Should we peg or float?

Opposition Leader Alfred Sant has now put the exchange rate of the lira firmly on the national agenda. Speaking in Parliament about what he expected from the forthcoming budget, he made a number of proposals which included "a gradual realignment" of the exchange rate. Premier Lawrence Gonzi, who had taunted Labour about where they stood on the restructuring of the economy and what in particular it would do, now has his answers.

Few questions in international economics have aroused more debate than the choice of an exchange rate regime. Should a country fix the exchange rate or allow it to float? And if pegged, to a single "hard" currency or a basket of currencies? Economic literature abounds with models and theories, though consensus is still elusive.

Dr Sant's call for a reversal of the creeping appreciation of the lira came hot on the heels of a major critique of economic policy by the former chairman of the MCESD, Edward Scicluna.

In an article in The Times (November 11), Prof. Scicluna unequivocally stated that "only a more flexible exchange rate" can restore to the Central Bank a measure of control on monetary policy. He called on the Central Bank to shake itself out of the fixed exchange rate mentality and to ditch a policy where the onus of adjustments is being fully borne by manufacturing and tourism rather than by the exchange rate. In other words, he accused the Bank of defending the exchange rate peg at the cost of economic growth and jobs. A serious charge, indeed.

What can Dr Sant and Prof. Scicluna quote in support of their proposals? Various studies do suggest there is a strong link between the choice of the exchange rate regime and macroeconomic performance. Adopting a pegged exchange rate can lead to lower inflation but also to slower productivity growth.

In at least one IMF study (Does the Exchange Rate Regime Matter for Inflation and Growth?, Ghosh, Ostry, Gulde, Wolf, 1997), countries that maintained pegged exchange rates were indeed found to have higher investment. But productivity grew more slowly than in countries with floating exchange rates. Overall, per capita growth was slightly lower in countries with pegged exchange rates.

The IMF analysis (based on observations of GDP growth and consumer price inflation over 145 countries and 30 years), used a three-way classification: pegged, intermediate (i.e., floating rates, but within a predetermined range) and floating.

Pegging the exchange rate can lower inflation by inducing greater policy discipline and instilling greater confidence in the currency. Policymakers have long maintained that a pegged exchange rate provides both a highly visible commitment as well as raises the political costs of loose monetary and fiscal policies.

The IMF authors measured inflation rates for each regime relative to the average inflation rate (across all regimes) in that year and showed that under pegged rates inflation was three percentage points lower than under intermediate and six percentage points less than under floating regimes.

What accounts for these results? They derive, in fact, from two separate effects. The first is discipline. Countries with pegged exchange rates have lower rates of growth in money supply, presumably because of the political costs of abandoning a peg. The growth of broad money (currency and deposits) averaged 17 per cent a year under pegged exchange rates compared with almost 30 per cent under floating regimes.

In addition, pegged exchange rates can engender greater confidence in the currency. Countries with pegged exchange rates had inflation two percentage points lower than those with intermediate regimes and four percentage points lower than those with floating regimes. This differential in favour of pegged rates is as large as six percentage points in lower-income countries but only three percentage points for countries without capital controls - perhaps because abjuring capital controls itself inspires confidence in the domestic currency.

Does pegging the exchange rate cause lower inflation? Or is it merely that countries with low inflation are better able to maintain a pegged exchange rate regime? Econometric studies of this simultaneity between the choice of the exchange rate regime and inflation suggest that countries with low inflation do indeed have a greater proclivity toward pegged exchange rates. But they also show that, even allowing for this, pegged exchange rates lead to lower inflation.

Moreover, the exchange rate regime can influence economic growth through investment or increased productivity. Pegged regimes have higher investment; floating regimes have faster productivity growth. Net, per capita GDP growth was slightly faster under floating regimes.

Annual GDP growth per capita averaged 1.6 per cent over the IMF sample. Growth was actually fastest under the intermediate regimes, averaging more than two per cent a year. It was 1.4 per cent a year under pegged exchange rates and 1.7 per cent under floating rates. Controlling for temporal variances in growth rates, the differential in favour of floating exchange rates widens to 0.8 per cent over all countries and as much as 1.5 per cent for lower-income countries.

By definition, economic growth can be explained by the use of more capital and labour (the factors of production) or by residual productivity growth. This productivity growth reflects both technological progress and - perhaps more important - changes in the economic efficiency with which capital and labour are used.

Investment rates were highest under pegged exchange rates - by as much as two percentage points of GDP - with the largest difference for the industrial and upper middle-income countries and almost none for the lower-income countries. With higher investment rates and lower output growth, productivity increases must have been smaller under fixed exchange rates.

Part of the higher productivity growth under floating rates is reflected in faster growth of external trade. Trade growth (measured as the sum of export growth and import growth) is almost three percentage points higher under floating rates. The lower-income countries show an even larger difference in trade growth between pegged and floating exchange rates.

While not overwhelming, the evidence suggests that fixing the nominal exchange rate can prevent relative prices (including, perhaps, real wages) from adjusting. This lowers economic efficiency. Part, though not all, of this lower productivity growth is offset by higher investment under pegged exchange rates. A comparison of countries that switched regimes shows that a move to floating exchange rates results in an increase of GDP growth of 0.3 percentage points one year after the switch and of more than one percentage point three years after the switch.

As Francesco Caramazza and Jahangir Aziz said in Fixed Or Flexible? Getting The Exchange Rate Right In The 1990s (IMF, 1998), the perceived need for greater exchange rate flexibility has probably resulted from the increasing globalisation of financial markets, which in turn imposes an often strict discipline on macroeconomic policies.

Trade-offs exist between fixed and more flexible regimes. If economic policy is based on the "anchor" of a currency peg, monetary policy must be subordinated to the needs of maintaining the peg. As a result the burden of adjustment to external shocks falls largely on fiscal policy (government spending and tax policies). But if fiscal policy itself is having a contractionary effect, then one can truly talk of the "nightmare scenario" conjured by Prof. Scicluna.