The case for floating exchange rates

The sorry plight of the Euro-zone provides a robust case for the primacy of floating exchange rates. In years past, many initiatives were undertaken to fix exchange rates – many ended in tears. After all, as Lady Thatcher so elegantly put it ‘you can’t buck the market’. This sentiment is particularly valid in today’s currency markets where vast sums of money change hands – often on spurious rumours.

Where the Euro-zone ends up is anybody’s guess – its denouement, though, seems nigh. Whilst Greece’s chaos is a tragedy for the country, the fact that ten-year yields in Italy have breached the critical 7% yield threshold is immensely worrying. As an EU big hitter, Italy’s current financial plight greatly increases the risk of contagion.

Aside from Ireland, Portugal and Greece, there are other potential casualties. The French Government is petrified that its credit rating may be cut, whilst its banks are exposed to large ‘haircuts’ on bad debts. Germany is desperately worried it may become the Euro-zone’s ‘lender of last resort’. Spain, whose position seems less grim compared with Italy, is also in the firing line. Expect, too, more reports of large transfers of deposits from the weaker Euro-zone member banks into Germany, Switzerland and the UK.

When the Euro was being debated, many siren voices predicted it would end in tears – and they were right. A combination of political myopia, hubris and sheer EU pigheadedness drove the project forward. Had the EU retained individual currencies, notably the Deutschmark, varying economic performances would be reflected by exchange rate movements. Hence, Italy’s old lire would be weak, to the benefit of its exporters’ competitiveness.

Instead, struggling Euro-zone members are locked into too high an exchange rate despite their profound wish to grow their economies. Of course, some companies dislike floating exchange rates, but currency risks can be insured against via banks. Let the case for floating exchange rates prevail.