A Self-Contradictory G-7 Statement

Finance ministers from the G-7 countries met over the weekend. As is customary at the end of such meetings, they issued a joint statement yesterday containing their thinking about the state of the world economy – and specifically addressed exchange rate movements. The statement was a compromise, and thus somewhat confused and self-contradictory. Here’s the relevant paragraph from the text of the communiqué:

We reaffirm that exchange rates should reflect economic fundamentals. Excess volatility and disorderly movements in exchange rates are undesirable for economic growth. We continue to monitor exchange markets closely and cooperate as appropriate. In this context, we emphasize that more flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility to promote smooth and widespread adjustments in the international financial system, based on market mechanisms.

They quite reasonably note that “excess volatility in exchange rates are undesirable for economic growth” – a statement with quite a bit of empirical validity, by the way. The statement implies that they prefer fixed exchange rates (or a very carefully managed float, such as Japan is currently practicing), to avoid volatility.

At the same time, they explicitly ask for “more flexibility in exchange rates” – which means allowing exchange rates to float freely. But another well-documented empirical fact is that when exchange rates float freely, they move in unpredictable, volatile ways. The unfortunate fact of the matter is that no one has yet figured out how to have flexible exchange rates without volatility.

So which do they really want – fixed or flexible exchange rates? This statement says that they want both.

Of course, the reason for this self-contradiction is that some of the G-7 members want one, and some the other. Japan wants to continue managing its exchange rate to keep its currency weak, while the US and EU want it to float against the dollar so the yen will strengthen. What I find interesting is that this statement perfectly reflects tremendous and deep-seated disagreement about where they would like exchange rates to go from here. I expect the tensions between the US, the EU, Japan, and China over this issue – which I’ve remarked on before – to just get worse. Whose preference will win? Time will tell…