Impact of the Floating Exchange Rate System on Debt
The floating exchange rate system
understand the international currency exchange system and its impact on
prosperity it is useful to look at how money works and its
connection with international trade. We often hear that the
value of our currency has increased or decreased against other
currencies. Or, we might read that importers are pleased or
exporters are not pleased with the latest current exchange rate, or
vice versa. This fluctuation in value occurs because many countries
have adopted what is known as a Floating Exchange Rate System.
Money is intended to distribute what is produced amongst
those who have produced it. The money people earn from selling
their produce enables and constrains them to buy goods and services
up to the value of what they have produced.
When one person
lends money to another, the lender reduces their ability to spend to
allow the borrower to spend that money. Such lending does not cause
total spending to increase above production.
If we work for someone, the money our employer earns enables
them to pay us and buy goods up to the value they have produced.
The wages or money we are paid enables us to buy some of the goods to
which our employer would otherwise have been entitled.
If the government
taxes people and spends only that
money, the government ensures that it is not buying more than people
would otherwise have spent or been entitled to spend. Even if
the government borrows from people to increase its spending, the
lenders are voluntarily reducing their spending to allow the
government to increase its spending. If everyone in
a country spends only what they earn or borrowed from someone else
who has earned it, then the country will not buy more than it
Increased spending and
In the Bretton Woods
era, before 1973, the fixed exchange rate system was the norm among western
economies. If a country with a fixed exchange
rate exports more than it imports so that foreign reserves
increase, that nation's income is rising. Although it has
increased income, it is also saving. It is saving because it is earning
from exports more than it is spending on imports.
As the money that
pours into the country from exports is greater than the money that
leaks out on imports, the amount of money in the country increases.
This additional money enables people to spend more in the country
and this spending enables that country to prosper, raising
wages, creating jobs, producing and selling more
goods and services.
Increased spending and national debt
When a person with a
debt to a bank repays the principal of that loan, they are reducing
their spending below what they have earned. When a bank lends
money it enables a borrower to spend more money than they have
earned. If new bank lending is equal to loan repayments, then the
increase in spending financed by the bank loan is equal to the
reduction in spending caused by repayment of the loan.
If bank lends more
than has been repaid to it, then it would be
increasing the amount of money in the economy and it would be financing
spending greater than what has been earned or produced in the
The only way a
country can buy more than it has produced is to import more than it
exports. To pay for those imports, a country needs foreign
currency. If it has foreign currency in reserve, it can use its
foreign currency reserves to pay for the goods. If it has gold
reserves, it may pay for those goods with gold. Alternatively, it
can borrow foreign currency and increase its foreign debt.
Floating exchange rate - the Nixon legacy
During the Vietnam
War, the US Government was borrowing money from the banking system
to finance spending on the war, particularly in 1968, 1971 and 1972.
Also, bank credit was growing rapidly during those years as shown in
Figure 1. These two sources of money caused the US economy to buy more than it produced.
As a consequence of
the US buying more than it produced, imports exceeded exports,
the US experience current account deficits in 1969 and again
in 1971 and 1972. US
gold reserves were held at artificially low prices and used to pay for the excess imports.
Some countries chose to be paid in gold. Consequently, US gold
reserves were severely depleted.
President Nixon was seeking re-election in 1972.
After tightening monetary policy in 1969-70, he allowed loose
monetary policy to stimulate the economy in 1971 and 1972 and did not
raise taxes to pay for the war. He imposed price
controls, devalued the currency and declared that the US would no
longer convert US dollars to gold. He presented this in such a way
that he was rescuing the US economy from price gougers and foreign
In March 1973, Richard Nixon
adopted a foreign reserve retention scheme commonly called the
"floating exchange rate system".
Figure 1: USA - Rate of
growth of bank credit to March 1973
Floating exchange rate - implications
system, the exchange rate fluctuates or "floats" to ensure that
foreign receipts equal foreign payments and the US Federal Reserve are
no longer drawn upon, or added to. That is, money entering
the country was required to equal money leaving the country.
convert their foreign earnings to local currency at a bank and
importers still go to the bank to buy foreign currency to pay
for their imports. However, the
banks are no longer allowed to put foreign earnings into foreign
reserves and take foreign payments from that reserve.
Banks must trade
their foreign currency earnings from exports and other sources for domestic
currency with those wanting to buy foreign currency to pay for
their imports and make other foreign payments. Thus spending on imports
and other foreign payments was required to equal
to earnings from exports and other sources of foreign
The foreign exchange
market consists not only of current transactions to pay for imports and
exports; it includes capital transactions such as international investment
and international loans. A country that
is financially secure and has high interest rates is likely to
attract more international investment than it invests
internationally. Also, a country whose
exchange rate appears low may be attractive to investors wanting to
speculate on an appreciation of that currency.
Furthermore, borrowers may choose to borrow from a country with
lower interest rates and investors may choose to invest in
countries with higher interest rates. These capital transactions are part of the foreign
payments and receipts are required to be equal in the foreign
exchange market. Hence, a surplus of foreign investments
and loan receipts can offset a deficit on the current account (trade
and other income transfers).
So, while floating
the dollar preserves official gold and foreign reserves, it does not
prevent the country from selling off the farm and increasing foreign
debt to pay for imports greater than exports. That is, while
the floating exchange rate system may preserve the central bank's
wealth, it does not preserve the nation's wealth.
