Too Sensational: On the Choice of Exchange Rate Regimes (Ohlin Lectures)

Too Sensational: On the Choice of Exchange Rate Regimes

The Ohlin Lectures 1. Jagdish Bhagwati, Protectionism (1988) 2. Richard N. Cooper, Economic Stabilization and Debt in Developing Countries (1992) 3. Assar Lindbeck, Unemployment and Macroeconomics (1993) 4. Anne O. Krueger, Political Economy of Policy Reform in Developing Countries (1993) 5. Ronald Findlay, Factor Proportions, Trade, and Growth (1995) 6. Paul Krugman, Development, Geography, and Economic Theory (1995) 7. Deepak K. Lal, Unintended Consequences: The Impact of Factor Endowments, Culture, and Politics on Long-Run Economic Performance (1998) 8. Ronald W. Jones, Globalization and the Theory of Input Trade (2000) 9. W. Max Corden, Too Sensational: On the Choice of Exchange Rate Regimes (2002)

Too Sensational: On the Choice of Exchange Rate Regimes

W. Max Corden

The MIT Press Cambridge, Massachusetts London, England

© 2002 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. Set in Palatino by The MIT Press. Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data Corden, W. M. (Warner Max) Too sensational : on the choice of exchange rate regimes / W. Max Corden. p. cm. — (Ohlin lectures) Inclues bibliographical references and index. ISBN 0-262-03298-8 (hc.) 1. Foreign exchange rates. 2. Foreign exchange. I. Title. II. Series. HG3851 .C66 2002 332.4'56—dc21 2001056263

for Dorothy

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Contents

“Too Sensational” Preface xi 1 Introduction 2

A Long History

ix

1 9

3 Two Regimes and Three Approaches

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4 The Fixed-But-Adjustable Exchange Rate Regime 5 In-Between Regimes

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61

6 The Real Targets Approach: A Diagrammatic Interlude 83 7 What Role for Fiscal Policy?

95

8 Contractionary Devaluation and Unhedged Foreign-Currency-Denominated Borrowing

117

9 Openness and the Size of the Economy: How Do They Affect Regime Choice? 133

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10 Lessons from Latin America: Chile, Brazil, Mexico 11 Argentina’s Great Currency Board Experiment 12 Lessons from Asia 13 Lessons from Europe

195 227

14 The Exchange Rate Regime: Too Sensational, Hollowed Out, Unimportant 245 Bibliography Index 271

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155 179

“Too Sensational”

Miss Prism: Cecily, you will read your Political Economy in my absence. The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational. Even these metallic problems have their melodramatic side. —Oscar Wilde, The Importance of Being Earnest. (first performed 1895)

In the nineteenth century Britain was on the gold standard and India on the silver standard. In the 1870s the price of silver fell precipitously, partly because major countries, notably France and the United States, had been moving from a bimetallic standard to the gold standard. As a result the Indian rupee depreciated sharply relative to the British currency (pound sterling) and many other currencies. This increased the competitiveness of Indian exports, but also raised the rupee cost of sterling-denominated “home charges” that India had to make to Britain. (These charges covered various costs of imports, pensions, and so on that the Government of India incurred in Britain.) Hence the choice of monetary regime became a subject of vigorous debate. In 1886 the Gold and Silver Commission was set up to investigate the causes and effects of the fall in

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“Too Sensational”

the silver price. It produced a voluminous report, which had benefited from submissions from most of the British economists of the period. Hence it becomes clear why Miss Prism concluded that “even these metallic problems have their melodramatic side.” Presumably the melodrama was associated with the consequences—including the debates—that resulted from the sudden and steep exchange rate depreciation of the rupee relative to sterling. It has its modern parallel in the many crises of the fixed-but-adjustable exchange rate regimes which are discussed at length in this book. They, also, have been “too sensational.”

Preface

This book is a substantial expansion of the two Ohlin Memorial Lectures that I gave at the Stockholm School of Economics in September 2000. I gave the lectures from notes that mostly contained the ideas of chapters 3 and 4 of this book, and some of the content of chapters 10–13. It was a great honor to be invited to speak in such a distinguished lecture series, in memory of one of the greatest figures in international economics this century. I would particularly like to thank Mats Lundahl for the invitation. Among economists world-wide Bertil Ohlin is famous both for his pioneering contributions to trade theory and for his development of the theory of the transfer problem in 1929, when, it must be said, he won a debate with John Maynard Keynes in The Economic Journal. In Sweden he was best known at first for his many articles in newspapers and journals on current economic issues, and later his major political role as leader of the Liberal Party. But, was he ever concerned with the particular issue that was the subject of my two lectures, and now of this book, namely the choice of exchange rate regimes? The answer is: yes, he was. With the German financial crisis in 1931 capital inflow into Sweden suddenly ceased. Swedish reserves declined, and the

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Swedish central bank (the Riksbank) tried to maintain convertibility into gold by obtaining foreign loans. But negotiations collapsed when Britain went off gold in 1932. At the same time France and the rest of the gold bloc stayed on gold at the original parity. Eventually Sweden had to suspend convertibility so that the krona was allowed to float, though the intention initially was to return (peg) to gold. With the British (pound sterling) devaluation, there were three alternatives for Sweden: return to gold at a devalued rate, peg to sterling, and allow the rate to float while using monetary policy to target the price level. Here was a classic “choice of exchange rate” decision to be made. Sweden wisely chose floating and price level targeting, which led to gradual inflation until the price level was restored to the predepression level. In response to the 1932 financial crisis the Riksbank was able to act as lender of last resort to the banking system. The exchange rate decision enabled Swedish policy to be flexible and thus quite expansionary in the circumstances. I owe this account to Eichengreen (1995). The main point here is that Bertil Ohlin, while in his early 1930s, played a role in the discussion of exchange rate policies. He and the other main Swedish economists at the time, Wicksell and Cassell, favored the price stability approach. They had long emphasized the importance of price stability as a precondition for prosperity, no doubt heavily influenced by the experience of German hyperinflation. In 1932 Ohlin published an article on Swedish monetary policy, and, later another, entitled “Can the gold bloc learn from the sterling bloc’s experiences?” (Ohlin 1936). He concluded: “It is obvious that currency depreciation has been an essential condition of economic improvement in the sterling countries.” My own interest in the subject of this book is long standing. It began with the proposals in the early 1970s for European

Preface

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monetary integration, which stimulated my 1971 Graham lecture at Princeton University on monetary integration (Corden 1972). Chapter 9 of this book builds directly on this earlier work. Later I became interested in the macroeconomic policies of developing countries as the result of a World Bank-sponsored project that led me into in-depth case studies of the experiences of many developing countries, published as Little et al. 1993. My ideas on exchange rate policy—especially the distinction between the nominal anchor approach and the real targets approach to the choice of exchange rate regime—were expounded in Corden 1991. In the current book my primary aim is to clarify issues, as well as draw some lessons from country experiences. In general I do not advocate simple solutions to problems, especially when they do not exist other than in the minds of advocates! But I do have some conclusions in the last chapter, and my policy views are scattered throughout the book. Chapters 3–9 consist primarily of verbal theory helped with a few diagrams; chapters 10–13 consist of case studies. In each case study I have sought to derive some lessons on the central issues raised in the earlier chapters. My method could be described as “story telling informed by theory.” I do not claim that the country cases are selected on any scientific basis. I have tended to select countries where there have been crises, or where interesting issues are highlighted. The length of chapter 12 indicates my particular familiarity with Asian countries and with the Asian crisis that began in 1997. I have devoted a whole chapter to Argentina not because that country is particularly important in the world but because it currently is a major laboratory experiment of the much-advocated currency board regime. I do not discuss at any length the many proposals for reform of the exchange rate relationships among the major currencies—the dollar,

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the yen, and the Euro. There is a vast literature on this oncepopular subject (referring of course to the dollar, the yen, and the Deutschmark), and I have given my skeptical views in Corden 1994. I would like to thank the Stockholm School of Economics, and especially Mats Lundahl and Pirjo Furtenbach, for their hospitality in their beautiful city. I have greatly benefited from extensive comments on drafts of the book, or on particular chapters, by George Tavlas and by Prema-Chandra Athukorala, Thilo Erhart, George Fane, Morris Goldstein, Sisira Jayasuriya, Vijay Joshi, Daniel Lederman, John Martin, and Francesco Mongelli. My colleague Jim Riedel helped with the diagrams, and Patricia Calvano and Rosa Bullock at the Paul H. Nitze School of Advanced International Studies of The Johns Hopkins University gave me their usual very competent secretarial support. I have made use of some passages in an article by me in The Annals of the American Academy of Political and Social Science, 2002, entitled “Exchange Rate Regimes for Emerging Market Economies: Lessons from Asia,” and thank the Academy for permission to publish them here. Washington, DC, September 2001

1

Introduction

There is a large literature on the choice of exchange rate regimes. Most of it has, until recently, been concerned with the exchange rate regimes of the developed countries. But since the emerging markets crises that began in 1994 with the Mexican crisis, attention has shifted to the choice of regimes for developing, especially emerging market, countries. That is also the emphasis of this book. In the literature on this subject many plans and views are put forward, but it is not always explicit what are the underlying models, the empirical bases for proposed policies, or the assumed value judgments. My main aim is to give some order to this field. My method is to set out three “approaches” and three “polar regimes.” I then use these as a framework for all further description and analysis. I have found these two classifications most helpful, and I hope the reader will also. The three approaches are the Nominal Anchor Approach, the Real Targets Approach, and the Exchange Rate Stability Approach. All are described in chapter 3. Then, there are three polar regimes. They are the absolutelyfixed exchange rate regime, the pure-floating regime, and the fixed-but-adjustable regime. The last I will henceforth call the FBAR. I analyze the first two regimes in terms of the three approaches in chapter 3 and the FBAR in chapter 4.

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Chapter 1

The three polar regimes are currently not the most prevalent regimes (although the FBAR was once) but all other regimes can be regarded as mixtures of two or more of these, and their effects can be described and analyzed more easily by using the three polar regimes as reference points. The other regimes I call “in-between regimes,” and they are listed and discussed in chapter 5. The regime that is now (2001) most common is “managed floating.” An overview of all the regimes can be obtained from figure 5.1. At this point I will not try to justify treating the FBAR as a polar regime. This is done in chapter 4. I discuss at length the advantages and disadvantages of the FBAR (including the closely related “active crawling peg regime”) because of the way FBARs often have ended in crises. Since these crises many writers in this field have been very critical of FBARs and many countries have abandoned them. I also give prominence to the currency board regime—which is an inbetween regime close to an absolutely-fixed regime. While currency boards are not at all common, they have been popular with some economists. I discuss the two major cases, namely Argentina (chapter 11) and Hong Kong (chapter 12) in detail. Perhaps the fashion for currency boards will have passed by the time this book is published, but they represent, along with monetary union, the main alternative to some kind of flexible exchange rate regime. I focus in particular on how economies react under various exchange rate regimes to negative and to positive shocks, especially the former. If the shocks are expected to be shortterm no exchange rate reaction may be needed. Fiscal policy, through what I call functional finance, may be able to deal with the problems created, as may stabilizing reactions by the private sector. Here I will generally have in mind those shocks where the consequences are expected to last for some

Introduction

3

years. These issues, and others, are discussed more fully in chapter 7. Chapter 2 gives some historical background, and chapters 3–9 are the theoretical chapters. Then follow the case studies—chapters 10 and 11 (Latin America), chapter 12 (Asia), and chapter 13 (Europe). Finally, chapter 14 is the conclusion, where I make some policy judgments in the light of what went before. Some of my policy views have also crept into earlier chapters. The book is concerned mainly with those developing countries that are integrated in the world capital market, though the theory is more generally applicable. I make various assumptions, from which I sometimes explicitly depart, but which mostly I maintain throughout the theoretical chapters. First, I assume that international capital mobility for the country concerned is significant. The growth of the international capital market, and the liberalization of capital movements by many developing countries, have been major developments in the world economy since the 1980s, and sometimes before. The crises of the 1990s in Asia can be attributed to some extent to such liberalization. In the theory chapters I take international capital mobility as given. But the degree of capital mobility can vary. The extreme assumptions of “perfect capital mobility” or “perfect substitutability of domestic-currency and foreign-currency-denominated bonds of equal maturity and by the same issuer” rarely apply. The model I use, and that is most appropriate, is the portfolio balance model. Only in a section of chapter 4 do I explicitly assume low or zero capital mobility. All the case studies (with the exception of that of India) are of countries that are or have been significant importers or exporters of capital, or both, relative to the size of their economies.

4

Chapter 1

Second, I assume that there is available as a nominal anchor one or more currencies that are suitable as an anchor for other currencies. The two candidates are obviously the US dollar and the Euro. Possibly there are others, such as the yen. I do not discuss the institutions, histories, and policies that sustain the suitability and reputations of these currencies, but just take their availability as given. In particular I do not discuss the low-inflation credentials of these two currencies. Third, I assume that, with regard to the impact on the international capital market, the country I am considering is a “small” country. It does not individually have a significant effect on world interest rates, and the only limits to its international borrowing capacity are set by the capital market’s assessment of exchange rate risks and default risks. It must be emphasized that, in this sense, currently all countries other than the United States, Japan, and Germany are small. Even China, France, and Britain are “small.” The scope of the book is limited in various ways. It does not have a systematic discussion of all the advantages and disadvantages of exchange controls and of taxes on capital inflows or outflows, and the practical problems they involve. Capital controls and taxes enter this book at several points. First, I make a distinction in chapter 4 between lowspeculation and high-speculation FBARs. Controls may be able to turn the latter into the former. Second, I discuss the Chilean experiment with taxes on short-term capital inflows, in chapter 10 and the Malaysian, Chinese, and Indian controls in chapter 12. The book does not deal with the “G3” issues. In a basic sense the three approaches and the classification of exchange rate regimes are as relevant to the United States, Japan, and the European Monetary Union (the G3) as they are to other countries. But the governments and central banks of these

Introduction

5

very large economies are the main actors in the international monetary system, and systemic issues are beyond the scope of this book. I have dealt with them in Corden 1994, and there is a large literature on the relationship between the G3 currencies and the choice of the exchange rate regime for them. Until the end of 1998 the third currency was not the Euro but the deutschmark (DM). Essentially the book is concerned with countries whose policies can be studied primarily from their own point of view, without regard to international, repercussions. I also do not discuss the institutional problems, and especially the decision-making processes, in the European Monetary Union. From the point of view of the scope of this book, the countries that are now members of EMU have made their choice of exchange rate regime, and their choices are most unlikely to change within any future one can foresee. My main interest is in the lessons EMU has for other countries, including potential new members. Finally, this is not a book about crises—their causes and effects—except in so far as this large subject bears on the precise topic of this book, namely the choice of exchange rate regimes. I do discuss some crises in detail in chapters 10 and 12, but the focus is always on the exchange rate aspect. The empirical content of this book is almost wholly in the case studies, some lengthy, and one brief, of twelve countries. There are many more from which lessons could be learned. Mostly, but not wholly, I have included countries that have recently had crises or that teach particular lessons. But another book could be written with case studies of many more countries. The case study approach has limitations. A common alternative to the case study method is to conduct multi-country econometric exercises. I cite several papers

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Chapter 1

reporting on such exercises. But this method also has wellknown limitations, especially the difficulty of making simple classifications of many countries’ changing, and not always transparent, exchange rate regimes. I believe that the official IMF classification, based on governments’ own descriptions of their regimes, is pretty meaningless. I discuss this problem further at the end of chapter 5. There is also the question whether countries should be weighted in some way, possibly according to the size of their economies. Is a multi-country econometric exercise meaningful when Chad has the same weight as India? In practice, economists in this and other fields have formed their views and developed their theories on the basis of particular countries’ experiences, often their own countries. In the case of US-based economists interested in developing countries, the influences have usually been the experiences of a few countries in Latin America. Thus twelve case studies are better than just one. But, more such case studies, even though based to a great extent on secondary sources, should be done. References There is a vast literature on the choice of exchange rate regimes. I shall refer to some of this in connection with particular countries and aspects. The clearest and most comprehensive recent review of the issues is in Eichengreen 1994. For a concise overview see Stockman 1999. Considering specifically the exchange rate regimes of developing countries, and only listing publications from 1990 onward, there are (among others) Joshi 1990, Corden 1991, Aghevli et al. 1991, Frankel 1999, Larrain and Velasco 1999, Cooper 1999a, Edwards 2001, and Mussa et al. 2000. The last

Introduction

7

is particularly comprehensive, and also deals with developed countries. Kaminsky and Reinhart (1999) analyze the relationships between banking and currency crises as experienced by fifteen developing countries in the period 1970–1995. Capital controls, taxes on capital flows, and exchange controls are discussed more fully in Cooper 1999b, Ariyoshi et al. 2000, and Fane 2000.

