In my latest "Marginalia" column ("Fixed or flexible exchange rate?", BS, September 10), I revisited the classic and as yet unresolved debate between fixed and flexible exchange rates, prompted by the recent hand-wringing of commentators of all stripes on the depreciating rupee.
Since the breakdown of the Bretton Woods system in 1973, most industrialised economies have maintained flexible exchange rate systems of one form or another - with the notable and important exception of the euro-zone countries, which created a common currency.
Yet, the euro floats against the dollar, yen, and other major global currencies. So while a fixed exchange rate prevails within the members of the euro zone (at least for now!), the euro zone as a whole, in fact, exists in a global economy of flexible exchange rates.
The Indian experience has matched that of many emerging economies, starting with a pegged (and overvalued) exchange rate, moving after liberalisation toward a flexible exchange rate - albeit one that is "managed" by the central bank rather than truly freely floating.
Proponents of flexible exchange rates, starting with the late Milton Friedman and his disciples, argue that they provide an economy with the necessary room to manoeuvre in an uncertain global macroeconomic environment and in a domestic economy in which prices are sluggish to adjust.
This remains the core defence of flexible exchange rates by major central banks to the present day. By letting the market determine the exchange rate, so the argument goes, central banks are free to pursue a monetary policy which stabilises domestic inflation. Fixing the exchange rate in a world of open capital markets essentially implies losing control over domestic monetary policy and thereby ties the hands of a central bank in the face of an economic slump.
Recent Indian experience would appear to accord with Friedman's argument. As I argued, absent a depreciating rupee, the consequences for the economy of standing pat at (say) '50 to the dollar would have been devastating, and might have caused a financial crisis reminiscent of East Asia in the 1990s. More to the point, once having freed the exchange rate starting in 1992, returning to a defensible pegged rate is difficult, if not impossible, given the RBI's current credibility gap.
Yet, taking a leaf from Robert Mundell, perhaps what we should be worrying about is not the movement of the rupee but its overall volatility. In statistical jargon, maybe we should look not just at the "mean" but the "standard deviation" of the rupee's movement over time. For example, if the rupee depreciates 20 per cent this year and appreciates 20 per cent next year, its average level will be unchanged over two years. But this misses out entirely on the possibly important effects of the large fluctuation in the value of the currency over those two years.
As a matter of basic economics, a more volatile exchange rate increases the uncertainty faced by individuals and businesses that deal - either directly or indirectly - in the foreign exchange market. In theory, it is possible to hedge against currency fluctuations in forward markets and through other sophisticated financial operations, but in practice these are costly for all but the largest of business enterprises.
A friend of mine who worked at the foreign exchange desk of a major New York investment bank made a small fortune (for her clients, and herself!) every day merely by shifting funds from one currency to another during a particular trading day, based on her predictions of expected movements of major currencies. (Of course, the same activities could end up losing a lot of money if you guess wrong. But the time we last met she was living in a multi-million dollar loft in Tribeca, so I expect she was winning more bets than she was losing.)
Such a strategy might insulate the big players. But when was the last time you took out a forward foreign exchange contract on the rupee to hedge against the possibility that your travel to the United States next year would be 25 per cent more expensive? And when was the last time a small- or medium-sized business enterprise did something similar?
Surprisingly, given the intuitive idea that exchange rate uncertainty is costly and, therefore, should have a dampening effect on economic activity, teasing this out in the data is difficult. Most empirical studies come to "mixed" conclusions, which is a polite way of saying they didn't learn anything useful.
But richer data sets, and more powerful statistical techniques, are finally allowing economists to get a better handle on the detrimental effects of exchange rate volatility.
In as yet unpublished research, my doctoral student, Afshan Dar-Brodeur, analysed data from a large sample of developing and emerging economies (including India) and found a small but significant (both economically and statistically) impact of exchange rate volatility on reducing a country's exports. Her headline finding suggests that a one standard deviation increase in exchange rate volatility dampens the volume of exports by six per cent.
So while a depreciating rupee, in theory, is good for exports, the subtler effect of a more volatile rupee should warrant the concern of our policymakers.