"Kee" Points with Jim Kee, Ph.D.

  • Shocks and Exchange Rates
  • Fixed versus Floating
  • Investor Risk Tolerance

Shocks and Exchange Rates 

Count me among those who feel that global trade-war concerns and potential problems with Italy’s politics and banking/debt ($2.3 trillion) are the world’s key concerns right now, not Turkey (Asian Times). Part of this has to do with the fact that Turkey is small and has a flexible or floating exchange rate, which tends to keep turmoil bottled up within a country. In one of my favorite metaphors, economist Jurg Niehans once likened a flexible exchange rate to dams or dividers in a pond. Throwing a rock in one part of the pond will not spill over to the others but rather result in turbulence in that part that was “bottled” up by the dam. In the same way, flexible exchange rates tend to bottle up “shocks” within their respective economies.

Continuing the metaphor, a fixed exchange rate would be analogous to removing the dividers, resulting in the shocks dissipating across countries. Whether this process is best described as “mitigating” shocks, versus spreading them to other countries (i.e. “contagion”), is open to debate. In fact, whether flexible exchange rates or fixed exchange rates are the way to go is part of an ongoing, decades-long debate among economists.

Fixed versus Floating

Perhaps the best known of these (debates) was between two Nobel Laureates, Milton Friedman and Robert Mundell. Friedman argued for flexible exchange rates, or letting markets rather than governments determine currency values. Mundell argued that this is a misconception; since governments legally define money, they should legally define its value in the same way that other weights and measures are internationally defined. I tend to favor Mundell’s view, but either way most economists favor one or the other versus the contrived middle ground of “pegged rates” in their various forms (i.e. crawling pegs, crawling bands, managed floats, dirty floats, etc.). That is because these “pegs” are subject to periodic revisions -usually devaluations -on the part of the monetary authorities, which invites endless speculation. That means constant risk of capital flight and economic collapse, as occurred during the Asian currency crisis of the late 1990s. We see it happening today in Venezuala, where President Nicolas Madur has just issued a new currency by lopping off five zeros from the old one. That’s what I call a devaluation! The IMF had categorized Venezuela’s currency regime as a “conventional peg.”

Investor Risk Tolerance

On an unrelated note, I heard Wharton Professor Kent Smetters this morning railing against risk-tolerance questionnaires used by most financial advisors because they are too simplistic. I agree with Smetters; these should only be a starting point. Interestingly, he pointed out that people tend to express higher “risk tolerances” during up markets and lower risk tolerances during down markets, so people’s attitudes towards risk are not constantHe also pointed out that many advisors fail to distinguish between “risk tolerance” and “risk capacity.” Many individuals are simply not in a good position to take on a lot of risk, that is, they have little risk capacity. 

As an aside, my personal favorite question to use to gauge risk capacity would be, “how often do you watch the markets?” If the answer is, “every day,” then I would say their ability to tolerate risk is a lot lower. As Jack Bogle famously said, “the stock market is a great distraction to the business of investing.” People tend to get too emotionally involved in the ups and downs of the markets when they watch them daily, which is greatly exacerbated by the media. That causes them to be too active, which is why we have the following quote from Nobel Laureate Paul Samuelson on our website:

“You should take money seriously. In fact, you shouldn’t enjoy investing. That’s a trap. It makes you too active. You churn your portfolio. You listen to stories, and most of the stories are not worth listening to.”