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Fixed Exchange Rates Fail. Is Facebook’s Libra Different? A commentary by Demelza Hays.
Facebook’s Libra Association will hold reserves of low volatility bonds and a basket of fiat currencies from reputable central banks. However, the value of each Libra will not be pegged to the reserves. According to the white paper, Libra’s value will follow the fluctuations in the underlying fiat currencies. Effectively, Libra will have a fixed exchange rate with a basket of fiat currencies. Fixed exchange rates are notorious for collapsing in the long run. One of the most recent fixed exchange rate blow-ups was the Swiss franc to euro peg of 1.20 CHF to 1 EUR. After repeatedly pledging to keep the peg at all costs, the SNB abruptly abandoned it on January 15, 2015.
Caught up in the “This Time is Different” mindset, most foreign exchange speculators never imagined the peg would break. They lost a lot of money. However, exchange rate collapses do not only hurt Wall Street. The year after the “Frankenshock”, Switzerland saw 6,000 additional unemployed each month, the stocks of export giants like Swatch dropped by as much as 15%, and the tourism industry took a dive with 142,000 fewer hotel bookings during the summer season.
...is a teacher at the University of Liechtenstein, and an economic advisor to RealUnit Schweiz AG.
The most famous fixed exchange rate hack was almost single-handedly perpetrated by one man: George Soros. Under the European Exchange Rate Mechanism system, Britain had a fixed peg to the Deutsche Mark. The English had the printing presses running faster than the Germans, putting a downward pressure on the exchange rate. In order to prop up the pound, the Bank of England used foreign reserves to purchase billions of pounds off the market. Soros bet against the BOE by shorting pounds. He used his hedge fund to flood the market with pounds, and on Black Wednesday, September 16, 1992, the pound lost 5% of its value, broke the peg, and Soros walked away with over a billion pounds in profit.
Although Libra will purportedly be pegged to a basket of fiats, no explanation of how it will maintain this peg has been provided. What will be the acceptable range? 5%? 10%? Where will they pull liquidity from in order to dampen exchange rate fluctuations? If users are not supposed to hold their savings in Libra, then the value of Libra will be susceptible to speculative attacks from savvy investors and full-stop abandonments by decision makers at Libra.
An alternative to managing a fixed exchange rate is to back currency with real assets. At least this was the idea behind Adam Smith’s Real Bill Doctrine. All bank credit in the economy would need to be backed by tangible goods. By limiting fiduciary media, or unbacked commercial papers, a run on the bank was less likely. This is the same with fixed exchange rate regimes. As long as people believe that the central bank’s reserves are sufficient to prop up the currency’s exchange rate, a crisis of confidence can be abated.
How Libra plans to fend off speculators is yet to be seen, but the likelihood that Libra can devise a strategy better than any of the exchange rates re- gimes that came before it is low. The “Emperor’s New Clothes” consist of bundling together a bas- ket of fiat currencies instead of just relying on one, and we can convince ourselves that being Made in USA still means something positive.
Author: Demelza Hays
The article was featured in our October edition 2019 „commerce“.
Demelza Hays is one of the "30 Under 30" alumni of 2018.
Opinions expressed by Forbes Contributors are their own.