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Why fixed exchange rates don't work Add to ...

Switzerland is heading down a well-trodden path by fixing the value of its currency to stop wild gyrations.

But it’s a risky strategy that has failed more often than it has succeeded.

Fixing, or pegging, a currency to another results in a constant exchange rate. In Switzerland’s case, the country set the value of its currency at 1.2 Swiss francs per euro Tuesday to stop a rapid runup that was threatening to price its exports out of world markets.

To make a peg work, a country’s central bank must continually buy and sell its own currency on foreign exchange markets in return for the currency to which it is tied.

Switzerland has introduced a hybrid version of pegging. The Swiss National Bank, for example, has pledged to buy euros in “unlimited” quantities to keep the value of the franc from rising above a fixed exchange threshold. The central bank will allow the currency to float freely below the official 1.2 francs per euro exchange rate.

The main attraction of a fixed currency is stability and predictability. In some cases, it can also create a better climate for investment and help control inflation.

The downside, of course, is that countries with fixed exchange rates forfeit control of their monetary policy. That makes them more susceptible to financial shocks elsewhere in the world and can lead to more frequent and aggressive attacks by speculators. Countries with fixed exchanges must essentially embrace the monetary policies of their currency sponsor.

There was a time – nearly 40 years ago – when virtually all currencies were fixed to the value of gold. The Bretton Woods regime broke down in the 1970s as countries found it increasingly difficult to maintain the strict financial discipline needed to keep their currencies fixed amid a surge in global commodity prices.

Efforts since by countries to return to pegged currencies have generally failed. Argentina, Mexico, Greece and Thailand are among the most spectacular failures.

And it has often led to problems when smaller countries tie their fortunes to larger ones. Studies have shown that small countries with pegged currencies suffer from higher unemployment, lower consumption and, ultimately, lost wealth.

That’s what happened to Greece, Portugal and Ireland after they joined the euro zone. When interest rates shot up after the financial crisis, those countries could not adjust quickly to rising interest rates by lowering wages.

With a floating exchange rate, countries can quickly respond to outside shocks by devaluing.

The one outlier is China’s peg of the yuan to a basket of currencies, including the U.S. dollar and the euro. Chinese financial authorities have kept the country’s currency artificially low, which has allowed it to become an exporting colossus. The downside is that it has created tension with its other exporting countries, distorted trade patterns and caused enormous global financial imbalances, including a buildup of foreign reserves, a real estate bubble and high inflation in China.

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