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2

A Long History

The subject matter of this book has a long history. Many times, exchange rate regime choices needed to be made, and they have led to vigorous debates among economists and the political community at the time. “The choice of exchange rate regimes” is certainly not a subject that was born recently. Hence I begin with some brief historical background. One must distinguish regime choices from exchange rate choices within a given regime. The decision to return to the gold standard after the First World War was a regime choice. The choice of parity at which to return was just an exchange rate choice. Similarly, during the Bretton Woods regime as well during the European Monetary System regime frequent decisions had to be made whether or not to alter exchange rates, and, if so, by how much. These were not regime choices. The Gold Standard versus the Bimetallic Standard In the nineteenth century the big issue, endlessly debated, concerned the choice between the gold standard and the bimetallic standard. The latter involved the use of both gold and silver, with a fixed ratio between them. The two other alternatives were to have free coinage, that is no metallic

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Chapter 2

standard at all, and the silver standard. The case for having a metallic standard of some kind was “to strap down Ministers of Finance” (Keynes 1923). In other words, the aim was to prevent the monetization of budget deficits, a process I shall be discussing in chapter 7 and which has its origin in far antiquity. When one looks closely at the debates when decisions had to be made, and after regime changes had taken place, the issue usually was: “inflation versus deflation.” Some interest groups and ideologies favored one, some another. Debtors liked inflation and creditors deflation. If supplies of gold had been increasing, while supplies of silver had not, then adherence to the gold standard would be inflationary. On the other hand, if supplies had not kept up with the growth of economies, or demand for non-monetary use had increased, so that the price of gold rose, adherence to gold would be deflationary. Because supplies of gold sometimes increased sharply (for example, as a result of the Californian and Australian gold discoveries) and at other times did not keep up with demand, adherence to the gold standard led to considerable general price level instability. A bimetallic standard tended (on the whole) to lead to a more stable price level, at least provided the fixed gold-silver ratio was between the limits at which only gold or only silver would be used. If supplies of silver increased relative to supplies of gold—so that the price of silver fell relative to the price of gold—eventually gold would become demonetized: the country would be on a silver standard. (“Bad money drives out good.”) During both the Napoleonic War and the First World War Britain went off gold, and prices rose. After these wars the issue was whether Britain should return to the gold standard and at what parity. In both cases it was decided to return to gold at the prewar parity. In both cases the effects were deflationary.

A Long History

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In 1879 the United States went on the gold standard. But in the latter part of the century there was a deflationary trend in all the gold standard countries. This led to a campaign in the United States (led by William Jennings Bryan) to take the United States off “the cross of gold” and move to a bimetallic standard. It became the central issue at the Presidential election campaign of 1896. McKinley, the gold standard candidate, won. Essentially it was an “inflation versus deflation” issue. This episode illustrates the importance of the choice of exchange rate regime issue at the time, and indeed right through the nineteenth century. From 1870 onward most of the major European economies, as well as the United States, followed Britain by going on the gold standard, giving up the use of silver. The movement away from silver, as well as other factors, led to a precipitous decline in the price of silver. It had the effect equivalent to a rise in the supply of silver. Thus the exchange rates of countries that remained on the silver standard, notably China and India, effectively depreciated relative to the gold standard countries. Familiar issues were raised: Indian competitiveness relative to Britain and other gold standard countries increased, debts and payments denominated in sterling increased in terms of Indian rupees, and the effects in India were likely to be inflationary. These issues were discussed by Keynes in his first book (1913), which was on Indian currency and finance. In 1893 (formally in 1899) the British rulers of India put India on the gold exchange standard, with Indian reserves held in the form of sterling in London. The Interwar Period: Back to Gold, Then Off Gold By the beginning of the twentieth century the international gold standard was well established although it had by no

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means ensured stability of price levels or avoided periods of deep recession. But in the highly disturbed interwar period 1919–1939 all the regime issues came to the fore again. This time silver was out of the running. The issues were two: first, there was the regime choice, whether to return to or stay on gold, and second, if there was to be return to gold after the free floating episode during the First World War, at which gold parity was there to be a return. As I have already noted, in 1925 Britain returned to gold at the prewar parity, with severe deflationary results right through the remainder of the 1920s. This experience had a lasting effect on the thinking of British economists and influenced the later Bretton Woods agreement. After the period of high inflation that followed the war, other European countries also returned to gold, for the obvious reason that they were eager to recover some price level stability and financial discipline. France returned to gold after an episode of high inflation. During its postwar high inflation period, not only its nominal exchange rate, but also its real exchange rate depreciated, and when France went back to gold in 1926 it chose a parity that, even in real terms, was much depreciated relative to prewar. Its experience contrasted with that of Britain. The French real economy did well in the 1920s, essentially because it returned to gold at a depreciated real exchange rate while Britain did so at an appreciated one. Britain and France also reacted differently from each other in response to the Great Depression, but this time it was Britain that followed the more expansionary path. Britain went off gold and depreciated in 1931, taking the whole sterling bloc with it, while France stayed on gold at the parity of the 1920s, so that the depression was much severer there. Presumably the British had looked back on their poor experience of the 1920s and were readier to go off gold, while

A Long History

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France looked back on a much better experience. But now the tables were turned when one compares the two countries. The big regime choice was made in crisis conditions in the 1930s. By contrast, in the 1920s there was little serious debate about going back to gold. Only a few, notably Keynes, advocated a managed exchange rate regime aimed at price level stability. In Keynes 1923 he posed clearly the choice between price level stability (meaning neither inflation nor deflation) and exchange rate stability (as represented by the gold standard), and laid out the arguments for and against clearly. He considered “strapping down Ministers of Finance” the strongest argument in favor of going back to gold. This is essentially the “discipline” argument for a nominal anchor exchange rate regime, an argument that is now very fashionable and that will play a big role in the following chapters here. He thought that, while the arguments for “strapping down” are “reasonable grounds for hesitation” (to move to a managed monetary regime), “the experience on which they are based is by no means fair to the capacities of statesmen and bankers. . . . I do not see that the regulation of the standard of value is essentially more difficult than many other objects of less social necessity which we attain successfully.” Bretton Woods: Reluctant Adjustment The only occasion when there was a thoroughly systematic approach to establishing a new exchange rate regime was the negotiation, primarily between the United States and Britain, that led to the 1944 Bretton Woods agreement. Of course, Bretton Woods involved more than just the exchange rate regime, but that is my focus here. Its principal exchange rate feature—namely the establishment of a fixed-but-adjustable regime, with changes not to be unilaterally decided but to be

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Chapter 2

approved by an international organization (the International Monetary Fund or IMF), can be explained by the general perception at the time of the faults of earlier regimes. Floating or flexible exchange rates in the 1930s (and also after the First World War) had been unstable, subject to (presumably) destabilizing speculation. Hence the new regime would have fixed rates. Rigidly fixed rates, as under the gold standard had prevented countries from making adjustments to maintain full employment. Hence the new regime would allow for adjustments when there were “fundamental “ disequilibria. Finally, in the 1930s, chaotic exchange rate relationships had developed as a result of competitive depreciation, with countries trying to reduce their unemployment at the expense of other countries. Hence the new regime would put an end to unilateral exchange rate decisions, and put the International Monetary Fund (IMF) at the center of the system. Furthermore, the belief that speculation tended to be destabilizing led to the approval of controls on international capital movements. The Bretton Woods regime did not turn out quite the way it was intended. In particular, exchange rate adjustments were extremely reluctant, so that it was closer to a fixed rate system—a gold exchange standard or gold-dollar regime— even though the possibility of devaluation within the system always existed. It is this fixed-but-adjustable exchange rate system (FBAR), which lasted for some countries even after the breakdown of the Bretton Woods regime, that I shall come back to many times in subsequent chapters. The Bretton Woods regime effectively ended in March 1973. The regime was not ended by any official decision, since there had been endless discussions about reforming, not ending, it. Rather, the regime broke down for reasons that I can hardly summarize briefly here. Above all, specula-

A Long History

15

tion against the dollar was made possible by increasing capital mobility. The result was that the new era of floating exchange rates among the major countries began. This episode raises the issue that is still relevant today, namely whether a fixed-but-adjustable regime can be compatible with high international capital mobility. The sterling and franc crises during the Bretton Woods era, and the final breakdown of the Bretton Woods regime itself, suggest that even with exchange controls, let alone without them, a fixedbut-adjustable regime is prone to crises, sometimes surviving, but finally ending. The Managed Floating Regime, the European Monetary System, and European Monetary Union The reality of the ending of the Bretton Woods regime was officially recognized by the Jamaica Agreement of 1976. Subject to two qualifications one can say that the new floating rate regime—more precisely, the managed floating rate regime—has lasted until now and no doubt will continue. The first qualification is that for a limited group of important countries independent floating ended in 1979, with the establishment of the European Monetary System (EMS), and this was succeeded by European Monetary Union (EMU). The second qualification is that developing countries (other than a few in Latin America) continued to adhere to fixed-butadjustable exchange rate regimes right into the 1990s. During the 1970s, and especially the 1980s, an extensive debate and a sophisticated literature developed, reflecting disappointment at the instability of exchange rates under the new managed floating regime. The stimulus came, above all, from the extraordinary movements of the dollar relative to the yen and the deutschmark in the 1980s. Many proposals

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Chapter 2

for regime changes were made, notably that there should be a return to some kind of fixed rate regime, backed up by monetary policy coordination among the major countries, and that a target zone regime, with various possible permutations, be established. There were even proposals blessed by the Wall Street Journal for a return to the gold standard. All these proposals have been thoroughly analyzed and much surveyed, but in fact none of them have been implemented. It can be said that by the early 1990s the reality was generally recognized that managed floating among the major currencies, with freedom of capital movements, was here to stay. The major regime change during this period up to 1999 was the establishment of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) in 1979. The original objective was quite clear: it was to stabilize, to a limited extent, exchange rate relationships among members of the EMS. The system lasted effectively until 1993, barely surviving the great EMS crisis of 1992, and surviving formally until 1999. I shall discuss it further in chapter 13. In January 1999 the European Monetary Union (EMU) was inaugurated. This was surely the most important regime change since the breakdown of Bretton Woods. I shall also come back to it in chapter 13. Proposals for European monetary integration actually go back to the early 1970s, though the officially planned implementation by stages came to a dead halt as a result of the instabilities and inflation differentials among potential members that developed in 1973. The modern academic literature on the broad subject of monetary integration and the choice of exchange rate regime goes right back to the seminal optimum currency area paper by Mundell (1961). This academic literature was naturally stimulated in the 1990s by the politically motivated decision

A Long History

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embodied in the Maastricht Treaty of 1991 to proceed in a staged process, with strict conditions, to European Monetary Union. Developing Countries’ Exchange Rate Regimes: Experiments and Crises I turn now to developing and ex-socialist (transition) countries. A brief regime experiment took place in the “Southern Cone” (Argentina, Chile, and Uruguay) from 1978 to 1981. The idea was to use a crawling peg exchange rate regime as a nominal anchor to get the inflation rate down. There have been several such programs since. In the case of Chile the program did succeed in radically reducing the rate of inflation, while in the Argentine case it did not. But in all three cases the regime ended in crisis. I shall discuss this kind of exchange-rate-based stabilization program at various points in later chapters. The experiments were based on a theory that originated at the University of Chicago, namely so-called “international monetarism.” This was a correct description since it did represent an extension to an open economy of the basic idea of monetarism. The idea of the latter was that a strong commitment to a predetermined rate of growth in the money supply would act as a nominal anchor for monetary policy and hence for the inflation rate. It would provide monetary policy discipline, and it would create the credibility that would keep inflationary expectations down to levels compatible with the growth rate of money. Exchange rate commitments, including the commitments implied in the gold standard, have earlier anchored monetary policy and the inflation rate in many countries. Yet this was the first occasion since the end of the interwar gold standard, when the nominal anchor

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Chapter 2

concept was put explicitly in the front seat when a decision on an exchange rate regime was being made. A series of exchange rate crises in developing and transition countries began in 1994, each of the crises leading to an exit from a fixed-but-adjustable or crawling peg exchange rate regime. I am sure every citizen and politician would agree that they were all “too sensational.” There was the Mexican crisis at the end of 1994, the Czech crisis in 1997, the Asian crisis, affecting Thailand, Indonesia, Malaysia, the Philippines, and Korea (and indirectly several other countries) in 1997, the Russian crisis in 1998, the Brazilian crisis following closely, and finally the Turkish crisis in 2001. I shall discuss several of these, especially the Mexican, Brazilian, and Asian crises, in detail in chapters 10 and 12. These crises—which were similar in kind, though much more severe, than the 1992 ERM crisis—led to a complete reconsideration of the exchange rate regime issue for the “emerging markets” countries. These were the developing countries that had liberalized international capital movements and were integrated in the world capital market. Perhaps the practice of the fixed-but-adjustable exchange rate regime (or crawling peg regime) was no longer tenable? Perhaps countries must choose between the extremes of an absolutely-fixed regime, like joining EMU, using the US dollar, or establishing a currency board on the one hand, and pure floating, possibly with just a little intervention in the foreign exchange market, on the other? In the potential regime chain from absolutely fixed to pure floating, was the middle being “hollowed out”? Suddenly currency boards seemed to become serious options and a few economists became enthusiasts for that particular arrangement. In practice, many of the affected countries moved to floating rate regimes, but not ones that could be described as pure floating

A Long History

19

or as neglecting the exchange rate. But I am anticipating. In the following chapters I will try to sort out and explore systematically the various issues in this ongoing debate. References On the gold standard see de Cecco 1992 and Eichengreen 1995. On the “cross of gold” see Sylla 1992. Eichengreen (1995) is extremely thorough on developments in the interwar period. On bimetallism, see Bordo 1992. On the Gold and Silver Commission, see Perlman 1992. Bordo and Schwartz (1997) describe numerous currency crises from 1797 (suspension of the gold standard by Britain) to 1994 (the Mexican crisis). On Bretton Woods and its breakdown, see Kenen 1992 and Bordo and Eichengreen 1993. On the failure of the reform process, see Williamson 1977. Solomon (1982) gives a detailed insider’s view of international monetary events from 1945 to 1980. On the Southern Cone experiment, see Corbo, de Melo, and Tybout 1986 and Edwards and Edwards 1991 on Chile and Little et al. 1993 (chapter 7) on the Argentine and Chilean experiences. An overview and analysis of events in international finance in the period 1980–1998 is in Solomon 1999. On proposals for reform of the exchange rate system of the major currencies (dollar, yen, deutschmark) after the breakdown of Bretton Woods, see McKinnon 1984, Cooper 1984, Williamson and Miller 1987, and Kenen 1988. Critical reviews of the main reform plans are in Eichengreen 1994, Corden 1994 (chapter 16), Goldstein 1995, and Clarida 2000. My own conclusion was that “managed floating is here to stay.”

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3

Two Regimes and Three Approaches

There are three polar exchange rate regimes: the absolutelyfixed regime, the pure-floating regime, and the fixed-butadjustable exchange rate regime, or FBAR. Then—in my view at least—there are three distinct approaches to exchange rate and monetary policy, namely the Nominal Anchor Approach, the Real Targets Approach, and the Exchange Rate Stability Approach. Each approach focuses on different objectives. It is a striking fault of many writers in this field that they ignore or underplay the possibility that all three approaches need to be considered. Actual regime choices will have to take all three approaches into account. In this chapter I shall discuss the first two exchange rate regimes, leaving the FBAR to the next chapter. It is conventional to treat the absolutely-fixed and the pure-floating regimes as polar cases of exchange rate regimes. The FBAR is usually seen as a compromise between the two, rather than a polar case of its own. To some extent the conventional view is justified, but the fact is that the FBAR has special problems of its own, having to do with speculation, so it cannot just be chosen by a balancing of the advantages and disadvantages of the other two polar regimes.