Floating exchange rate - eliminates national savings
Floating the dollar
has another side effect. Under the fixed exchange rate system, an
increase in exports causes additional money to flow into the
economy. As we saw in point 6, it is a form of national saving
that enables the country to increase its spending. But under the
floating exchange rate system, there is no national saving: no
increase in foreign reserves. An
increase in export income requires an immediate increase in spending
For example, if the
country increased its export of chemicals, the only way those
exporters can convert their funds to local currency is if there is
an increase of imports of, say, pots and pans. Those pots and pans
are imported to be sold within the economy.
Floating exchange rate - makes domestic product
If these pots and
pans are to be sold,
they must be cheaper than pots and pans made in the local economy.
Consequently, the local producers of pots and pans lose business. This requirement for
imports to increase when exports increase has unfortunate
consequences. Export success
in some industries in an economy with a floating exchange rates undermines
the competitiveness of other industries in that economy. Those
industries forced to compete with imports
intentionally made cheaper by
the 'float' can be put out of business. The floating exchange rate
system requires demand for imports to rise. Without an increase
total demand, it can only mean that demand for domestic products must
Nixon's recession - the oil crisis
In an environment of
fixed exchange rates, there are two sources of new money: increased
foreign reserves and bank credit. Floating the exchange
increasing foreign reserves as a source of new money. Hence the
only source of new money is the growth of bank credit.
Richard Nixon had to
convince other major traders UK, France, Germany and Japan first to
Woods Agreement if he was to succeed with his policy
of floating the US exchange rate to meet his own political agenda.
This he did by making his problem their problem. He asked the group
of ten countries to revalue their currencies and then when that
failed, offering them little alternative but to float their exchange
When the US floated
its exchange rate together with the other countries, there was a
sudden reduction in the rate of growth of export income and the amount of new money entering the
economy. Economies need additional money to grow.
Nixon's policies meant that there was no longer any growth in the amount of money
This reduction in
monetary growth combined with a reduction in the growth of bank
credit in 1975 and 1976 (see Figure 2) caused a recession which was called the Oil Crisis
(because it coincided with a period of high oil prices).
Figure 2: USA- Rate of
growth of bank credit to April 2010
Post Bretton Woods - Financial deregulation and foreign debt
It appears that
financial deregulation may have contributed to the floating of the
crisis of the early 1970's. However, once the exchange rate was
floated, financial deregulation was necessary to allow bank lending
to create more money and so stimulate their economy.
deregulation was touted as a desirable policy stance and so Australia followed
the US in deregulating its financial system. This caused excessive
bank lending that depleted foreign reserves and
destabilised Australia's fixed exchange rate system, forcing
the Australian government to float the exchange rate in 1983 as
a foreign reserve retention scheme.
Australia's gross external debt, then 22% of its Gross Domestic Product
(GDP) has escalated at a steady rate to be more than 100% of GDP, and
of the relationship between bank credit and the current account deficit
The relationship between bank
credit and the current account deficit in an environment of floating
exchange rates can be explained using the
Current Account Deficit and Bank Credit
chart, the real exchange rate is on the vertical axis and income,
expenditure, exports, imports, international capital flows and
credit growth are measured on the horizontal axis. The supply of
exports is given by the X-X line, the demand for imports is given by
the M-M line and national income by the Y-Y line. If we exclude
credit growth and capital flows, the equilibrium exchange rate would
be at e1 with exports and imports equal at A1 and national income at
Z1. National income is made up of exports (0-A1) and sales of
products to the domestic economy (A1-Z1).
If we now assume
commercial bank credit of 0-B1, national expenditure (0-Z2) exceeds
national income (0-Z1) by the growth of bank credit. This can be
E = Y +
Where: E is
is national income; and
is the growth of commercial bank credit.
We can further define income
and expenditure as according to the sources of income and the
direction of expenditure as follows:
Y = N +
Where: N is the
sale of local products in the domestic economy (A2-Z2);
is sale of exports (0-A3).
E = N +
Where: N is the
purchase of domestic products (A2-Z2); and
is the purchase of imports (0-A2).
Substituting equations 2
and 3 in equation 4, we can conclude:
N + M = N + X
M = X +
M – X =
That is, we have concluded
that to clear the domestic goods market, the current account deficit
must be equal to the growth of bank credit. This relationship is
verified by the data presented elsewhere for the
Zealand and the Philippines.
It is explained further using dynamic models in "Formula
for current account balance".
Also, we know that to clear
the foreign exchange market imports must equal exports plus net
foreign capital inflow. That is:
M = X + K
Where K is the
net foreign capital inflow.
From equations (4) and (5)
we can conclude that:
M - X = K =
The equality between the
growth of bank credit and net foreign capital inflow is shown in the
chart as the K–Cr line. When net foreign capital inflow is added to
exports, the supply of foreign currency is given by the X+K – X+K
Equilibrium in the foreign
exchange market is now attained at the exchange rate e2.
At that exchange rate, imports rise from 0-A1 to 0-A2.
Exports decline from 0-A1 to 0-A3. The
difference A3-A2 is the current account
deficit which is equal to the net capital inflow (0-B1),
the growth of bank credit (0-B1) and the difference
between national expenditure and national income (Z1-Z2).
National income is now made
up of exports (0-A3) and sales of domestic products (A2-Z2).
National expenditure is on imports (0-A2) and the
purchase of domestic products (A2-Z2). The
difference between national expenditure and national income (Z2-Z1)
caused by the credit growth in the domestic market generates imports
in excess of exports (A2-A3) that is financed
by foreign capital on the foreign exchange market. That is,
the growth of bank credit causes the rise in foreign debt and,
therefore, a reduction in the nation's wealth. See also the
implications of inflation for foreign debt
where foreign debt must grow faster than the capacity to repay