Question: Are flexible exchange rates better than fixed exchange rates?

Answer: Silly oversimplified question.

In a blog post today, Paul Krugman asks Do Currency Regimes Matter? – in the context of the Euro Area. My answer to that would be James Tobin’s wisecrack:

I believe that the basic problem today is not the exchange rate regime, whether fixed or floating. Debate on the regime evades and obscures the essential problem.

Of course that doesn’t mean one ties both shoes together and irrevocably fixes exchange rates (and give up the government powers to make drafts at the central bank) but the essential problem referred above – although gets diluted – doesn’t go away outside a monetary union. Also, a crucial element often missed in the discussion is the existence of the “common market” which acted as (and still acts as) a constraint on Euro Area economies to expand domestic demand.

Sadly by blurring issues such as this and oversimplifying the macroeconomics behind all this, the Euro Area was formed with the incredible lacuna.

One of economists’ fantasy is assuming the existence of a floating exchange rate regime without any need of official intervention. Although it is true for some nations, it doesn’t mean any nation can simply “truly float” and stop worrying.

In the same article A Proposal For International Monetary Reform, Tobin also points out:

Clearly flexible rates have not been the panacea which their more extravagant advocates had hoped …

although also pointing out that:

… I still think that floating rates are an improvement on the Bretton Woods system. I do contend that the major problems we are now experiencing will continue unless something else is done too.

Incidentally, I do not think Tobin tax in the foreign exchange markets is the way to go as has been pointed out by economists working in fx microstructure theory. Nonetheless Tobin’s highly important insights remain.

John Maynard Keynes’ biggest disservice to the economics profession is to not start with an open economy. In a world of free trade and free movement of capital, a nation’s biggest constraint on raising output is the “balance-of-payments constraint”. It is sad that in spite of the crisis the economic profession has not even started debating on the constraints imposed on nations due to free trade (and the whole world as a consequence).