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In addition to the three polar regimes there are many “inbetween” regimes that are compromises of various kinds between any two or between all three of these polar regimes, and I shall discuss them in chapter 5. Figure 5.1 gives an overview of the various regimes. An example of an inbetween regime is the target zone regime, adopted by many countries at various times. But the most common type of regime is now “managed floating.” The Absolutely-Fixed Regime and the Pure-Floating Regime In the absolutely-fixed regime the country has neither an independent exchange rate policy nor an independent monetary policy. The two principal examples of an absolutelyfixed exchange rate regime are dollarization and monetary union. With dollarization the country uses another country’s currency, and its monetary policy is determined by the other country’s central bank. It may use the dollar, or some other currency, such as the Euro. (I use dollarization as shorthand for the use of any foreign currency.) With monetary union there is a common currency and a common central bank. Dollarization and monetary union differ in the following respects. First, with dollarization the country must accept the monetary policy of the “hegemonic” or anchor country, while with monetary union the country’s representatives may be on the board of the central bank of the union and thus have some influence on the common monetary policy of the union. Second, with dollarization the country must give up real resources to obtain the necessary currency from the anchor country, while with monetary union the country may obtain some share of the seigniorage generated by the creation of the union’s base money.

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23

A currency board system (discussed in detail in chapter 5) may come close to being an absolutely-fixed regime. It would need to be firmly established and its survival must be fully credible. If it is a proper or pure currency board system, its rules will include not only commitment to a firmly fixed exchange rate but also strict regulations that effectively prohibit an independent monetary policy. Neither budget deficits nor rescues of commercial banks can be financed by money creation. The country’s money base must be fully backed by foreign exchange reserves. The pure-floating regime is one where there is no direct intervention by the central bank in the foreign exchange market. While the exchange rate will still be influenced by monetary policy, such policy is not formally or informally directed to achieve particular exchange rate targets. There is no commitment to a particular exchange rate. The exchange rate responds both to market forces (especially expectations) and to monetary policy acting on interest rates. The absence of commitment to a particular exchange rate is central. I shall now expound the three approaches to exchange rate and monetary policy, using them to compare the absolutelyfixed regime with the pure-floating regime. In this chapter I shall always assume high international capital mobility. The Nominal Anchor Approach A country may have a history of high inflation. One immediately thinks of Argentina and Brazil here. The reason for high inflation is usually the financing of fiscal deficits by money creation—that is, monetization of deficits. This is the case where fiscal deficits lead to monetary expansion, which in turn leads to price and wage rises. An alternative mechanism is one where inflationary expectations, or just cost-push or

24

Chapter 3

even political pressures, lead to wage increases, and thus price increases. The money supply is then increased so as to avoid the declines in real money supply that would otherwise result, and that would cause recession and unemployment. Simplifying somewhat, at any point in time the inflationary process may thus continue because of monetization of deficits or of inflationary expectations. In addition, inflation may result from monetary expansion designed to raise short-term employment and output above their natural (long-term non-inflation) levels. A simple solution is to fix the exchange rate to an anchor currency—i.e. the currency of a country that has a long history of low inflation and well-established institutions that will ensure low inflation continues. The exchange rate becomes the nominal anchor. The two major currencies that are currently available as anchors are the US dollar and the Euro. In the extreme absolutely-fixed case the country would give up its own currency. It would dollarize (or “Euro-ize”) or join the EMU. When the aim is to reduce inflation a common alternative to fixing the exchange is to have an exchange-rate-based stabilization program with a “crawling peg” exchange rate regime. I shall discuss that in chapter 5. If inflation is to be reduced without unacceptable recessions and unemployment being caused, both discipline and credibility are required. Discipline refers to restrictions on the ability to expand the money supply to finance fiscal deficits or to ratify wage increases. Credibility refers here to the establishment in the labor market of the belief that fiscal deficits and wage increases will not be ratified by monetary expansion, and that price inflation will slow down or end because the necessary monetary expansion will not take place. Such credibility should then stop or slow up the wage increases. If the country has a fixed exchange rate commitment prices of

Two Regimes and Three Approaches

25

tradables will not be able rise much ahead of those of the anchor country. Furthermore, with an absolutely-fixed regime there is no freedom to expand the money supply. This does not mean that there cannot be episodes of temporary inflation when relative prices of nontradables need to rise, possibly because of a domestic boom financed by capital inflow. But continuous domestically generated inflation is not possible. In the pure-floating regime the exchange rate cannot act as a nominal anchor. But this does not mean that there cannot be a nominal anchor at all. A monetary policy resulting from a strong commitment to low inflation can play a similar role. A strict money supply growth rule that serves as a nominal anchor was often advocated during the short era of enthusiastic monetarism in the 1970s and early 1980s. While such a strict rule was rarely implemented, inflation and exchange rate expectations were much influenced by statistics of money growth rates. But a major difficulty arose (both in Britain under the early Thatcher government and in the United States) because velocities of circulation turned out to be quite unstable and unpredictable, so that growth rates of money (whether defined narrowly or broadly) were poor guides to nominal income growth. More recently, inflation targeting, pioneered in a formal way in New Zealand, Canada, and the United Kingdom, has become popular. The central bank makes a commitment to a specific low inflation rate (or to a narrow range), and seeks to fulfill the commitment by varying the short-term interest rate. The commitment is essentially medium-term, and is either established by the government or made in collaboration between the government and the central bank. To avoid political pressure to depart from the commitment the central bank has to have independence from the government and

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parliament in its monetary management—though not necessarily in the establishment of the objective. To ensure credibility for its policies full information about its policies and forecasts needs to be provided, usually now in the form of a regular “inflation report.” This system of inflation targeting does not necessarily lead to exchange rate stability. It can also result in short-term departures from the target, particularly because of the long lag between policy implementation (that is, interest rate changes) and the inflation outcome. In addition, interest rate policy has to be based on forecasts of what inflation trends would be if there were no policy change. Such forecasts are difficult to get right. Hence inflation targeting has usually a medium-term orientation. But if the central bank is truly independent, and thus not required to finance budget deficits, rescue banks, or offset the unemployment effects of wage increases, and if it is competently managed, the system can work—as indeed it has in Britain, Canada, New Zealand, Sweden, and some other countries. It ensures discipline, and if it works for some time, also credibility. The Real Targets Approach In the 1970s and the 1980s, if a developing country had an unsustainable current-account deficit and called upon the International Monetary Fund (IMF) to provide temporary finance, the IMF would usually set some technically simple (but politically difficult) conditions: reduce the fiscal deficit and devalue. The aim of devaluation was to make the country more competitive. A nominal devaluation was assumed to bring about a real devaluation, and the two targets—internal and external balance—were both real targets. This is an example of the Real Targets Approach. It was assumed that

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27

wages and other factor payments would not rise sufficiently to negate the real effects of the nominal devaluation, nor that a demand contraction alone, brought about by fiscal contraction, would achieve the necessary decline in real wages and thus improvement in competitiveness. This Real Targets Approach to exchange rate policy was once conventional, and might be described as Keynesian. I shall elaborate on it in chapter 6. Here I compare it with the Nominal Anchor Approach and also draw attention to its key assumptions. With the Real Targets Approach monetary and exchange rate policy are directed at a real target—namely output or employment, which in turn depend on various real factors and, above all, on the real wage. In the pure-floating rate regime that I am considering here, if the nominal wage rises, so that the real wage rises and employment is reduced below its desired level, a monetary expansion will then follow. It will depreciate the exchange rate, raise prices, and reduce the real wage again. Thus in this approach monetary policy, including its effect on the exchange rate, follows wage movements rather than leading them. This can be contrasted with the Nominal Anchor Approach. In that case the nominal exchange rate or monetary policy lead, while nominal wages are expected to follow—that is to adjust to the given nominal variables, producing a particular real wage and real exchange rate outcome. The more credible is the nominal anchor policy the quicker will the rate of nominal wage increase adjust to it. Coming back to the Real Targets Approach, suppose that there is a negative (adverse) shock that, for a given real wage, would reduce employment. To maintain the desired level of employment the real wage would have to fall. Assuming that the nominal wage is given, a rise in the domestic price level, brought about by a domestic demand expansion or nominal

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exchange rate depreciation (both brought about by monetary expansion in a floating rate regime) could then bring about the desired decline in the real wage and thus maintain employment. There are two assumptions implied in this approach. I must emphasize the importance of these assumptions for much of the discussion of exchange rate regimes. First, nominal wages are rigid or somewhat inflexible downward, so that a rise in prices is required to reduce the real wage and hence restore employment. The usual and plausible assumption is that in the short run at least excess supply of labor does not lead to a sufficient decline, if any, in nominal wages, even though excess demand would soon lead to a rise. Thus nominal wages are rigid (more or less) downward, even though flexible upward. The second assumption is that a decline in real wages brought about by a rise in prices will not be offset after a short lag by an increase in nominal wages designed to restore the real wage level. Thus, there is not formal or informal indexation. In other words, the assumption is that the real wage, by contrast with the nominal wage, is flexible downward. Insofar as this package of assumptions is valid there are thus two asymmetries: first nominal wages are rigid downward but not upward, and second the real wage is flexible downward even though the nominal wage is not. The absolutely-fixed exchange rate regime is clearly not compatible with this approach. By contrast, with a purefloating regime, an adverse shock that initially leads to recession and unemployment can be followed by a monetary expansion that lowers interest rates, hence leading to some domestic demand expansion and depreciating the nominal exchange rate. The nominal depreciation in turn would depreciate the real exchange rate, so making the economy more competitive, and so raising employment.

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29

The Exchange Rate Stability Approach I now come to the third approach to the choice of exchange rate regime. This focuses on a special problem of floating rates, as evidenced, for example, in the history since 1973 of the yen-dollar rate. In a floating rate regime exchange rates fluctuate, reflecting changing market expectations and herd behavior. There is short-run volatility and there are mediumrun “misalignments.” Not many people are left who would describe such movements as always, or even mostly, rational or correctly reflecting “fundamentals.” This approach provided the motivation for the establishment of the European Monetary System in 1979. Let me put the case for the Exchange Rate Stability Approach strongly, as it is often expressed, even though empirical work cannot show conclusively that exchange rate instability has done harm. In June 1995 the yen-dollar rate was 85 yen to the dollar. Three years later it was 141. Can such movements possibly be rationalized in terms of fundamentals? Exchange rates overshoot. From 1979 to February 1985 the dollar (on a trade-weighted basis) appreciated 50%. By 1987 it was back to where it was in 1979. The most dramatic story is that of the Indonesian rupiah in 1998. During that year the rupiah-dollar rate rose from 8,325 in March to about 15,000 in June, and by the end of the year it was back to 8,000. Perhaps one need not pursue this matter further here. It is certainly plausible that these ups-and-downs, sometimes stretching over quite long periods, are harmful for trade and for long-term capital movements, even though how much has been hard to measure. They raise transaction costs. They discourage longer-term investment flows. Perhaps they discourage international diversification of financial portfolios

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Chapter 3

(although the ups-and-downs of the dollar have not stopped a massive inflow of portfolio capital into the United States). They lead to disturbing domestic income redistributions that are eventually reversed. If private firms borrow abroad in foreign-currency-denominated form, they create balance sheet problems for themselves whenever the currency depreciates. I have little doubt that the harm is greater for developing countries where the exchange rate is particularly important, than for the United States, Germany, and possibly Japan. Of course, it is implied here that nominal fluctuations have real effects, and, in particular, that wages and prices of nontradables—or even prices of import-competing goods— are somewhat rigid or sluggish, so that nominal exchange rate fluctuations lead to somewhat similar real exchange rate fluctuations. This has certainly been true in the case of the major industrial country currencies, notably the dollar. Monetary policy can moderate such instabilities but at the expense of interest rate instability. When the dollar appreciates severely, having adverse effects on export and importcompeting firms, US interest rates might be lowered, hence inducing some depreciation, and later, when the dollar depreciates, interest rates can be raised. But then interest rates may have to be moved in directions that do not necessarily suit the domestic economy. In a floating rate regime, as expectations in the international capital market fluctuate, either spot exchange rates or interest rates (or some combination of them) must fluctuate also. All this is obvious and well accepted in general, though there are also plenty of episodes, such as the appreciation of the dollar from 1981 to early 1984, where fundamentals (including fiscal and monetary policies), rather than market irrationality or herd behavior, can explain exchange rate movements. In any case, if one believes that often such movements do not reflect fundamentals, or expec-

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tations of changes in fundamentals, correctly or sensibly, and that such movements have adverse effects, an argument for a fixed rather than a floating rate regime clearly emerges. Let me give more precision to this line of thought, and also bring out the crucial qualification. Consider first the case where the exchange rate fluctuates purely because of fluctuations in market expectations about the future exchange rate, possibly depending on expectations about future monetary policy. If these fluctuating expectations are taken as given, then an attempt to fix the exchange rate would simply convert exchange rate instability into interest rate instability. It is not obvious that this would be an improvement. On the other hand, a decision to fix the exchange rate permanently and credibly, possibly by moving to an absolutely-fixed regime or to a currency board, would stabilize the expectations themselves and thus yield a net stability gain. I believe that this is the essence of the Exchange Rate Stability Approach. Next, consider the case where the exchange rate in a floating rate regime varies because of variations in underlying real factors, for example variations in non-speculative capital flows or terms of trade changes. In that case exchange rate stabilization would increase real instabilities. This effect is at the heart of the Real Targets Approach. Changes in real exchange rates may be required by fundamentals in the real economy, including divergences in business cycles or terms of trade changes. To stabilize exchange rates would then have adverse effects. The Federal Reserve Board and the European Central Bank (ECB) might have tried to stabilize the Eurodollar rate from 1999, when the Euro unexpectedly depreciated. The ECB would have needed to raise interest rates in Euroland while the Federal Reserve Board would have had to reduce interest rates in the United States. This would have been inappropriate both for the booming domestic economy

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Chapter 3

in the United States and the sluggish economy in Euroland. On the other hand, if exchange rates fluctuated purely because of unstable or irrational market expectations, or herd behavior, the case for the Exchange Rate Stability Approach would be very strong. The Nominal Anchor Approach Again: Fixed Exchange Rate versus Inflation Targeting I outlined above the use of inflation targeting as a nominal anchor in a pure-floating exchange rate regime. The nominal anchor in that case is the commitment of the management of the country’s monetary policy to the achievement in the medium and long run of a pre-announced rate of inflation. It is an alternative to using a commitment to an exchange rate as a nominal anchor. Let me now compare the two forms of commitment. For countries with a serious inflation history, inflation targeting is likely to yield less discipline and credibility than the absolutely-fixed exchange rate regime. Of course, I assume that the exchange rate in the latter case is tied to a firmly established low-inflation currency—that is the dollar or the Euro. The implementation of inflation targeting is not as easily monitored as an absolute commitment to an exchange rate. The possibility of an inflationary policy is not completely ruled out. Credibility is harder to establish. Therefore, if the Nominal Anchor Approach were to provide the sole criterion for exchange rate and monetary policy, and provided a suitable anchor currency is available, the absolutely-fixed exchange rate regime should be preferred. That is a favorable mark for the absolutely-fixed regime. In spite of this, I believe that normally an inflation-targeting floating-rate regime is preferable for countries that are not actually part of a monetary union. The Nominal Anchor

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Approach cannot be the only consideration in the choice of an exchange rate regime. Avoiding a recession is surely also an objective of policy. Suppose a country encounters a negative shock, whether originating at home or abroad, that, with a fixed exchange rate, would cause a recession. I now assume realistically that there is some downward rigidity of nominal wages and of prices of nontradables. With an absolutely fixed exchange rate, the monetary policy of the country concerned could do nothing about the recession because the country no longer has an independent monetary policy. By contrast, with a floating rate regime there is scope for a monetary expansion that would lower the interest rate and depreciate the exchange rate, hence moderating the recession. If the recession is deep, or is expected to be prolonged, such monetary expansion would not increase inflation significantly and thus would not endanger the inflation target. The most important point is that inflation targeting is more flexible than a fixed exchange rate regime. It is true that some recession might still be necessary to counteract the wage-push and hence inflationary pressures that would result from depreciation. This would also be true if the terms of trade have worsened because of a rise in import prices. But the main point remains. The inflation targeting regime allows for some flexibility; the absolutely-fixed exchange rate regime does not. Whether the central bank actually makes use of such flexibility is another matter. At least it has the opportunity to do so. In terms of the two approaches, namely the Nominal Anchor Approach and the Real Targets Approach, the former is concerned with keeping inflation low and (oversimplifying a little) the latter with avoiding recession. It is appropriate to take the Real Targets Approach into account in the short run even though the Nominal Anchor Approach

