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10/29/96

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Economist writes rulebook to discourage speculation in currency markets

STANFORD -- Imagine a sporting event where the referees are only vaguely aware of the rules, and if they look them up, they'll be referred to the wrong set. According to the thesis of a new book by Ronald McKinnon, the Eberle Professor of Economics at Stanford, that, in essence, is the situation with the people who influence long-term interest rates by setting the rules for currency exchange rates.

McKinnon,is one of the world's foremost experts on international monetary policy but he is a bit of a lone ranger when it comes to his advocacy for tightening the rules by which the major central banks operate. With one book, The Rules of the Game: International Money and Exchange Rates (MIT Press), just published, and another due out next spring on the interaction of the Japanese and American monetary systems, McKinnon hopes to convince authorities of at least two of the world's three richest countries to draw up tighter rules for managing their currencies. Such action by the United States and Japan or by Germany and one of the other two, he claims, would reduce the amount of speculation that goes on in currency markets. Speculation raises long-term interest rates, McKinnon says, by making investors worry that if they leave their investments in one place, they will eventually lose money.

To make his case, McKinnon traces the history of world's last seven monetary regimes, the good, the bad and the ugly. He has written down the unwritten rules of each period in a series of tables that are explained in narrative detail. Given that elections occur every few years in most countries, McKinnon says he came to believe that the world needed a rule book that the new draft picks for finance ministry and central bank positions can use to get up to speed quickly.

"If the authorities understand what the rules of the game are, then there is a greater chance that they'll continue to abide by them in a consistent fashion," McKinnon says. "One of the big reasons the old fixed-rate dollar standard broke down [after World War II ] was that the United States government authorities never really understood what their role should have been."

The American authorities' role evolved by accident, according to McKinnon, into one of keeping open capital markets and remaining passive while other countries pegged to the dollar, but anchoring the value of all currencies by keeping American price levels stable.

The fixed-dollar standard was never formally established as the world operating regime, however, because countries had agreed to avoid strong international restraints on national policies in the Bretton Woods Treaty of 1944. Then the U.S. Congress passed the Marshall Plan to aid European recovery in 1948 and the Dodge plan for Japanese recovery in 1949, both of which indirectly made parity with the dollar a condition for U.S. aid.

"Marshall-Dodge sounds like a western sheriff," McKinnon jokes, "but those plans set the rules for exchange rates after World War II, and not the Bretton Woods agreement to which the textbooks refer."

McKinnon blames his own colleagues, rather than politicians, for spreading confusion about the rules of the monetary game. The confusion began because of fierce opposition to international currency standards by the famous British economist John Maynard Keynes, who designed Bretton Woods.

"Keynes' idea was that there should be no post-war monetary standard where all the countries had the same rate of price inflation and a fixed exchange rate. You can understand where he was coming from because the collapse of the international gold standard had caused the great depression. He felt countries should be autonomous and never again beholden to an external standard."

Countries need some leeway to inflate or deflate their currencies in crises, McKinnon agrees. "[During] the Civil War in 1863, the U.S. suspended its gold parity, but the promise was that when the war was over, presuming that the North won, they would go back to their traditional parity, and they did in 1879.

"There are other examples where parity was suspended for a few months, but it was an unwritten rule for countries to go back to the gold standard as soon as they could, and it was quite important to interest rate stability because investors knew in the very long run gold parity would be maintained."

No respected economist today advocates returning to a gold standard, but McKinnon says he believes that the world's overall financial security would be greater if economists wrote intellectual justifications for currency standards in general. The dollar standard after World War II, he says, was "by any definition the most successful monetary system the world has ever seen. Price inflation was very low in the 1950s and 1960s, the rate of growth in all industrial countries was extremely high and unemployment was low."

Yet Charles DeGaulle and other politicians bridled at the United States dominating other countries' monetary policy, and, following Keynes' lead, economists also thought it was a good thing if countries could manage their own monetary policy, McKinnon says. "A large number of American economists were also quite unhappy because they thought that foreigners were taking unfair advantage of the United States, which had to behave passively in foreign exchange markets for the standard to work.

"What went into our textbooks was what Keynes initiated in the Bretton Woods Treaty, so there is still this disjointedness between the books and the reality. The dollar standard of the 1950s and '60s made it very awkward for countries to change their exchange rates. However, both major macroeconomic schools ­ the Keynesians and the monetarists like Milton Friedman ­ favored flexible or floating exchange rates. Because nobody had written down the rules of the dollar standard precisely, there was very little defense of the world's most successful monetary system."

The dollar standard collapsed when the Nixon administration, facing the financing problems of the Vietnam War, chose inflation over disinflating the dollar's value. What followed, McKinnon says, was a period of free-floating exchange rates, then two huge inflationary periods in the United States followed by a major deflation in 1984, all of which, he argues, had more to do with generating the world business cycle than the two oil crises.

"The era from 1973 to 1984 was so unstable," he says, that "almost nobody believes in free-floating currency anymore. People are thinking now about how to manage exchange rates so things calm down a bit, and that is where understanding this history really matters."

Since 1985, monetary officials have been "learning by doing," McKinnon says. When speculators threaten to upset the relative values of the dollar, yen and mark, he says, the Fed, the Bank of Japan and the Bundesbank have intervened to put a floor on the value of the dollar. Other countries have also intervened to stabilize the relationships of the big three currencies. "We are getting back to a managed rate system, and my plan for reform isn't all that different, except that I would push management a little harder. One new wrinkle would be the idea of virtual exchange stability. Although speculation might move the exchange rates sharply from time to time, governments would aim to restore their traditional exchange parity in the long run ­ a re-implementation of the old restoration rule of the gold-standard days.

There are political costs, he concedes. European politicians would have to give up the fiction that their currencies