In a recent article, former vice presidential nominee Jack Kemp defied economic logic when he defended fixed exchange rates. The crux of his argument was that currency markets are inherently imperfect, as the prices (exchange rates) are determined by governments, who control the supply of money. He argues that national governments monopolize the supply of money, and are thus able to manipulate their exchange rate. Fixed exchange rate regimes, on the other hand, are impervious to government manipulation, because they are artificially held in place, even when a country’s money supply changes. He goes so far as to recommend the US resurrect the Gold standard in some form, so that dollars can be traded like a commodity.

There are two responses to Mr. Kemp’s fallacious reasoning. First, while no markets can be perfectly efficient, currency markets come as close as can be expected. Money supply is unarguably an important factor in a country’s exchange rate, but it is one of many factors. Institutions and banks consider inflation, interest rates, and general political circumstances when trading currencies. The price of a nation’s currency therefore, should be a near perfect indication of what foreign holders of that nation’s currency feel it is worth.

Second, Mr. Kemp fails to understand the dilemma facing all central banks. When a central banks tries to control its currency, it loses the ability to conduct an independent monetary policy. A central bank can control interest rates, inflation, or its exchange rate- never all three. Therefore, because China maintains a fixed exchange rate, it is unable to control the supply of Yuan, and is also unable to control inflation and long term interest rates.

Read the full article: Faux Foreign Exchange Signals