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may need to govern medium- and long-run policy. Inflation targeting combined with a concern with avoiding recessions makes this possible, while a fixed exchange rate does not. The Real Targets Approach Again: A Tale of Ireland and the United Kingdom I shall now show that, from the point of view of the Real Targets Approach the distinction between the pure-floating regime and the absolutely-fixed regime does not matter much when a country encounters a positive shock, such as a capital inflow boom. But it does matter when there is a negative shock. This can be illustrated by a comparison between Britain and the Republic of Ireland. In 2000 Britain was operating under a floating rate inflation targeting regime. For various reasons there was a modest sectoral export boom, mostly in the financial sector, and also some perceived general productivity improvements which led to capital inflow, and hence an appreciation of the exchange rate. Inflation targeting avoided inflation, so that there was not just a nominal but also a real appreciation. This had an adverse effect (a “Dutch Disease” effect) on those export industries, principally manufacturing, that had not benefited from significant productivity improvements or increases in world demand. Capital inflow financed the current-account deficit that resulted from the spending boom and the real appreciation. The Republic of Ireland was a member of the European Monetary Union, and hence it was in an absolutely-fixed exchange rate regime, at least relative to other members of the EMU. It could not pursue an independent monetary policy. As in Britain, there was a productivity improvement and, for various reasons, both a big inflow of foreign capital and a domestic spending boom. Wages and prices of nontrad-

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ables—and of assets producing nontradable services, notably real estate—rose. Hence, even though the exchange rate was fixed relative to the other EMU members, real appreciation resulted. Actually, the productivity improvement was much greater than in the British case. I shall discuss the remarkable Irish growth story in more detail in chapter 13. In Ireland real appreciation was brought about not by nominal appreciation, as in Britain, but by domestic prices rising—that is, as a result of temporary inflation which represented an adjustment of relative prices. Nevertheless, there was no danger that inflationary expectations would be generated by this process. Membership in the EMU ensured that there could not be any monetary expansion in Ireland other than that which resulted from the adjustment process brought about by capital inflow. The main point is that the real effects of the capital inflow and the productivity boom were qualitatively much the same in the two countries, and thus independent of the choice of exchange rate regime. In Britain the nominal exchange rate appreciated; in Ireland domestic prices rose. In both countries the real exchange rate appreciated. In Britain some advocates of EMU entry attributed real appreciation and hence loss of competitiveness relative to European trading partners to the choice of exchange rate regime. They blamed the loss of competitiveness on the earlier decision that Britain should not join the EMU for the time being. Yet, leaving aside some complications, the exchange rate regime probably did not make much difference. Given a boom and capital inflow, a real appreciation could be expected under any regime. The only qualification to this simple conclusion—and it may be significant—is that, for any given shock, nominal appreciation usually comes quicker than the rise in domestic prices. But let us go on. Suppose the booms in the two countries come to an end, and perhaps turn into slumps. In the case of

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Ireland there will indeed be a recession. If we suppose—as is surely realistic—that Irish wages would not fall much, there would then be little real depreciation to improve competitiveness and thus moderate the slump. In Ireland the earlier process set off by the boom would not simply be reversed. I am assuming here the short- or medium-run asymmetry in wages behavior that I have referred to earlier and that is at the heart of the Real Targets Approach. The current-account deficit will indeed be reduced or even disappear, but this will have been brought about by the recession, not by any recovery of competitiveness. In Britain, by contrast, when the boom and capital inflow come to an end, the exchange rate will depreciate, and this will bring about a recovery of competitiveness. Nominal wages would not need to fall for a recovery of competitiveness to result. After a lag, improved competitiveness is likely to compensate to some extent or even completely for the effects of the reduction in demand, and so moderate the recession. To summarize, when there is a positive shock, the choice of exchange rate regime does not make much difference. The shock could take the form of increased capital inflow, productivity improvements, an increase in world demand for some exports, or improved terms of trade. But this is not true when there is a negative shock. The Real Targets Approach, with its realistic assumption of asymmetry in wages behavior, with downward rigidity of nominal wages and flexibility of real wages, then comes into play. The Exchange Rate Stability Approach Again: Effect of International Capital Mobility One might assume that speculation is, on the whole, destabilizing. This is, indeed, widely believed. It provides the basis

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for advocacy of restrictions or taxes on short-term capital flows. It is not an assumption that is necessarily implied in the argument based on the Exchange Rate Stability Approach that I have just given, but let us consider its implications for the moment. How will growing international capital mobility—which we have certainly seen in the world in recent years—then affect the choice of exchange rate regime? I consider here only the choice between an absolutely-fixed regime and a pure floating regime. Presumably the growth of the international capital market, combined with capital market liberalization and the difficulty of controlling international capital flows, will increase speculation. If speculation is on the whole destabilizing, this will make floating rates more unstable. The conclusion then follows that the case against floating and thus in favor of an absolutely-fixed regime will strengthen over time. For example, it strengthens the case for various countries joining the EMU. But there are difficulties with this line of argument. First, destabilizing speculation is likely to be unprofitable. To buy when a currency is dear and sell when it is cheap will both destabilize it and be unprofitable. In a pure-floating rate regime a speculator who does this consistently must lose money. Second, there is an alternative view, also commonly held and persuasive. It is based on the assumption that speculation is, on the whole, stabilizing. I emphasize that this argument does not prove that speculation is stabilizing but, rather, it develops a common-sense line of thought that assumes speculation to be stabilizing for exchange rates, at least on balance. This alternative view is relevant for those developing countries which have an underdeveloped financial system and where there is a lack of interest in the country’s currency on the part of international banks and international market

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operators. In these cases there will be an absence of speculation and floating exchange rates would actually be very unstable. For example, suppose a developing country’s export income suddenly, but temporarily, declines for whatever reason. In the absence of stabilizing speculation, if the exchange rate floated, there would be a severe depreciation of the exchange rate. When export income recovers the next year a big appreciation would follow. Similarly, variable inflows of direct investment would destabilize the exchange rate. Stabilizing speculation would have smoothed exchange rate changes. The essential point is that absence of speculation makes floating exchange rates more unstable. It is assumed that speculation would have stabilized exchange rates, rather than, as is often assumed, destabilized them. Therefore, the less capital mobility and hence speculation there is, the stronger is the case for choosing absolutely-fixed rate regimes. It follows that, as their capital markets become more open, and as the international capital market becomes more efficient and sophisticated in engaging in stabilizing speculation in minor currencies, the less need there will be for such developing countries to choose absolutely-fixed exchange rate regimes. References On the nominal anchor approach, see Bruno 1991, Corden 1991, Corden 1994, Westbrook and Willett 1999, and Tavlas 2000. Ghosh et al. (1997) show, on the basis of a multi-country study (136 countries, 1967–1990, annual observations), that inflation rates and inflation volatility are lower under pegged (mostly FBAR) regimes than under floating. While the term “Real Targets Approach” comes from Corden 1991, the basic idea goes back to the theory of internal

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and external balance pioneered by Meade (1951). I have expounded it in Corden 1994. The Real Targets Approach assumes very realistically that nominal wages are sticky, or at least sluggish, downward in the short run in response to negative shocks that require real wages to fall. There is a “New-Keynesian” literature (surveyed in Snowdon, Vane, and Wynarczyk 1994) that seeks to explain why this is so. For convenience I have labeled this assumption, as have many others, as Keynesian. It has been integral to a great deal of popular or textbook “Keynesian” theory and policy analysis, and also makes sense of the policy conclusions of many of Keynes’s followers. At one place in The General Theory (Keynes 1936, pp. 8–9) Keynes did indeed argue for the assumption on empirical grounds, but he did not adhere to that justification of the assumption elsewhere in the same book. For a list of his various justifications, see Corden 1978, p. 164. Above all, it is clear (as far as anything connected with The General Theory is clear), that this assumption was actually not central to Keynes’s messages as he saw them. On this, see Meltzer 1988. On inflation targeting, see Mishkin 2000, Svensson 2000, and Eichengreen 2001.

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4

The Fixed-ButAdjustable Exchange Rate Regime

The fixed-but-adjustable exchange rate regime, or FBAR for short, is essentially the Bretton Woods regime. It was the regime of most developing countries even after the breakdown of Bretton Woods in 1973, right into the early 1990s. It is not only of historical interest to study it. A few developing countries (notably China) still have it, or some modified version of it, but also various more-popular “inbetween” regimes discussed in the next chapter have FBAR-like features. It is sometimes called the “adjustable peg” regime. With this regime the exchange rate is determined by policy and is maintained by direct intervention in the foreign exchange market, or by the central bank actually making the market, offering to buy and sell foreign exchange at a fixed price. There is a commitment to a particular policydetermined exchange rate. The rate may be changed, but adjustment is reluctant and infrequent. Changes in it reflect either official perceptions of changes in “fundamentals” that require an exchange rate adjustment, or strong market pressures affecting the foreign exchange reserves and thus forcing an adjustment.

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The Low-Speculation FBAR I intend now to proceed in two stages. In the first stage I shall assume low or zero international capital mobility. Thus the regime can be called the “low-speculation FBAR.” I shall maintain this assumption only in this section, because I want to isolate the effect of capital mobility. In the following section and the rest of the book I assume high capital mobility. Now I assume that there are strict and effective controls on short-term capital movements. There is then little or no connection between the domestic and the foreign interest rate. This gives freedom to monetary policy management to ignore differences between the domestic and the foreign interest rate. The domestic monetary effects of intervention in the foreign exchange market by the central bank can be sterilized, so that in the short run monetary (interest rate) policy is independent of exchange rate policy. Most important, there is little scope for speculation on the exchange rate. In reality there will still be some scope for speculation through leads and lags in payments for imports and exports, through similar leads and lags in transmission of remittances from local citizens working in other countries (important for several developing countries), and through variations in flows of longterm capital. My aim is to isolate the effects on the FBAR of high international capital mobility. This has three purposes. First, this assumption helps in understanding the effects of capital controls. Second, it does describe actual situations that were prevalent in most developing countries until the capital market liberalizations of the late 1980s and the 1990s. Finally, it narrows down the particular regime that has

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been associated with major crises in the 1990s and that, many agree, needs to be avoided in the future. This is the widely condemned high-speculation FBAR to which I come later. In this low-speculation environment the FBAR certainly works. It does not mean that the exchange rate can stay immutably fixed just because the government wants it to. A change may be required because of a decline in foreign exchange reserves, or an inability to borrow more, caused by fundamentals—real expenditure being too high or the real exchange rate being too appreciated, or both. An adverse movement in the terms of trade or a decline in foreign direct investment (FDI) may require devaluation, at least if it is not expected to be very temporary. If such a change is not made in time, so that the foreign exchange reserves run out, there will still be a crisis. But such a change would not be forced by speculation, which is ruled out at this stage. One may recall not just the Bretton Woods era for advanced economies, but also the situation of most developing countries in the 1970s and the 1980s. A typical developing country story, which I already mentioned in the previous chapter, has been the following. A country has a current-account deficit, usually originating in a public sector deficit, which it can no longer finance out of foreign exchange reserves or from official foreign borrowing, whether from the private international capital market or foreign official sources. It calls in the IMF. The recommendation is to reduce absorption (public and private expenditure) and to devalue. Devaluation was seen as an explicit policy decision. Since the source of the problem in the 1970s and the early 1980s was usually a public spending boom, culminating in the debt crisis, the emphasis was usually on

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cutting public rather than private spending. The targets were to attain “external balance” (the current-account level that could be financed) while maintaining the initial level of “internal balance” (demand for domestic goods and services), and the policy instruments were domestic demand management (fiscal and monetary policies) and the exchange rate. Nominal devaluation was assumed to lead to real devaluation. Let me now assess the low-speculation FBAR in the light of the three approaches to the choice of exchange rate regime. If the assumptions of the Real Targets Approach apply and that approach is considered the most important one, then the FBAR scores very high, and certainly is superior to the absolutely-fixed regime. Real devaluations can be brought about in response to negative shocks. The FBAR also scores very high on the criterion of the Exchange Rate Stability Approach. The exchange rate does not fluctuate with market sentiment. It is thus superior from that point of view to the pure-floating regime. Taking both these approaches into account, one can only conclude that the low-speculation FBAR is not just a happy compromise, but is superior to both alternative regimes. What about the Nominal Anchor Approach? The fixed rate of the FBAR is often meant to be a nominal anchor even though the country still has an apparently independent monetary policy. The reluctance to devalue even when fundamentals indicate the need to devalue is often explained by the attempt to maintain the credibility of a fixed exchange rate that is meant to be a nominal anchor. If there were a fiscal or a monetary expansion, or a combination of the two, prices would rise and, in the absence of devaluation, there would be real appreciation. This would worsen the current

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account, hence leading to a loss of reserves, which will eventually be incompatible with the maintenance of the FBAR. Thus the fear of such an outcome is meant to provide the discipline for monetary policy and wage increases, and hence the anchor. Of course we know that often it has failed to do so. It must be added that wages may rise in anticipation of the abandonment of discipline, and that this will lead to real appreciation, to unemployment, and eventually to nominal devaluation. In other words, if maintenance of discipline is in doubt, credibility in the labor market will be lost, and the regime will be under pressure. The commitment to an exchange rate is not absolute: there is an element of discretion. Thus the maintenance of discipline will always be in some doubt. It is important to bear in mind that, even in the absence of foreign exchange speculation, expectations and credibility still matter because of labor market effects. A possible way out is the insertion of an “escape clause” in the rules of the system. It would be designed to make the FBAR compatible with the Nominal Anchor Approach by taking away discretion in exchange rate management. The rules of the FBAR would consist of a commitment to an (almost) absolutely-fixed exchange rate regime, but with a carefully specified escape clause defining the limited circumstances under which exchange rate adjustment would be allowed. This approach would rule out ratification of domestic monetary expansions or of wage increases, but would allow devaluations in response to certain specified external or domestic shocks. Possibly such an arrangement could be as credible as inflation targeting, though not as much as a truly absolutely-fixed exchange rate regime. As

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far as I am aware, no country now has such an escape clause FBAR. But arguably, the Bretton Woods system was such a regime. It only allowed devaluations if there was a “fundamental disequilibrium” and if approval was given by the IMF. A particular concern one might have about the lowspeculation FBAR relative to a pure-floating regime has to do with the “jerkiness” of exchange rate adjustments. If the exchange rate is to fulfill the role of a temporary nominal anchor, and if short-term exchange rate instability is to be avoided, adjustments must not be frequent. There has thus been a logic behind the reluctance of governments to make adjustments. But it means that when adjustments—principally devaluations—do take place they are usually large and traumatic. Governments wait until their foreign exchange reserves have nearly run out. Adjustments are not gradual but are “jerky.” In this respect the FBAR regime compares unfavorably with the pure-floating regime. There are really two disadvantages of the low-speculation FBAR (which also apply to the high-speculation FBAR, to be discussed shortly). First, exchange rate policy is inevitably heavily politicized when adjustments are rare and large. Second, and connected with the first, adverse effects on some sectors of the community are large and very visible. Thus devaluations have adverse effects on consumers of imported products, on wage earners, unless they are in import-competing or export sectors, on domestic producers who use imported materials and components, and on holders of foreign-currency-denominated debt, and especially banks. I do not think this consideration outweighs the advantage that the low-speculation FBAR has over the pure-floating regime, but it is worth noting. Certainly it

