The Two Markets

the way things actually are

If such a free-floating currency system were allowed to function without intervention ā€“ apart from short-term, emergency situations when, for whatever reason, exchange rate volatility becomes a threat to a country’s financial system ā€“ then the imbalances arising from trade between economies with diverging performance levels would automatically be rectified. Trade deficits and surpluses would be transitory, not enduring, as they are today; nor would the same countries always be running either a trade deficit or a surplus.

But alas, that has not been the reality. Ever since Nixon broke with the Bretton Woods system, there has been a situation of currency wars, sometimes hotter, sometimes colder. There are two basic forms these currency struggles can take: a strong currency country locking its currency to a weak one, or vice versa, a weak currency country locking its currency to a strong one. The former is exemplified in the European Monetary Union; the latter in the Asian Tiger economies. In both cases, the aim is to maintain a trade advantage. Exporting countries wish to continue exporting, and continue generating trade surpluses. They use exchange rates to enable themselves to do that.