Consider the volumes. Around $1.5 trillion to $2 trillion-worth of foreign exchange is traded on the world's markets every day, less than 15% of which is for trade-related purposes. To defend foreign-exchange parities, the authorities would have to ban "speculation". Doing so would precipitate a collapse in equity and bond valuations, as well trade flows and global growth prospects. It's not going to happen.
That's why, ultimately, the recent carefully-worded announcement, promising close macro-policy coordination by French president Jacques Chirac and Japan's prime minister Keizo Obuchi, is so much hot air. And the statement from German chancellor Gerhard Schröder after meeting with Obuchi was no more profound. So why bother with these meetings at all? The answer lies in PR. Japanese and European politicians have to do everything to placate their electorates - particularly those destined, in 1999, to lose their jobs.
Growth in euroland is slowing sharply too. Recently, Heiner Flassbeck (Germany's state secretary for international economic affairs and finance minister Oskar Lafontaine's right-hand man) said that he's pinning his hopes for a rebound almost exclusively on lower interest rates and higher wages - both in Germany and the rest of euroland. However, not only are such policies out of the politicians' hands, but the major impact would be to price European producers (further) out of world markets and boost the ranks of the unemployed.
The euro will be undermined rather than helped by relatively tight monetary policy in contradiction to excessive and expanding fiscal deficits. Corporate profits will get hit in the scissor action of rising labour costs and falling output prices. So the ECB may well be slow to ease. And the slower it will act, the more the politicians clamour for it to do so.
I now expect European real GDP growth this year to be no more than 1%. Japan will remain in a deep contraction, unprecedented for a G3 economy, of 4% in 1999. With the US still growing above a 3% pace (though heading for slowdown too), I expect a stronger dollar in 1999, especially against the yen.
David Roche is president of Independent Strategy, a research firm based in London.
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