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explains the reluctance to devalue of many governments in the past. The High-Speculation FBAR and Its Special Problems For analysis of the high-speculation FBAR international capital mobility must be introduced. Exchange controls are removed or are not effective. The domestic interest rate is no longer independent of the foreign interest rate. If the domestic interest rate is too low relative to the foreign interest rate plus a margin that allows for the market’s expectations of depreciation and for default risk, there will be capital outflow. There is scope for speculative short-term capital movements. As I have pointed out, the essence of the FBAR is the commitment to a fixed exchange rate, which is subject to the possibility of a policy-determined adjustment. Hence it is not an absolutely-fixed exchange rate regime. There is an element of discretion in exchange rate policy, even though discretion will be exercised reluctantly. Thus there will be speculation on a change in the exchange rate. When there is a speculative run on the currency the central bank has initially three options, or some combination of them. First, at the first signs of speculation against the exchange rate, it might devalue and so give the speculators what they expect. But this really means that the FBAR is abandoned since exchange rate adjustment is determined by “the market” and not by policy. Second, in order to hold the exchange rate it might sell foreign exchange out of its reserves and buy domestic currency. The effects on the domestic interest rate would be sterilized by monetary policy, so that, at this stage the domestic interest rate would

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not change. But there is a limit here: foreign exchange reserves, plus the ability of the central bank to borrow internationally, are finite. The hope will be that, before the reserves run out, speculation against the rate will end. If not, then the central bank might move to the third step (which is very often actually the first step). It might raise interest rates sufficiently to make it unattractive for speculators to move out of the domestic currency. Temporary or long-term stability of the exchange rate may then be achieved at the cost of interest rate instability. If a 10% devaluation is expected within one week an increase in the short-term interest rate of 520% per annum will be needed to stem the loss of foreign exchange reserves while the exchange rate is kept fixed. If market expectations fluctuate, the interest rate will also have to fluctuate. This is the essential step needed to maintain the regime. It means that eventually monetary (interest rate) policy has to be fully committed to the objective of exchange rate stability. Finally, after attempting to hold the rate, either by direct intervention or by raising interest rates sufficiently, but failing to change the expectations of speculators, the central bank may eventually give way to the market. It then devalues or allows the exchange rate to float. It would do this if it found the consequences of big interest rate increases too painful for the financial sector, for indebted companies and individuals, and for aggregate demand. This is a familiar FBAR crisis story. One can distinguish anticipatory, self-fulfilling, and disturbing speculation. If fundamentals suggest that devaluation was, in any case, inevitable, but speculation forced a devaluation or depreciation earlier, one can say that specu-

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lation was just “anticipatory.” If fundamentals did not justify devaluation, but devaluation was forced by speculation because of the limited supply of foreign exchange reserves and the high cost of maintaining high interest rates, then speculation was “self-fulfilling.” Finally, speculation might be countered with temporary increases in interest rates that do succeed in restoring credibility to the exchange rate commitment. In that case a stable exchange rate is maintained at the cost of destabilizing interest rates, and speculation is only “disturbing.” Something more should be said about self-fulfilling crises. Suppose that there is no reason to devalue because of fundamentals, and that in the absence of speculation there would not have been any devaluation. There have not been any negative shocks either from the capital market or the terms of trade, and nominal wages have not increased in excess of productivity growth. Nevertheless, the illinformed or herd-driven market expects devaluation. For an individual speculator it may be quite rational to expect devaluation if he or she expects that others also have that expectation. Alternatively, one or more speculators with market power may try to force devaluation in order to profit from it. The central bank then tries to resist by drawing on the foreign exchange reserves and by raising interest rates. But the reserves are limited and higher interest rates create difficulties, possibly because of the fragility of the banking system. Eventually there is no option but to devalue. The lower the foreign exchange reserves the more likely is it that devaluation cannot be avoided, even though the fundamentals do not require it. In other words, the more likely it is that speculation turns out to be self-fulfilling rather than just disturbing.

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Is the new post-devaluation situation that results from self-fulfilling speculation an equilibrium? Devaluation will raise the domestic price level. If the nominal money supply and the nominal wage level stayed unchanged the real money supply and the real wage would have fallen. There would be real and not just nominal devaluation. Hence the current account would improve and the foreign exchange reserves would build up again. Assuming the original situation was an equilibrium, this is then not a new equilibrium. Alternatively, suppose that monetary policy and the labor market react to the devaluation. The money supply is increased and nominal wages rise until the original real equilibrium is restored. In that case the economy has indeed reached a new equilibrium, which is the same in real terms as the original one but with a more devalued exchange rate, and with increased nominal money supply and nominal wages. This is the story of a multiple-equilibrium model, though not the only possible one. Because of the reactions of monetary policy and the labor market, the speculators have brought about a new equilibrium. It must be emphasized that this kind of self-fulfilling speculation can also take place with a floating rate regime, and not just with an FBAR. Under both regimes speculation may generate instability. With an FBAR, but not with a pure floating rate regime, central bank losses will be incurred. If speculation was anticipatory or self-fulfilling, and if the initial policy response in the case of an FBAR was to draw on foreign exchange reserves to maintain the exchange rate, the central bank will finally have made losses that represent a transfer of income from taxpayers to successful speculators. Huge losses (so called quasi-fiscal losses) have been made at various times by central banks

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for this reason. These losses are not measured by the value of the foreign exchange reserves initially lost, since the reserves can eventually be restored at the new, devalued exchange rate. The reserves (dollars) were sold initially at a low price (in terms of pesos, the domestic currency), and are later bought back at a high price. The net cost is the difference, measured in pesos, between the low selling price of dollars and the high buy-back price. The high-speculation FBAR has been discredited by the crises of the 1990s—the crisis of the Exchange Rate Mechanism (ERM) of the European Monetary System (1992), and the Mexican (1994), East Asian (1997), Russian (1998), and Brazilian (1999) crises. And there were forerunners not only in Latin America but, above all, the sterling and franc crises of the Bretton Woods system and the dollar crises of 1971 and 1973 that led to the breakdown of that system. Most speculation leading to major exchange rate crises has been anticipatory. Necessary adjustments in the light of changing fundamentals have often been too reluctant. Unsuccessful attempts were made to sustain rates by direct intervention, leading to large losses by central banks to the benefit of speculators. Interest rates have had to be raised very high, with damaging domestic effects, in vain attempts to maintain exchange rates. Emergency loans from the IMF have temporarily sustained the exchange rate commitments. Finally, the various FBARs have broken down in an environment of crisis. This has also been true when speculation has been self-fulfilling, rather than being justified by fundamentals. The FBAR is a system that is “too sensational.” Finance ministers have sought to assure markets that exchange rates would not be devalued, but finally have been obliged to give way and either devalue or abandon the

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system. Often this has discredited not just the system but also the governments, and sometimes also the IMF. In all these respects the high-speculation FBAR compares unfavorably not only with the absolutely-fixed regime— where there is no scope or reason for speculation—but also with the pure-floating regime. When the exchange rate floats and the central bank does not intervene at all, it cannot make losses. Furthermore, market fluctuations can be absorbed not only by interest rate but also by exchange rate changes, and politicians and central banks are not committed to an exchange rate and hence are not required to give assurances that they cannot maintain. Intervention, Sterilized and Non-Sterilized Before concluding this chapter I want to take a detour. This is just an extended footnote. What, precisely, is meant by sterilized intervention, and in what circumstances is it really effective? So far I have only skated over this matter. Even if sterilized intervention is effective in some way, what are the limits to it? This issue is relevant not only for the FBAR but also for other regimes to be discussed in the next chapter, especially managed floating. The broad answer is that there are well-defined limits, but sterilization can be effective for limited periods. Consider the case of a speculative attack on a currency. In the absence of intervention the exchange rate would depreciate. Non-sterilized intervention to keep the exchange rate constant would involve the central bank selling foreign currency out of its reserves, with the money supply declining. With a declining money supply the interest rate would rise. This would set in process two equilibrating mechanisms: (1) The higher interest rate would draw capital in, moderating

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and possibly ending the speculative attack. (2) The higher interest rate would eventually reduce spending and hence improve the current account. Sterilization of the monetary effects of intervention through a purchase of domestic bonds would increase the money supply again and lower the interest rate. If there is full sterilization of the money supply effects then, finally, the money supply will be unchanged relative to the situation before intervention. If there is full sterilization of the interest rate effects, then finally the interest rate will be unchanged. The two are not exactly the same, though this is often assumed. I shall come to the distinction between money supply sterilization and interest rate sterilization shortly. Here I shall define sterilized intervention as an intervention policy where simultaneously open market operations keep the interest rate constant. In subsequent chapters of this book, whenever I refer to intervention in the foreign exchange market without specifying sterilization I shall always have sterilized intervention defined in this way in mind. It is to be distinguished from an interest rate policy, which is a monetary policy pursued through open market or similar operations that explicitly changes the interest rate. These definitions are in accord with common usage in the policy world. For example, a speculative attack usually leads to both intervention in the form of a sale of foreign exchange out of the reserves and to a rise in interest rates. These are normally regarded as two distinct, if complementary, policy reactions. Non-sterilized intervention is then a combination of the two policies. Now I come to a subtlety, a footnote within a footnote. Is there really a distinction between money supply sterilization and interest rate sterilization? I use here the standard

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portfolio balance model, on which see Branson 1979. The main point is this: Suppose there is a speculative attack on the currency and, in response, there is sterilized intervention that keeps both the exchange rate and the money supply constant. Sterilization in this case means that the central bank buys domestic bonds to prevent the money supply from declining, as it would in the absence of sterilization. But the purchase of domestic bonds will lower the interest rate. Even though the money supply stays unchanged the interest rate must fall when the supply of domestic bonds in the market declines. I am assuming here that the domestic interest rate equates demand and supply of money relative to domestic bonds. That is the crucial assumption. The world interest rate is assumed constant, but the extra demand for foreign assets as reflected in the speculative attack is met by the extra supply provided by the sale of foreign exchange reserves by the central bank. It follows then that, if money supply stabilization would lead to a decline in the interest rate, interest rate stabilization would require some net decline in the money supply, even though not as great as would result from non-sterilized intervention (which would actually lead to a rise in the interest rate). Let me come back to the main question: When there is a speculative attack on the currency, what are the limits to such sterilized intervention that keeps the interest rate constant? The limit is that the foreign exchange reserves will eventually run out, possibly quite quickly. The reason is that the two equilibrating mechanisms that would have resulted from a rise in the interest rate brought about by non-sterilized intervention have been aborted by sterilization. The greater is international capital mobility the quicker

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will the foreign exchange reserves run out. With very high capital mobility, any failure of the domestic interest rate to rise to the level that would compensate for the expected depreciation that brought about the speculative attack would lead to massive capital outflow, and thus to an inability to maintain the exchange rate at the desired level. The exchange rate would have to depreciate. Now consider the opposite case. The objective of foreign exchange intervention may be to prevent an appreciation, possibly because of speculation in favor of the currency, or an improvement in export income. Intervention would then lead to a build-up of foreign exchange reserves. If there were sterilization of interest rate effects it would also lead to a continuous sale of domestic bonds. There would be no limit to the accumulation of foreign exchange reserves, but there would be another kind of limit. The central bank would be accumulating foreign liquid assets and at the same time, through the sale of bonds, it would be accumulating domestic liabilities or reducing its holding of domestic assets. If the domestic interest rate were higher than the relevant foreign interest rate (reflecting a risk factor and the increasing difficulty of selling bonds in a thin market) the central bank would incur growing losses. Such asset transformation was very costly for central banks of emerging market countries that tried to sterilize, or partly sterilize, the domestic monetary (or interest rate) effects of capital inflows during the great boom of capital inflows into emerging market countries of the early 1990s. Finally, it must be noted that there is a large literature discussing the effectiveness of sterilized intervention in the dollar-yen-DM market in the 1980s in a regime of managed

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floating. I will not even attempt to summarize it here. A standard reference is Dominguez and Frankel 1993. The main point to make for the present purpose is this. The more substitutable are domestic and foreign bonds because of a low or zero risk factor, the less effect on the exchange rate can there be when one or more central banks change the proportions of these bonds in the world market. Perhaps an intervention can signal their intentions about future monetary policies, but the portfolio balance effects would be very small. Here I am concerned primarily with developing countries, where portfolio balance effects are likely to be significant. Summary: The Three Polar Policy Regimes To conclude, what are some of the conclusions about the three polar exchange rate regimes that emerge from this and the preceding chapter? In the absolutely-fixed regime the country has neither an independent monetary policy nor an independent exchange rate policy. In the pure-floating regime the country has an independent monetary policy but not an independent exchange rate policy. In the low-speculation (low capital mobility) FBAR it can have both an independent monetary policy and an independent exchange rate policy. Finally, in the high-speculation (high capital mobility) FBAR it has an independent exchange rate policy but—other than in the short run—not an independent monetary policy. Monetary policy in that regime must be completely dedicated to the exchange rate commitment. The incompatibility of an independent exchange rate policy with an independent monetary policy and high capital mobility is the familiar

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“impossible trinity.” Only effective capital controls can turn a high-speculation FBAR into a low-speculation one and thus make an independent exchange rate policy compatible with an independent monetary policy. With regard to choices between these regimes, my broad judgment is as follows. First, the low-speculation FBAR is superior both to the absolutely-fixed regime and to the pure-floating regime subject to two provisos: (1) that the assumptions of the Real Targets Approach apply, with weight also given to the Exchange Rate Stability Approach, and (2) that the enforcement and distortion costs of capital controls do not outweigh the benefits of this regime. Second, the high-speculation FBAR is inferior to the purefloating regime for the reasons I have listed above. Third, in choosing between the absolutely-fixed regime and the highspeculation FBAR one has to strike a balance. The costs of not being able to pursue the Real Targets Approach to any extent (as in the absolutely-fixed regime) must be tradedoff against the costs of the FBAR resulting from its imperfect credibility and the resultant effects just discussed. On all these matters the case studies in later chapters shed some light. The fourth point is one that really should be emphasized because it helps one to understand why some economists favor absolutely-fixed regimes. Given either of two assumptions there is an overwhelming case for an absolutely-fixed regime. If these assumptions held the Real Targets Approach would be irrelevant. The alternative assumptions are (1) that nominal wages and prices of nontradables are (given a little time for adjustment) highly flexible not only upward but also downward and (2) that nominal devaluations are quickly offset by wage rises that

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prevent real devaluations. I do not believe that either of these two assumptions is generally realistic over relevant medium-term time spans for other than very small economies, but there are economists who apparently do. Hence they favor absolutely fixed regimes. If these assumptions held, it would be sufficient that the absolutely fixed regime meet the requirement both of the Nominal Anchor Approach and of the Exchange Rate Stability Approach. Furthermore, all the difficulties brought about by exchange rate speculation would be avoided. Finally, contrary to much that has been written, the fact that the high-speculation FBAR may be inferior to both the absolutely-fixed regime and the pure-floating regime does not mean that either of these two polar regimes must be chosen. This is the “hollowing-out of the middle” proposition that I discuss further in chapter 14. The low-speculation FBAR may be appropriate for some countries, possibly with the help of effective exchange controls. Furthermore, there are several in-between regimes that should be considered. I shall turn to these in the next chapter, and in chapter 6 come back to considering the assumptions of the Real Targets Approach. References The disadvantages and proneness to crises of FBARs in the modern world of high capital mobility have, at least in recent years, been most clearly expounded in Obstfeld and Rogoff 1995 (a very influential paper) and in Mussa et al. 2000. There is a large literature on models of speculative attacks in FBARs. On anticipatory speculation, see Krugman 1979.

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On self-fulfilling speculation, see Obstfeld 1986 and Flood and Garber 1984. A more comprehensive approach, taking into account the escape clause as a “conditional commitment device” by the monetary authorities is in Jeanne 2000. Empirical and analytical papers on exchange rate crises are in Tavlas (ed.) 1997.

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5

In-Between Regimes

One can go a long way by just analyzing three pure regimes. But the reality is that actual regimes are usually more complicated. They are variations upon, or some amalgam of, the three pure regimes. Some countries have pegged regimes of one kind or another, and these have been the predominant regimes since the end of the Second World War until the early 1990s, aside from the regimes of the dollar, yen, and DM. But now (2001) most independent countries that are integrated in the world capital market, other than those that are members of the EMU, have managed floating regimes, or at least they describe their regimes in that way. The EMU itself has an almost pure floating regime relative to the outside world, but there appears to have been just a little management. One can get overwhelmed by the complications, and lose sight of the essential differences between regimes. I shall try to simplify, no doubt at the cost of some inaccuracy and needed qualifications. Here I give an overview, and come to the details below. Figure 5.1 begins with the three pure regimes, namely absolutely fixed, FBAR, and pure floating. The next step is to distinguish two categories, namely those regimes that are in between the absolutely-fixed regime and the FBAR and those that are in between the FBAR and the pure floating regime.

