Re: Flexible exchange rates and the need for reserves

[paul davidson <pdavidson@xxxxxxx>]

At 11:24 AM 4/22/02 , you wrote:
> Paul, I agree with your observations,  However, private market makers
> today do not
> rely on reserves.  They use derivatives to hedge their exposures.


Private market makers TODAYy can rely on derivatives to hedge their
exposures as long as the central bank implies it is still is ready to
INTERVENE in the foreign exchange market to maintain orderliness and
operate under a managed exchange rate regime -- that preserves at least a
modicum of orderliness.  But when the central bank fears that it will run
out of reserves and is no longer willing to intervene, then the free
market  day-to-day  exchange rate becomes chaotic -- and ultimately the
entire financial system is threatened--( see Argentina today, or the 1997
Asian currency crisis). Then the IMF must ultimately intervene to provide
the reserves -- after obtaining its Shylock's pound of flesh -- to
reestablish an orderly market and prevent  financial chaos.

If, however, I understand you Henry, you are implying that if the central
bank  announced it would NEVER intervene in the exchange market, then the
private market makers could simply use derivatives to cover their exposure
-- and as long as the demand and supply for foreign exchange was stable
over time then no foreign reserves would be needed.  Of course this was
Friedman's point-- but if demand and supply are stable over time then we do
not need flexible exchange rates!

If the central bank announced it would never intervene -- then could all
private market makers of exchange rates -- ass well as market makers for
derivatives, etc -- be assured that all exposures could be covered, if
there was a sudden significant shift in either demand and /or supply?  And
isn't this the problem we worry about -- the possibility of a meltdown in
the exchange rate system -- with systemic bankruptcies that could bring the
international financial system to collapse

>   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.


In a Friedmanic free market determined exchange rate system -- without any
central bank,  government or international intervention (e.g.. IMF) -- the
day of reckoning is almost inevitable except under the most static of
situations.

What we want is institutions that  encourage rapid global economic growth
especially among the LDCS (unless we want to assure a constant and growing
supply of terrorists who will wage physical (not fiscal) war on the
capitalist institutions of the developed nations).  By global rapid
economic growth implies non static conditions and, unless we have the
proper institutions to maintain market orderliness in place, therefore
economic growth brings the day of reckoning close to the horizon !

Paul