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THE GLOBAL CAPITAL MARKET: Capital Mobility 6

Eventually, the very success of the Bretton Woods system in spurring international trade and the related capital movements brought about its own collapse by resurrecting the “inconsistent trinity.” For the United States, maintaining fixed exchange rates seemed to require high interest rates and slower growth; for Germany, fixed exchange rates seemed to require giving up domestic control over inflation. Even the relatively limited capital mobility that existed by the early 1970s allowed furious speculative attacks on the major currencies. After vain attempts to restore fixed dollar exchange rates, the industrial countries moved to floating rates early in 1973. Although viewed at the time as a temporary emergency measure, the floating-dollar-rate regime is still with us a quarter-century later.

Capital Mobility and Exchange-Rate Flexibility

Floating exchange rates have allowed the explosion in international financial markets experienced over that same quarter-century. Freed from one element of the trinity — fixed exchange rates — countries have been able to open their capital markets while still retaining the flexibility to deploy monetary policy in pursuit of national objectives.

Numerous countries have tried to fix their exchange rates for various reasons, but few have been willing or able to do so for long. Sooner or later, exchange-rate stability tends to come into conflict with other policy objectives to which votes attach greater priority. Once the capital markets catch on to the government’s predicament, a crisis can add enough economic pain to make the authorities give in.