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Absolutely fixed rate regime

Pure floating regime

FBAR

in-between

in-between

Currency board

Pegged

Flexible peg

Target zone (band)

Managed floating

Crawling peg

Active (pre-announced)

Passive

Figure 5.1 In-between exchange rate regimes.

In fact, only one regime comes in the first category, namely the currency board regime. It could be described as being very close to the absolutely-fixed regime (dollarization or monetary union) and in later discussion I may sometimes bracket it with that regime. It differs from dollarization and monetary union primarily in one way. There is still some possibility of a change in the exchange rate, usually a slight one, and hence it has something of the key FBAR characteristic. In the second category (in-between FBAR and pure floating) are three regimes, (i) the pegged rate regime, (ii) the managed float, and (iii) the target zone (or band) regime. The pegged rate regime has two versions, namely the flexible peg and the crawling peg. In the flexible peg regime the exchange rate is fixed at a point in time by the central bank, and it may be stable for short periods. But it can be altered readily. It dif-

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fers from the FBAR in that there is not a strong commitment to the rate, so that this regime avoids exchange rate crises, and it differs from pure floating in that it avoids short-run instability. I shall come to the crawling peg shortly. With managed floating the central bank is free to intervene in the foreign exchange market, so influencing the exchange rate, and it does actually intervene. This regime differs from the FBAR and the pegged rate because there is no commitment to a rate, not even a short-run one. It differs from pure floating because the central bank can intervene to stabilize the rate, to change the rate in any way it chooses, or even aim to make a profit in the foreign exchange market. At this point I pause to list three of the regimes just described, as well as the three polar regimes, in order of the commitment each requires to a particular exchange rate. The list starts with the absolutely-fixed rate regime (absolute commitment) and goes on to currency board (very high commitment), FBAR (high commitment with reluctant adjustment), flexible peg (low commitment, and only in the short run), and finally both managed and pure floating (no commitment). It should also be mentioned here that it is common to distinguish regimes as to whether they involve “hard pegs” or “soft pegs.” These terms are not as precise as the terms I am using here. Hard pegs seem to cover both absolutely-fixed regimes and currency boards while soft pegs cover FBARs, flexible pegs, crawling pegs, and possibly also target zones. The target zone or band regime is an amalgam of the FBAR (or possibly the pegged rate) and either managed or pure floating. There is a central (pegged) rate and there is a band around it within which the actual rate floats. At the upper and lower limits the rate is pegged. There is some commitment to the pegged rates at the limits, though the extent of the commitment can vary.

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Coming now to the crawling peg regime, it has been adopted when a country has started with a significant degree of inflation relative to trading partners or competitors. The rate depreciates steadily at intervals, though it is pegged by the central bank at a point in time. Here there is the important distinction between the active and the passive crawling peg. With the active (or pre-announced) crawling peg regime there is a “tablita” which sets out the rate of depreciation of the exchange rate in advance, and is designed to act as a nominal anchor. There is a strong commitment to the tablita, so this is almost a version of the FBAR. With a passive (or ex-post) crawling peg regime the exchange rate is adjusted regularly in the light of the rate of inflation at a recent date, the aim being to keep the real exchange rate constant. Over and above this, the rate may be altered at intervals if a change in the real rate is thought necessary. Finally, there is a further choice, namely between a singlecurrency peg and a basket peg. In all the cases shown in figure 5.1, other than the managed and the pure float, there is a peg of some kind. It may be firmly fixed, fixed-butadjustable, fixed only in the short run (flexible peg), crawling, or just a central rate in a target zone regime, but the following question always arises: To which currency, or to which basket of currencies, should the exchange rate be pegged? I shall discuss this question at the end of this chapter. Currency Board The only regime that is in between the absolutely-fixed regime and the FBAR is the currency board regime. There are many historical examples from the British Empire, but the most important economies that at the time of writing (June 2001) have currency boards, or regimes that closely approxi-

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mate currency boards, are Hong Kong (since 1983) and Argentina (since 1991). The countries of francophone Africa— the members of the Communauté Financière Africaine (CFA) zone—make up a grouping that has many of the characteristics of a currency board. There are also several smaller economies, notably Bulgaria and Estonia, where currency board regimes have been established in the 1990s. For a few years (until the recent Argentine crisis) currency boards have been “the flavor of the month” among some economists. There is always uncertainty as to whether the Argentine regime will last, and I shall discuss this case at length in chapter 11. If the system is ended in Argentina it will confirm some doubts that I express in that chapter. With a currency board regime there is, first of all, a strong commitment to a fixed exchange rate. The exchange rate is fixed in some way that makes it difficult to change. This, broadly, has the same implications that I noted in chapter 3 for the absolutely-fixed regime. In particular, the exchange rate instrument cannot be used to avoid a recession when there is a negative shock. Second, the money base is backed 100% by foreign currency reserves. These reserves consist of liquid interest-earning foreign assets. The interest income represents the seigniorage or profits that the central bank or government receives from its monopoly of the money supply. Any change in the reserves leads to an equal change in the money base. These rules are similar to the “rules of the game” of the gold standard. The reserves need not consist of gold but, as with the gold standard, the money base varies with the reserves. A third requirement is usually that there are no exchange controls. Most important, the money supply cannot be increased to finance budget deficits. This does not rule out budget deficits, but they must be bond-financed. Similarly, in its

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strict form a currency board regime does not allow the money supply to be increased in order to finance a government’s or a central bank’s role as rescuer of the financial system, and in particular as the lender of last resort for banks. Again, this does not rule out government financing of such a role through bond finance. It has to be stressed that the currency board regime ensures monetary discipline but not fiscal discipline. The crucial feature of a currency board regime is that the exchange rate commitment is backed up by strict rules about money creation. Such rules ensure monetary discipline and thus give credibility to the maintenance of the fixed exchange rate. If the regime is expected to last, and hence is credible, it will have two favorable effects. First, wage demands and the willingness of employers to grant increases will be based on the belief that there will not be inflation, or inflation will not continue for long, so that real appreciation resulting from wages pressure will be avoided. (I am referring here to inflation relative to the inflation rate in the anchor country.) But there can still be monetary expansion, and hence real appreciation, if the foreign exchange reserves increase because of a current account surplus or capital inflow. Such real appreciation would just reflect a movement to a new equilibrium real exchange rate. Second, if the regime is fully credible devaluation will not be expected, and thus the interest rate will not rise above the world rate (plus a default risk factor). In practice, even the Hong Kong and Argentine regimes have not succeeded in establishing full credibility, as indicated by significant interest rate differentials, especially at times of crises in emerging markets. These high interest rates have familiar adverse effects, especially on government budgets. What would happen if a currency board regime were replaced by an absolutely-fixed regime in the form of dollar-

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ization? First, seigniorage would be lost. Second, full credibility that the fixed rate will be maintained would be achieved, with the welcome result that interest rates would fall. Third, all possibility of abandoning the regime and moving to an FBAR or to a floating regime would be ruled out. Thus, all residual policy flexibility would be given up. The trade-off between flexibility for the government, and credibility of its commitments is indeed a familiar one. Dollarization removes flexibility and provides full credibility. This is controversial. The advocates of dollarization for Latin American countries welcome the removal of flexibility because, on the basis of their (perhaps plausible) interpretation of Latin American economic history, they do not trust governments. In many cases they would even be satisfied with currency boards. This is the discipline argument for the Nominal Anchor Approach. The reduction in interest rates would be a pure bonus. But there may be times when it would be better if the government or the central bank—even in Latin America— did have some freedom of action. Circumstances may change. In particular, the labor market may fail to adjust to a severely negative shock. Sometimes it is suggested that in a currency board regime the foreign exchange reserves should not be equal in value at the fixed exchange rate only to the money base but rather to a more broader definition of the money supply, probably M1. The base consists of currency plus commercial bank reserves held by the central bank. It thus represents the obligations of the central bank, and the minimum obligation that the central bank undertakes when it makes an unlimited commitment to a fixed exchange rate. M1 also includes those deposits with commercial banks that are not backed by the commercial banks’ reserves with the central banks and their currency holdings. These are not obligations of the central bank. If the

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central bank is prepared to convert all these domestic bank deposits into foreign exchange, then it is actually prepared to act as lender of last resort for the commercial banks. If the public wished to convert all of its bank deposits into dollars, the central bank would have the dollars available. Since the preservation of financial solvency is usually an important public policy objective, there is a lot to be said for the reserves held by a currency board to be sufficient to cover this role. I now turn to various regimes that are in between the FBAR and the pure-floating rate regime. Flexible Peg In this regime the exchange rate is pegged by the central bank in the short run. This is done by intervention in the market or by the central bank actually making the market. The rate is rapidly and frequently adjusted in response to market forces or perceived changes in fundamentals. There is no commitment to a particular exchange rate, to a tablita, or to maintaining the real exchange rate. Other than in the short run, the effect is not so different from a pure-floating regime. But, of course, the rate does not actually float. It avoids exchange rate instability or volatility, but only in the short run. It is not subject to speculative crises as a high-speculation FBAR is. Such a regime does not provide a nominal anchor. But the flexibility of the peg combined with relative freedom of monetary policy (subject to the need to sustain the shortterm peg) means that the Real Targets Approach can be fully satisfied. One might ask: what does such a regime achieve relative to a pure-floating regime? The answer is that it avoids shortterm volatility. This is not the same as avoiding medium-term

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misalignments. But short-term volatility has costs, essentially the costs of hedging short-term borrowing and lending. This is important for countries, mainly small developing countries, for which hedging is costly or not available, because the potential market for the currency is very small or because the domestic financial system is underdeveloped. In such countries short-run depreciations of the exchange rate can have very adverse effects on banks and firms that have debts— usually foreign debts—denominated in foreign currency. Another way of putting this is to say that in some countries there is an absence of stabilizing speculation, which makes a case for fixed rates, at least in the short run. Managed Floating If the central bank intervenes in the foreign exchange market but makes no commitments to a particular exchange rate or target zone, then the country has a managed floating regime. Depending on the degree of capital mobility this intervention has to be backed up by interest rate policy. Indeed, interest rate policy alone might be the method of influencing the exchange rate. I have already discussed this in the previous chapter. The managed floating regime is now the most common regime. The interventions may be ad hoc or there may be some unannounced target zone, but the key difference between managed floating and both the FBAR and the standard (announced) target zone is that there is no commitment to an exchange rate. There is thus no attempt to influence expectations and there can be no credibility problem. This regime differs from pure floating because intervention by the central bank in the foreign exchange market is not ruled out. The implicit hypothesis is that sometimes central banks can do better than the market. The aim is to stabilize

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exchange rate movements occasionally, or at least moderate fluctuations, and avoid extreme movements. Since stabilizing intervention is usually profitable, the central bank is, in effect, speculating in the market with the intention of occasionally or somewhat stabilizing the rate, and so incidentally or even intentionally making a profit. The motivation here is based on the Exchange Rate Stability Approach. Compared with the pure-floating regime and the FBAR, the great attraction to policy-makers of managed floating is that this regime gives them freedom to intervene or to use interest rate policy to achieve an exchange rate objective. But, because there is no commitment, there is never a danger of losing credibility and hence of political embarrassment. This managed floating regime actually gives policy makers maximum discretion in exchange rate policy. They might have an informal target concept in mind, but they do not announce it and hence are not obliged to implement it. They may implement it through intervention or through interest rate policy, or some combination. If the interest rate is systematically adjusted to deliberately affect the exchange rate, the policy should also be described as managed floating, though this is not the usual use of the term. Target Zone (Band) Now I come to a regime that is an obvious combination of the pure-floating regime and the FBAR, with the advantages and disadvantages of both. There have been various examples of this kind of regime, notably the Exchange Rate Mechanism (ERM) of the European Monetary System. There is a central rate, which is adjustable, as in the FBAR. Around it is a band or zone within which the actual rate floats. There are upper and lower limits to the band, and the

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central bank may make some kind of commitment to prevent, or just discourage, the actual rate from going outside these two limits. Within the limits (targets), this regime is just like a pure-floating regime—except insofar as the actual rate is influenced by expectations of intervention at the limits. At the limits it is like an FBAR if there is a strong commitment to keeping the actual rate within the limits. If the band is very wide the system approximates the pure-floating regime and if the band is very narrow it approximates the FBAR. It can readily be seen that this kind of regime can have many permutations. It can have wide bands or narrow bands, the central rate may be crawling or fixed, and it may be readily adjusted (like a flexible peg) or only reluctantly (like an FBAR). The crawl may be active or passive. The size of the band may be occasionally adjusted or absolutely fixed. Most important, the commitment to keep the actual rates within the limits may be firm, heavily qualified, or not much more than a statement of what is desired by the authorities, rather than intended to be enforced. Furthermore, within the band the rate may freely float or there may be some ad hoc intervention. Suppose that the size of the band is not very large—say 5–10% each way—and that the commitment to maintaining the limits is strong. We may then consider the implications within the band and at the limits. Within the band, the exchange rate may be volatile for moderate movements and in the short run. This would present difficulties for countries for which hedging against exchange rate fluctuations is costly or not available—that is, countries for which a flexible peg is appropriate. But for many countries, including all the advanced industrial countries, it is not a problem. It is more important that, by maintaining the limits or targets, “misalignments” are avoided.

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“Misalignments” are large medium- and long-term exchange rate movements that are perceived by advocates of target zones to have been unjustified by fundamentals. A target zone regime meets the requirements of the Exchange Rate Stability Approach. The desire for exchange rate stability is the reason why target zone regimes have been advocated and sometimes practiced. Advocates of such a regime for the dollar-yen-DM relationship, notably Fred Bergsten (the Director of the Institute of International Economics), Paul Volcker (the former Chairman of the Federal Reserve Board), and John Williamson (a senior fellow of the Institute of International Economics and an influential and prolific writer on the choice of exchange rate regimes), have been much influenced by the extreme movements or misalignments of the dollar in the 1980s. At the limits this regime has exactly the same problems as the FBAR. Suppose the commitment to maintain the limits does not have full credibility, especially when fundamentals indicate that devaluation beyond the limit may be desirable. If the central bank intervenes, selling foreign currency, it will make a loss if the rate cannot be held, while raising the interest rate sufficiently to offset market expectations will have various, possibly unacceptable, costs. These are identical to the problems that FBARs have encountered. The target zone regime with wide bands may be thought of as a modification of the pure-floating regime. It is based on a combination of two hypotheses. The first is that markets are prone to overshooting, irrational exuberance or panic, herd behavior, and excessive “short-termism,” and that central banks have better judgment. This is the “superior judgment” hypothesis. It justifies central bank commitment to maintain the limits. Naturally, those who are ideologically inclined toward the view that governments and their agencies are no more likely to get it right than private markets, will not

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agree. The second hypothesis at the heart of the target zone approach is that commitments or advice by the central bank will actually influence market behavior. This is the “guidance hypothesis.” Markets need guidance. Hence, intervention by the central bank or interest rate adjustments may not actually be needed at the limits. This is just the familiar point that if the limits are credible they will not be challenged. But some advocates of target zones go further: Even if there is no commitment by the central bank to maintain the limits, a statement of them as guidance to what are reasonable limits, taking fundamentals into account, will affect market behavior. In discussions of target zone proposals for the three major currencies, it has been often noted that there is no easy way of determining the central rate, often described as the “equilibrium rate.” Detailed proposals have been made by Williamson and Miller (1987). But this problem is not unique to target zone regimes. It also applies to the determination of the fixed rate in an FBAR, to the determination of the desired real exchange rate in a passive crawl, and to the choice of appropriate rate when a country establishes a currency board regime or when it joins a monetary union. In chapter 13 I shall touch on the controversial issue of the choice of exchange rate when the former East Germany formed a monetary union with the Federal Republic. The arguments against target zones are quite simple. First, it may be too costly for the central bank to maintain commitments at the limits. Second, if the target zones are expressed only as guidance, so that there is no commitment, the credibility of the central bank would be damaged when the markets do not accept the guidance, causing the exchange rate to move beyond the limits. These two arguments explain why announced target zone regimes are no longer popular with

