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Pegging at an overvalued rate is not sustainable in the long term, because it requires using foreign exchange reserves, and the central bank of a currency zone has no ability to create new foreign exchange. Since its not sustainable in the long term, it can also attract speculative activity, and since the defense against that speculative activity consumes the foreign exchange reserves at an even faster rate, the speculative attack itself is likely to attract further speculation, creating a "feeding frenzy".
Explains Soros' ejection of the Pound from the European Monetary union as well as the Argentine corralito crisis and many others coming from pegging weak currencies to the dollar. It also might explain what happened in 1925 when Churchill as Chancellor of the Exchequer ignorantly set the exchange rate of the pound to the gold standard too high.

However, it is impossible for everyone to attempt a long-term peg of their currency as not every currency can be (slightly) undervalued at the same time. Was that the basic weakness of the gold standard and then of the bretton-woods systems before Nixon foated the dollar?

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes

by Carrie (migeru at eurotrib dot com) on Mon Jun 2nd, 2008 at 06:33:06 AM EST
[ Parent ]
... a peg within a floating point system, but rather its a fixed point system.

A fixed point peg can be defended from speculation, so long as the side under pressure to devalue is defended by the other central bank ... because the other currency is under upward pressure, and that central bank can create its own currency to defend against upward pressure.

When the pound was forced out of the ERM, the Bundesbank did not want to defend the ERM exchange rate of the pound, AFAIR because it was faced with the inflationary impact of the integration of East and West Germany, and the side effect of pushing down against that upward pressure is an increase in supply of reserves, pushing down the floor inter-bank reserve lending rate.

And the Bank of England AFAIR did not want to defend the pound by increasing interest rates, AFAIR because the UK was coming out of a recession, so as it defended the FXR with purchases of pounds using foreign exchange reserves, at the same time it issued pounds as reserves domestically to keep the interest rate down.

To be able to defend a system of pegged exchange rates, you either need the central banks on either side of the peg to put first priority on defending the exchange rates, or regulatory controls on flows of financial capital across international boundaries, or both. The EU eliminated the capital controls in transactions between ERM members, and as it turned out when push came to shove, the priority on defending the ERM was not there.

The break-down of Bretton Woods was similar ... in the original Bretton Woods system, all currency pegs were to gold, and net clearances were in gold. The use of US$ for clearances was a convention that developed, to avoid the inconvenience of net clearances between reserve banks in gold.

When France refused to accept that the US$ in the early 70's was at the correct peg to gold, and demanded clearances in gold, the US was faced with either an ongoing series of devaluations by the USG, a radical change in economic policy to reduce the downward pressure on the dollar which showed up in the requirement to pay net clearances, or else an abandonment of the Bretton Woods system. In the end, though it took a little while to play out, the last course was taken.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Mon Jun 2nd, 2008 at 09:44:10 AM EST
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