Free Floating Currencies, Interest Rates and Multilateral International Trade
#Interest Rates,    #Gold Standard,    #Trade Balance,    #Free Floating Currencies   

The interconnectedness between trade balance, interest rates and foreign exchange rates of national currencies is discussed. The case for gold standard and free market interest rates is outlined. The reasoning behind the introduction of free-floating exchange rates is presented. The inherent flaws of current system are exposed; the indispensable conditions for balanced trade and fair exchange rates are formulated.

By historical standards the currently existing global system of free-floating fiat currencies is fairly new – the last tie of US dollar with gold was severed in August 1971. Although this drastic step was initially offered to the American public as a temporary measure, the course of action had never been reversed. The immediate fallout, albeit unnoticed by public, had profound effect on the global economy – gold has been supplanted by fiat currency, namely US dollar, as clearing tool of international trade. Somewhat flawed, but overall rather robust, system that kept multilateral international trade in check was insidiously superseded by a system inherently unstable and, as history demonstrated, bereft of necessary ability to balance international trade. Trade deficits, run by some nations, became persistent and structural imbalances in national economies skewed allocation of capital and resources around the globe.

Trade balance and interest rate – the case of gold standard

Albeit not immediately obvious, the connection between trade balance and interest rates – free floating interest rates rates that are the subject to market forces – becomes clear at deeper exploration. The simplest case to discuss is the case of free international trade among the nations that are on real gold standard – where banknotes are freely exchangeable to specie by all market participants. In this case all the nations use gold as money, while names of national currencies – be that mark, frank or pound – are merely the different names for different gold weights.

In this case, the trade among all subjects of international trade is inherently balanced – no one nation can run continuous deficits; at the same time structures of national economies is also balanced – enterprises, running perennial losses, going out of business, thus releasing resources and capital to more successful competitors. The argument behind this assertion is rather straightforward (see fig.1):

  • any trade deficit run by a nation attenuates the gold reserves;

  • this loss of money is tantamount to dwindling capital available for investments. Lack of capital exerts upward pressure on interest rates;

  • rising interest rates invoke bankruptcies among enterprises with unsustainable debts, that, on the other hand, lowers consumption for a period of time when former employees of bankrupted businesses are out of work and releases resources for enterprises that could weather the storm. At the same time, nation consumes less foreign produced goods that mitigates trade deficit;

  • rising interest rates draw capital, seeking higher yields, from abroad. This flow of new funds available for investments lowers interest rates eventually.
[td]Fig. 1. Flow of goods and capital – the case of trade imbalance

Obviously, the free market forces are very efficient at keeping in check multilateral international trade and balancing the structure of national economy, provided that trade and flow of capital is free and interest rates are subject to supply and demand for savings. The obvious rule, derived from this hypothetical case, goes as follows – trade deficit of a nation must be mitigated by increase in interest rates.

Free-floating currencies are indispensable constituents of balanced international trade

Indeed, the architects of contemporary financial system, based entirely on fiat currencies, had no choice other than to devise mechanism of free-floating national currencies as a viable tool of keeping international trade in balance. The logic behind this reasoning was rather compelling (see fig. 2):

if a certain nation begins to run prolonged trade deficit then the exchange rate of national currency falls against national currencies of trade partners that run surpluses. The central bank of the former nation increases interest rates, thus invoking bankruptcies of defunct businesses, reducing consumption and decreasing trade deficit at the same time creating conducive conditions for deployment of foreign capital, striving for higher yield. This interest rate hike should be significant enough in amplitude and duration to attract private foreign capital from the nations with trade surplus and lower interest rates. In other words – free-floating exchange rates of national currency is an efficient indicator of structural imbalance in national economy and foreign trade that must be heeded by central banks.

Fig. 2. Back-feed loop resulting from trade deficit – the case of fiat free-floating currencies

Inherent flaw of modern system of free-floating currencies

The modern free-floating currencies system has an inherent flaw that lies in the realm of interest rates – the interest rates are not subject of free market forces but set by decree of central banks. Obviously, so far as the interest rates set by decree are close enough to ones, defined by market forces, the difference is inconspicuous at least for short period of time. In the lack of self-correcting mechanism, artificially defined interest rates lead to dislocation of capital in national economy that eventually results in trade deficit, falling national currency and economic turmoil. The natural course for the interest rates in this case would be upwards. Not so, according to the central banks – in the wake of negative trade reports the interest rates have never been raised. More than that, every economic conflagration was extinguished by lowering interest rates.

The importance of this divergence between the natural way to balance trade and path, chosen by central banks, is difficult to overestimate. Over the course of decades the central banks do exactly opposite what is supposed to be done to mitigate trade imbalance – instead of raising interest rates and keeping it at elevated levels until the trade is balanced over some prolonged period of time they are depressing rates, exacerbating accumulated imbalances and preventing necessary structural changes in economy from occurring. The result of such interference is glaringly obvious – some nations are running perennial trade deficits that, in paradoxical way, hurts them (the economies of these nations are so skewed into consumption that high-paying manufacturing jobs are almost extinct), while the others are running unending surpluses, not enjoying the fruits of their labor in full but rather vendor-financing the former ones.

Necessary conditions that would balance international trade

The main culprits behind misaligned exchange rates, skewed interest rates and imbalanced trade are the central banks of sovereign nations. Their policy of setting interest rates, that have nothing in common with supply of available savings and demand for capital, are sowing the seeds of structural imbalance in economies that eventually lead to imbalanced international trade. The concomitant trends in exchange rates that reflect these dislocations are greeted by central banks not as signals to take affirmative steps to hike interest rates, bring about restructuring of national economies and, as a result, balance international trade, but rather as pesky obstacles that can be overtaken by interference in forex market. For the course of over 40 years these coordinated efforts of central banks to bring the exchange rates to “conducive” for economic growth levels lead to exactly opposite result – the imbalances are getting more pronounced.

The pertinent question would be if the system of free-floating fiat currencies is viable. It would be reasonable to presume that it is, albeit if certain conditions are met. Just like in the case of gold standard free-floating fiat currencies might work as an instrument to balance trade if interest rates in economies are set by market forces. The system comprised of three elements – international trade, exchange rates and interest rates – would find its dynamic balance if every element has its own degree of freedom.
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Elani avatar Elani 24 Lis
Excellently written article!
VictoriaVika avatar VictoriaVika 25 Lis
Great one, well done! Good luck with it :)
Marenno avatar Marenno 25 Lis
fxigor avatar fxigor 18 Gru
I am glad when I can learn more about fundamental analysis. Nice Back-feed loop resulting from trade deficit Figure.