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governments. Governments and central banks may, of course, have unannounced or informal target zones, but such procedures come under the heading of managed floating. Active Crawling Peg: Exchange-Rate-Based Stabilization A crawling peg regime, whether of the active or the passive kind, is appropriate for countries that start with high rates of inflation relative to trading partners and competitors. These regimes are essentially variations on or refinements of the FBAR, and they have many of the advantages and disadvantages of FBARs. It is important to distinguish the active from the passive crawling peg. The active crawling peg regime can be justified by the Nominal Anchor Approach and the passive crawling peg regime reflects the Real Targets Approach. The active crawling peg has been part of the exchangerate-based stabilization programs of many Latin American countries. As part of such a program, a scale or “tablita” is announced, showing the rate at which the currency will depreciate, perhaps week-by-week or month by month. This pre-announced rate of depreciation will be less than the country’s rate of inflation from the start, and it will decline steadily. The idea is that a steady decline in inflation of wages and of the prices of nontradables will follow the tablita closely. The exchange rate leads and wages follow. The speed of wage and price adjustment to the tablita will depend on the degree of indexation of wages and, above all, on the credibility of the program. At the same time there must be monetary discipline, depending, above all, on fiscal discipline. Otherwise a growing current-account deficit will force an end to the system. As I have just noted, the active crawling peg is just a variant of the FBAR, with a tablita replacing the initial fixed rate

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in the FBAR. When credibility of the regime in the labor market takes time to establish some real appreciation is inevitable; however, such real appreciation will be less when there is a tablita than when there is a rigid fixed rate initially. This means that this version of the FBAR is less likely to end in crisis, or that the crisis will come later, than with the regular FBAR. This, in turn, will strengthen the credibility of the system. Nevertheless, it must be added that active crawling peg regimes as part of exchange-rate-based stabilization programs have often ended in crises. The main examples of such crises come from Latin America, but the most recent case comes from Turkey, where the crawling peg regime collapsed in February 2001. Passive Crawling Peg I am not aware of any passive crawling peg regimes in recent years, but there are examples from the past, notably Brazil and Colombia. With a passive crawling peg the nominal exchange rate is adjusted on some regular basis to compensate for past or recent inflation relative to inflation in trading partners and competitors, the aim being to keep the real exchange rate constant. There is no pre-announced tablita. If the country’s inflation rate rises because of wage increases or monetary expansion, then the rate of devaluation will also rise. The aim, above all, is to avoid real appreciations, which would result when the country has high inflation but the nominal exchange rate were fixed or if there were a tablita designed to bring the inflation rate down. The passive crawling peg regime is motivated by the Real Targets Approach: the real exchange rate is targeted. This regime is less likely to lead to a crisis than the simple FBAR because the real exchange rate is fixed, and not the nominal

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rate. The passive crawling peg differs radically from the active crawling peg. The latter is a nominal anchor and is likely to reduce inflation and lead to real appreciation. The exchange rate tablita leads and it is hoped that monetary policy and wages will follow. By contrast, the passive crawling peg ratifies the effects of monetary expansion and wage increases: monetary expansion and wages lead and the nominal exchange rate follows. In a regime where the real exchange rate is generally kept constant, at least after short lags, there is still the possibility of negative shocks, requiring real devaluations. Thus, some countries (notably Brazil and Colombia, the crawling peg pioneers) have had crawling peg regimes that were passive with regard to adjustment to inflation differentials but that had a discretionary element designed to allow for negative shocks. Thus, occasionally there would be a devaluation greater than what was required to keep the real exchange rate constant. Once there is an element of discretion, speculation will be provoked, as with an FBAR. Multi-Currency Pegging (Basket) Should a developing country peg to one currency, such as the dollar, the Euro or the yen, or should it peg to a basket of these currencies, such as a trade-weighted one? This has been an important issue for those countries in Latin America and Asia whose trade is not heavily concentrated on the United States, the Euro region, or Japan. For example, if the dollar appreciates relative to the other major currencies, countries that peg to the dollar will find that their trade-weighted rate (called effective rate) also appreciates, and they will then lose competitiveness. Such an appreciation that is not policydetermined is then, arguably, undesirable. This effect could

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be avoided or reduced if the exchange rate were pegged to a basket of the three currencies. Once it is decided to have such a basket there are questions about its precise composition, but I shall not pursue such questions here. I shall argue that the case for use of a basket is not very strong. This issue of whether there should be single currency pegging or pegging to a basket, and in the latter case, what the composition of the basket should be, is not relevant if the exchange rate floats, whether or not with some management. There has to be some element of exchange rate pegging. It is also not relevant if an absolutely-fixed regime is chosen since a country cannot use a basket of foreign currencies as its official currency. (A country can allow currency competition, but that is another matter, and does not involve a fixed basket.) Furthermore, a country cannot join more than one monetary union. Thus the issue of whether to peg to a single currency or a basket is relevant only for the FBAR and for various inbetween regimes—at one extreme the currency board and the other the flexible peg. There are two principal reasons for preferring a singlecurrency peg to a multi-currency one. First, a single-currency peg is more easily monitored and is therefore more effective as a nominal anchor. It is clearer whether discipline is being maintained, so that the peg will be more credible. This argument applies only if the exchange rate is actually meant to be a nominal anchor, in which case monitoring to ensure credibility is important. Second, one of the advantages of a pegged rate is that it fosters trade with the country the currency of which is the anchor. This is a familiar point that supports the case for fixed rates, a major motivation of the Exchange Rate Stability Approach. In the case of a basket there is no assurance of stability relative to any of the countries whose currencies make up the basket, so that this

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advantage is completely lost. This argument only applies to absolute or prolonged pegging, as with a currency board or the FBAR. It does not apply to the crawling peg regimes or the flexible peg. But it is relevant not only for trade but also for capital mobility. From this point of view the dollar has clearly been supreme. It is the currency that is most commonly used in the world capital market. The dollar belongs to the country that has the biggest and most versatile capital market. Managed Floating Again: Informal Regimes Finally, I would like to come back to managed floating and take note of the various informal regimes that are all included under the title of managed floating. They do indeed have many of the characteristics of managed floating, especially the strong element of policy discretion. But there is more. There is some tendency to exchange-rate pegging, so that these regimes are between managed floating and other regimes, such as the FBAR and flexible pegs. By 2001 it seemed that the “informal” regime has become a common type of regime for emerging market countries—that is, for developing countries that are reasonably integrated in the world capital market. In some cases intervention in the foreign exchange market backed up by interest rate policy keeps the exchange rate quite stable in the very short run (say a month), hence avoiding very-short-run volatility, although the rate does move over a longer period. It is then almost like a flexible peg regime. In other cases, the exchange rate is stable over a longer period, possibly several years, with occasional depreciations. In that case it is almost like an FBAR. There is no formal commitment to a rate but an extended period of sta-

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bility may create the impression of commitment, and indeed adjustment of a rate may be reluctant. In some cases there is a target zone, which guides official intervention and interest rate policy, but the limits of the zone are not actually made public. Thus it is an implicit rather than a formal or “announced” target zone. These are not just pegged regimes in disguise. Rather they are regimes that are in between managed floating with ad hoc intervention and the various pegged or target zone regimes that I have described earlier. They are attractive to governments because of the discretion they allow governments, especially in dealing with negative shocks. At the same time such regimes give exchange rates a moderate degree of stability. Such regimes are described by their governments as “managed floating,” and there is indeed no formal commitment to a particular exchange rate or zone, whether short-term or long-term. Thus there is no element of a Nominal Anchor Approach to exchange rate policy. Furthermore, the risk of loss of credibility which results when an FBAR breaks down, is avoided. Such regimes might just be regarded as particular cases of managed floating. Nevertheless they do have characteristics of flexible pegs, FBARs, or target zone regimes, and the analyses given earlier of these regimes apply to some extent in these cases. The best examples of managed floating regimes that were almost like FBARs come from the East Asian countries (other than China and Japan) before the 1997 crisis. I shall be describing them in detail in chapter 12. In a widely noted paper entitled “Fear of Floating” Calvo and Reinhart (2000) analyze monthly exchange rate data from 1970 to 1999 for 39 countries. They find that almost all developing countries that officially described (to the IMF) their regimes as managed floats, actually kept their exchange rates quite stable—

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though not necessarily absolutely fixed—for long periods. This was also true of some developed countries, notably Canada. McKinnon (2000) also shows that, even when there are longer-term changes in exchange rates of developing countries, in the very short run exchange rates usually do not fluctuate. His work seems to give empirical support to the prevalence of informal flexible pegs. Furthermore, the East Asian countries appear to have adopted such informal regimes again since their recovery from the 1997 crisis. Here I would add that, if the East Asian developing countries move to, or return to, an informal FBAR-style managed floating regime, as seems possible, the issue of whether they should peg informally to the dollar or to a basket including the yen (and possibly also the Euro) may again arise. References On currency boards, see Walters and Hanke 1992, Hanke, Jonung, and Schuler 1993, and Perry (ed.) 1997. Williamson (1995) provides a thorough and detached review of the issues. Crawling peg regimes were first practiced in Brazil and Colombia in the 1960s. For the first analysis and advocacy of crawling pegs, see Williamson 1965. Recent analysis of the “crawling band” (crawling peg plus target zone), with case studies of Chile, Colombia, and Israel, is in Williamson 1996. On proposals for target zones for the major currencies, see Williamson 1985, Williamson and Miller 1987, and Kenen 1988. Proposals for developing countries are in Williamson 2000. Critical analyses are in Eichengreen 1994, Corden 1994, and, especially dealing with recent proposals for the major currencies, Clarida 2000. In a pioneering paper circulated in 1988, Krugman (1991a) analyzed the likely behavior of exchange rates within target

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zones when the limits of the band are credible. He showed that interventions at the limits would not actually be necessary. The subsequent technical literature has been surveyed by Svensson (1992). The issue of single-currency pegging versus multicurrency pegging for developing countries was important after the breakdown of Bretton Woods right through the 1980s when the major currencies floated while developing countries continued with FBAR regimes. For surveys and analysis see Williamson 1982 and Joshi 1990. For a discussion of the optimal basket for East Asian countries, with an emphasis on the role of the yen, assuming that there will be some pegging in the future, see Kwan 2001.

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6

The Real Targets Approach: A Diagrammatic Interlude

In the familiar Swan diagram (figure 6.1), the vertical axis shows the real exchange rate, R, and the horizontal axis shows real absorption, E. The real exchange rate refers to the ratio of the domestic price of tradables to the price of nontradables. Absorption is total real expenditure by the country, whether on home-produced goods or on imports. R = ePf /Pn , where e is the nominal exchange rate, Pf is the foreign price level of tradables, and Pn is the price level of nontradables. A rise in e is a nominal devaluation or depreciation; an increase in R is a real depreciation. The nominal exchange rate is defined as the number of pesos (home currency) per dollar (foreign currency). Curve Y0 traces out the combinations of R and E that yield a given level of demand for domestic output and hence a given level of income. A higher curve, such as Y1, represents a higher level of output. Curve C0 traces out the combinations of R and E that yield a given current account, and C1 represents a level that is more in surplus or less in deficit. The negative and positive slopes of the curves express the “switching” effect of a change in R. Switching refers to the shifts in the patterns of output and expenditure that result from changes in the ratio between the price of tradables relative to the price of

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R

Real exchange rate

C1

C0

Q′ B G Q

y1

K y0

E Absorption

Figure 6.1 The Swan diagram. Original source: Swan 1963.

nontradables represented by R. These are the substitution effects. If there were no switching—as is possible in the short run—the curves would be vertical. There is an alternative way of defining R. It could refer to the relative price of imports, measured in pesos, to the average price of all goods produced at home, whether importables, exportables, or nontradables. In that case, we would have R = ePf /Ph , where Ph is the average price level of homeproduced goods. Switching refers then only to the shifts in the patterns of domestic and foreign expenditure resulting from a change in R. In this case a change in R is the same as a change in the country’s terms of trade, whereas the previous definition is compatible with the small-country assumption, where the terms of trade are given to the country. In general I shall have in mind the first definition though most of the discussion is fully applicable to the second definition.

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I shall define the curve Y0 as representing “internal balance.” If the economy is above it, such as the point Q', the price of nontradables Pn (or the price of home-produced goods, Ph ) will rise rapidly until the economy gets back to the Y0 curve. On the other hand, if the economy is at a point below the Y0 curve, such as G, Ph will not fall, or will decline only very slowly, so that there is no natural, or quick tendency for it to get back to Y0. This is one of the asymmetries to which I have referred. A Negative Shock and the Real Targets Approach We start at Q, where the economy is in internal balance and at the current-account level represented by C0. We can think of this as a current-account deficit financed by private capital inflow, by official borrowing, and by some decline in the country’s foreign exchange reserves. Now the capital inflow stops, and perhaps there has to be some net repayment of capital, so that the new, required, current-account balance—a reduced deficit or even a surplus—is represented by the curve C1. Thus, there has been a negative shock. There can be other kinds of negative shock, but this is the one I will use here to explain the key points. If R were to remain unchanged the economy would have to move to G, requiring an appropriate decline in absorption, E. At this point there is a departure from internal balance. There would be an excess supply of output and eventually unemployment (relative to the internal balance level). If internal balance is to be maintained the economy must move to B. This requires a rise in R and some decline in absorption relative to the initial level, but not as big a decline as at G. The decline in absorption could result directly (partially or wholly) from the decline in capital inflow itself, or from

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deliberate monetary or fiscal policy adjustments. Here the focus is on the required adjustment in the real exchange rate: the rise in R. I shall hold the foreign price level Pf constant. Thus, a rise in R could result either from a decline in Pn or from a rise in e (nominal depreciation), or from some combination of the two. If the decline in Pn is slow, or if Pn is completely rigid downward, then a rise in e is required. When there is a negative shock there has to be a nominal devaluation (in an FBAR regime) or a nominal depreciation (brought about by monetary expansion in a floating rate regime). That is the essence of the Real Targets Approach. It rests thus on two assumptions. First, the objective of policy is to attain, or maintain two real (as distinct from nominal) targets: internal balance and the appropriate current account (external balance). Second, the price level of nontradables (or perhaps of all home-produced goods) is inflexible or sluggish downward. The story is slightly different for a positive shock compared with a negative one. As I have already noted, I am making the asymmetric assumption that excess demand for nontradables would cause Pn to increase even though excess supply or unemployment does not cause it to decrease. Thus, Pn is flexible upward, though it is inflexible (or sluggish) downward. Suppose that capital inflow increases so that the new equilibrium will involve a higher current-account deficit. This means that absorption can increase. In figure 6.1 it means that the new equilibrium will be on a C curve to the right of C0 (not drawn). If the real exchange rate finally settles at a point that yields internal balance, it will be at a point such as K in figure 6.1. A real appreciation (fall in R) will then be required to bring about a move from Q to K. In that case Pn will rise to eliminate excess demand that is created by the increase in absorption, and there will therefore be no need to

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bring about a nominal appreciation (reduce e), unless indeed it is desired to avoid a rise in Pn (or Ph ). Introducing Wages, Real and Nominal Wages have not been introduced yet. The next step is to convert the whole analysis into a wages-employment model. I assume that there is a consistent negative relationship between the real exchange rate, R, and the real wage, W/P. Thus, a real depreciation must reduce the real wage. If there is no reduction in the real wage there cannot be a real depreciation. This assumption could be based on a number of possible models. One possibility is that nontradables are labor intensive relative to tradables. Another possibility is that the price of home-produced goods (Ph ) depends primarily or even wholly on the nominal wage while the average price level facing wage earners is a weighted average of the domestic prices of imports (ePf ) and the prices of home-produced goods (Ph ). Similarly, I assume that there is a positive relationship between output (Y) and employment (N), and that this positive relationship is based on a normal production function. In figure 6.2 the negatively sloped labor demand curve D0 shows how employment rises as the real wage falls for a given current account. A downward movement along that curve corresponds to an upward movement along the C0 curve in figure 6.1. The starting point is Q, yielding employment N0 , which corresponds to Y0 in figure 6.1. Provisionally I assume that the labor supply curve is vertical through Q. Hence, the internal balance level of employment is fixed. A negative shock shifts the labor demand curve in figure 6.2 down to D1 , which corresponds to C1 in figure 6.1. If internal balance is to be maintained, the new equilibrium must be at B. On the other hand, if the real wage did not fall, equilibrium

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W/P

Real wage

S

Q

G

H

B

D0 D1

N0

N

Employment

Figure 6.2 The wages diagram.

would be at G. The D curves are drawn on the assumption that the level of absorption is always so adjusted as to achieve the required current account at any given level of employment. This should be clear from figure 6.1 A movement from Q to B involves an improved current account but constant Y, and hence constant employment, and it requires a decline in absorption. A movement from B to G involves a constant current account but reduced employment, and it also requires a decline in absorption. Let me now tell the Real Targets story in terms of figure 6.2, which is the “wages diagram.” There is a negative shock. The current account has to improve, and the level of absorption will always have to be adjusted so as to bring this about. The question is: What happens to the real wage? Assume that the nominal wage, W, is sluggish downward. It does fall in response to unemployment beyond the “natural” level of unemployment at N0 , but it falls very slowly.

