Re: Flexible exchange rates and the need for reserves

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Paul, I agree with your observations,  However, private market makers today do not
rely on reserves.  They use derivatives to hedge their exposures.  Your point about
bankruptcy is well taken and in structured finance, counterparty risk transfers
individual market maker collapse into systemic crisis.  The real problem with
structured finance is that while the incentive for individual market participants
to use such instruments is supposingly protection against volatility, but
profitability for the institutions that create these instruments come from
volatility.  Since the cost of protection must equal the profit to provide
protection, and since profit drives the market, the system inevitable heads for
collapse.  That was the real flaw of the Enron business plan.  The creative
accounting only served to delay the day of reckoning.

Henry C.K. Liu

paul davidson wrote:

> At 07:55 PM 4/21/02 , you wrote:
> >It seems that there is a confusion about the term flexible exchange rate.
> >
> >A freely exchangable currency with a traget exchange rate requires more
> >reserves
> >to hold the target.  If there is no target exchange rate, no reserves are
> >needed,
> >as Gunnar points out.
>
> Only under some very unrealistic conditions, can a logical construct that
> makes the above point be demonstrated. (but as explained below these
> conditions cannot exist in the real world.)
>
> In the real world tGunnar's point is not correct even if the government (or
> central bank) does not attempt to influence the exchange rate in any
> manner,. Nevertheless, if there is to be an organized  and orderly free
> market in foreign  exchange -- there must be "market makers" in order to
> assure a liquid  foreign exchange market. Thus private bankers will have to
> move in to "make" the market and each of those bankers will have to keep
> reserves to maintain orderliness.  The sum total of all the privately held
> reserves will exceed that necessary for central banks to maintain a fixed
> exchange rate.  Moreover if one or more of the private banker "market
> makers" were to go bankrupt in an attempt to maintain orderliness in the
> face of a bandwagon (herd behavior) movement, then there need not exist any
> set of exchange rates that will clear all markets simultaneously (as Arrow
> and Hahn have, in their book, demonstrated -- any bankruptcy jeopardizes
> the existence of any general equilibrium).
>
> The idea that there can exist a free market determined equilibrium exchange
> rate over time in a changing world economy is a Friedmanic myth -- that
> requires impossible logical conditions -- as FrIedman admitted when he
> responded to my criticism in the JPE in 1972  when Freidman wrote" A price
> may be flexible... yet be relatively stable, because demand and supply are
> relatively stable overtime (e.g., this was the case with the exchange rate
> of the Canadian dollar in the 1950s). Violent instability of prices in
> terms of a specific money would greatly reduce the usefulness of that
> money...."
>
> It is nice to know that exchange rates can be perfectly flexible as long as
> demand and supply are stable over time..... The question occurs what should
> be done when the exchange rate becomes unstable -- and people rush to a
> different liquidity store of value?
>
>   All of this is discussed in great detail in a chapter of my forthcoming
> book (to be published this summer) FINANCIAL MARKETS, MONEY AND THE REAL WORLD.
>
> paul