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Initially, assume a fixed exchange rate regime. The prices of tradables (or of imports in our second model) in terms of domestic currency are fixed. At first the economy moves from Q to G. The rise in unemployment then leads to a slow decline in W, until B is reached. P will also fall, but because ePf does not change, P (a weighted average of ePf and Pn ) will fall less than W. During the possibly lengthy period when W declines there will be excess unemployment. Next, assume an FBAR or a flexible exchange rate regime. Right from the beginning e is raised sufficiently (and hence P increases) to bring about the necessary decline in the real wage. The movement is directly from Q to B. The transitional period of excess unemployment can then be avoided. In this case the devaluation or depreciation fulfills a pro-equilibrium role: It moves the economy to the new equilibrium—the new real target—faster than would a reliance on the downward flexibility of nominal wages. The assumption that the nominal wage is rigid, or at least sluggish, downward, is the crucial Keynesian assumption. The Real Targets Approach is the open-economy version of a standard Keynesian model. The nominal wage rigidity assumption is what makes the Real Targets Approach essentially Keynesian. Not many economists living in the real world would dispute that in the short run there is some degree of sluggishness downward of nominal wages in most, if not all, countries. But they might argue that it is really very short-term, and that it should not be a basis for economic policy. Even if it is long-lasting, it should not provide a justification for compensating policies—such as monetary or fiscal expansion, or devaluation—because such policies would have adverse longer-term effects, mostly through expectations. There is a vast literature in this area.

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Crude Keynesianism, which Keynes himself did not subscribe to but which was widely accepted in the 1950s and the 1960s, assumed longer-term nominal wage rigidity both downward and (within limits) upward, and is discredited. But in my view—based on overwhelming empirical evidence—Keynesian analysis and policies as presented here are still appropriate for short-to-medium-term situations. The next step is to introduce a positively sloped labor supply curve, represented by S in figure 6.2. It shows the minimum real wage level that trade unions and other actors in the labor market will accept at various levels of employment. This curve traces out the natural rate of employment. For example, at the point H the labor-market actors will settle for a lower real wage than at Q because employment is lower. But, starting from G, the downward adjustment of W to get to this lower real wage is sluggish. In contrast, if the real wage is less than the minimum, wage setters in the labor market (in particular, trade unions) will quickly raise the nominal wage to get back to the S curve, unless wage setters are surprised by the rise in prices or there is some upward rigidity in W owing to wage contracts. Now, consider two special cases. First, the real wage may be completely rigid. For every rise in e leading to a rise in P, there will quickly be a rise in W designed to keep W/P constant. This is the case of formal or informal wage indexation. In figure 6.2 this means that, for all practical purposes, after the negative shock the economy has to stay at G. One could think of the labor supply curve S as being horizontal. One has to bear in mind that the supply curve of individual workers is likely to be positively sloped, so that a negative shock would lead to increased involuntary unemployment. Furthermore, there may be lags in the process, so that a decline in W/P can be brought about by

The Real Targets Approach

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continuous depreciation of the exchange rate, but at the cost of continuous inflation. We come then to an important conclusion emphasized in chapter 3: if the real wage is rigid the Real Targets Approach to exchange rate policy does not work. There is no point in having the nominal exchange rate available as an instrument of policy when it cannot affect (other than for a very short period) the real wage. To make the exchange rate instrument necessary, nominal wages have to be inflexible (or sluggish) downward; to make it effective, real wages have to be flexible. The second special case is that of an anti-equilibrium exchange rate policy. I shall describe here an open-economy version of the familiar argument (Friedman 1968) that points out the limitations of a Keynesian demand expansion policy designed to reduce the level of unemployment below its natural rate. The exchange rate is depreciated so as to get the real wage down to B, where employment was before the negative shock. But B represents a level of unemployment that is less than the natural rate: B is below the S curve. Thus, it is not sustainable. The nominal wage will rise to compensate for the rise in P until S is attained. Any point below the S curve will provoke this reaction. This anti-equilibrium exchange rate policy is the case where depreciation or devaluation is designed to attain a degree of competitiveness that cannot be sustained because it will provoke a wage-price spiral. Continuous depreciation may be able to sustain a point below S for some time if there are lags in wage adjustment, or if the exchange rate policy surprises the trade unions or whoever fixes wages. It will lead to a devaluation-wage-price spiral, involving an inflationary process that is doomed eventually to lead to a higher rate of inflation (as inflationary expectations adjust) without finally ensuring a level of

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employment greater than that indicated by the S curve. To sum up: A devaluation that aims to bring the economy along D1 from point G in the direction of point H is a pro-equilibrium policy, and one that aims to bring it to a point below H is an anti-equilibrium policy. The Real Targets Approach requires the exchange rate to be adjusted so as to get to a sustainable target (H), not an unsustainable target (such as B). Introducing International Labor Mobility The positive slope of the S curve makes the point that reduced demand for labor will (in equilibrium) lead both to reduced employment in the country and to a lower real wage. I have emphasized “employment in the country” since the curve could reflect, among other things, the international mobility (if any) of labor. Workers may emigrate. The higher is the international mobility of labor, the more elastic will be the labor supply curve facing employers in the country, as represented by the S curve. A reduction in the real wage not only reduces the domestic supply of labor but also causes some people to work abroad and thus further reduce the supply available at home. Thus, the higher is labor mobility, the flatter is the S curve. Hence, for a given negative shock (downward shift of the D curve), the higher is international labor mobility, the less does the real wage need to fall and the more employment in the country will fall. This conclusion is related to the theory of optimum currency areas that originated in Mundell 1961. This theory says that the higher is international (or interregional) labor mobility, the less is the need for a devaluation when there is a negative shock. In terms of this model, that is another way of saying: The higher is international labor mobility, the less is the need for the real wage to fall.

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The Three Options Finally, let us consider the options when there is a negative shock. The first option is to keep the nominal exchange rate fixed and allow the market to work. There will then be a recession—a movement from Q to G—and perhaps a slow decline in nominal wages until eventually H is reached. During this period the economy will be operating below its capacity, with unemployment above the natural rate. It could be a short period or a very long period. If it were a short period there would be no need for nominal exchange rate adjustment. The second option is to devalue, or bring about depreciation through monetary expansion, so that the economy could get quickly to H. Recession will then be avoided, or at least moderated. This is the main argument for the Real Targets Approach. If the real wage were rigid (S curve horizontal) there would be no point in devaluation: recession could not be avoided. The third option is fiscal expansion. If the negative shock were believed to be temporary, a fiscal expansion might be financed by foreign borrowing, if that is possible, or out of foreign exchange reserves that have been accumulated for such an eventuality. In that case it would not be necessary to ensure a current-account improvement. Financing would replace adjustment. The economy could remain at Q. The exchange rate could remain fixed. Fiscal policy, and its bearing on the choice of an exchange rate regime, will be discussed in the next chapter.

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7

What Role for Fiscal Policy?

The relationship between fiscal policy and the exchange rate regime is quite complex. Figure 7.1 lays out the various cases and categories. One needs to distinguish fiscal policy as an instrument and fiscal policy as a constraint. In the first case it could be the solution to a problem—possibly a problem caused by an exchange rate regime. Here I introduce the concept of “functional finance.” In the second case it could be the problem itself. Fiscal policy may be unstable or actually out of control. In this second case I assume that fiscal instability or lack of control is given, and the exchange rate regime simply has to adapt to it. This leaves a third case to consider: can the exchange rate regime actually change the fiscal situation? That is the discipline issue. My focus here is not on optimal fiscal policy but on the optimal choice of exchange rate regime given fiscal policy, or given the possibility that the choice of regime can change fiscal policy. I shall proceed as follows. First I shall assume that fiscal policy is an available policy instrument for macroeconomic purposes. It can be used for what I shall call “functional finance.” This term embraces counter-cyclical policy, but it is broader because it is not just concerned with smoothing the trade cycle. I shall show that, in so far as functional finance is

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Fiscal policy as solution (instrument)

Fiscal policy as problem (constraint)

Functional finance

Negative shock (recession)

Fiscal policy as problem (not given)

Discipline (by exchange rate regime)

Positive shock (real appreciation)

Bond-financed deficit and unstable

Currency Flexible board regime

FBAR

Monetized deficit and out of control

Figure 7.1 What role for fiscal policy?

practiced, the case in favor of a fixed exchange rate regime is strengthened. Next I shall come to the category where fiscal policy is the problem itself. I shall distinguish within this category the case where deficits are bond-financed and fiscal policies are unstable, from the case where out-of-control deficits are monetized, thus causing inflation. Needless to say, I shall have Latin American history in mind for this last case. I shall show that in these cases—where fiscal policy is the problem and has to be taken as given—there is a strong argument for some kind of flexible exchange rate regime. Finally, I shall come to the case where the fiscal situation is not taken as given. This involves the fiscal discipline issue. Can the exchange rate regime discipline fiscal policy—that is, can it convert an unstable or out-of-control fiscal policy into one that is in control and possibly available as an instrument

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of macroeconomic policy? Here I am very skeptical, but I shall put forward arguments that have been advanced both in favor of fixed and in favor of flexible exchange rate regimes. I begin here with the functional finance approach—where fiscal policy is the solution to a problem. I apply this approach to two cases. The first case is a typical negative shock, namely a decline in capital inflows which is likely to give rise to a recession, especially in a fixed exchange rate regime. The second case is a positive shock, such as an increase in capital inflows, where, in the absence of a functional finance policy, a real appreciation and thus a “Dutch Disease” effect would result. In both cases I assume that the government has the political and administrative capacity to manage fiscal policy so as to attain macroeconomic objectives. Functional Finance: Decline in Capital Inflow and Domestic Recession Suppose that capital inflow and domestic investment spending decline for whatever reason, perhaps because of adverse perceptions of future profitability of domestic firms. I assume that the exchange rate is fixed. A recession results. Imports fall, and thus the current account improves. The budget balance deteriorates, owing to reduced tax revenues, this being the familiar automatic stabilizer. This is much like the Asian crisis story. In that case exchange rates did depreciate greatly, but such depreciations had no switching effects for some time. What would a fiscal expansion do? It could reverse or moderate the recession, that being the objective of such a functional finance policy. Extra government spending, or private spending out of tax cuts, would substitute for

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reduced private investment spending. By reversing the recession it would reverse the fiscal deterioration caused by the automatic stabilizer effect, but the fiscal expansion itself would put the budget into deficit relative to the initial situation. And this deficit would have to be financed by borrowing. Combining the external effect of the reduction in private investment with the effect of the offsetting fiscal expansion, lower private sector borrowing abroad would be replaced by increased public sector borrowing or by a reduction in foreign exchange reserves. Fiscal policy is financing while exchange rate depreciation is adjustment. That is a significant distinction. Depreciation would help to bring the real exchange rate and the real wage to a new equilibrium. Fiscal expansion does not do this. In that sense fiscal policy and exchange rate adjustment are alternatives, not substitutes. But there is clearly a role for financing, and hence for fiscal policy, if the slump is expected to be only temporary. There can even be a shortterm role for financing when a longer-term adjustment is thought to be needed. If the shock is sudden, fiscal policy can smooth the path of adjustment by allowing more time for it. Given the fixed exchange rate regime, adjustment would have to take the form of reductions of nominal wages and of prices of domestically produced goods and services, at least relative to productivity growth. Thus in both cases a temporary fiscal expansion has a potential role. Even if the exchange rate is allowed to depreciate, a negative shock is likely to produce a short-term recession because of the usual lag in the switching effect of depreciation. That was certainly true in the Asian crisis. Hence there is a role for functional finance even in that case. It is easy to see numerous qualifications or difficulties about this functional finance approach. The most obvious

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one is that, when the world market’s perceptions of the country’s private sector prospects have deteriorated, it may not be possible for the government to borrow in the market to finance its deficit. It would have to rely on its foreign exchange reserves and on emergency official loans, for example from the IMF. The availability of such funds will constrain the fiscal stabilization policy. The important message—which I shall reiterate—is that the country must run fiscal surpluses in the boom, on the basis of which it builds up foreign exchange reserves or reduces earlier indebtedness, so that it can run deficits in the slump. That is the true functional finance policy. Even if public sector borrowing in the world market were possible at a time of slump, optimal long-run fiscal policy (public debt policy) cannot be ignored. If a country had failed to run budget surpluses in the preceding boom, it may be inappropriate from a long-run point of view for that country to run deficits in the slump There are other difficulties and qualifications. There are lags in making fiscal policy decisions and implementing them, and further lags in their effects. At the minimum the automatic stabilizer that has produced a fiscal deficit as a result of the recession should be allowed to work. No attempt should be made to bring the budget back into balance at that time. It is difficult for the public and for politicians to understand that at a time of recession the deficit should actually be increased by deliberate policy when previously there has been a focus on reducing public debt and keeping budget deficits under control. This was very apparent in the United States in 2001. Above all, it is crucial that there have been earlier surpluses, so that it can be seen by the public and by the international capital market that the country can “afford” these short-term deficits.

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One also needs to remind oneself of the Barro-Ricardo complication (Barro 1989), which is emphasized heavily in modern macroeconomic theory. If a fiscal deficit leads people to expect that taxes will be raised later to pay interest and pay off the extra public debt, private consumption on the part of far-sighted taxpayers may decline. They will build up their savings in order to provide for the expected higher taxes in the future. Alternatively they may save more in the expectation that the government in the future will not be able to pay adequate old age pensions. With private saving increasing, in the extreme case little or no extra aggregate demand may result from a short-term fiscal expansion. Hence functional finance would not influence aggregate spending. I have always been skeptical about the practical importance of this approach, but macroeconomic events in Japan in the 1990s have given us at least one case study where it appears to have some support. Implicit in the functional finance argument that I have advanced so far (and with which I shall continue) is that, if there are such offsetting private sector reactions, they are only partial. The Barro-Ricardo complication makes the point that fiscal policy changes may be offset partially or even wholly by farsighted, rational private sector reactions. Directly relevant to the present discussion, and following from the same logic, is the possibility that instability originating externally, whether through the international capital market or terms of trade changes, will be offset by stabilizing reactions by the domestic private sector. For example, when there is an improvement in the terms of trade the private sector may increase its savings, in anticipation of a later slump. When the slump comes, the private sector dissaves, drawing on funds accumulated during the boom that were invested by financial institutions abroad. Thus dissaving might avoid a recession.

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This is a case of consumption smoothing. One can also envisage investment smoothing in response to the fickleness of the international capital market. The main point is simply that the more stabilizing consumption or investment smoothing takes place on the part of the domestic private sector, the less need there is for stabilizing policy by the public sector, that is, for functional finance. One might ask: why should one expect a government to have more foresight or rationality than the private sector, or indeed more motivation to stabilize an economy? These are familiar issues, and finally one has to make empirical judgments. Can a government be trusted with regard to its motives or its competence? Do private firms and individuals tend to behave in stabilizing ways? I am inclined to say: it all depends on countries and cases. Certainly, the crisis stories I tell in later chapters do not give much support to a belief in the stabilizing behavior of private agents. In any case, at this stage I shall assume that, in spite of some possible stabilizing behavior by private agents, there is still a task left for functional finance. Coming back, then, to the main issue, what is the conclusion for the choice of exchange rate regime? It is that the case against fixed exchange rates on the grounds of the Real Targets Approach is at least weakened if the country has the capacity and the willingness to practice functional finance in both boom and slump. The recession effect of a negative shock can be avoided, or at least moderated. But, to repeat, this functional finance policy, and hence this conclusion about the exchange rate regime, requires not just budget deficits to counteract a recession but also surpluses in a boom. I shall come back to this important point in my discussion of the Argentine case in chapter 11.

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Functional Finance: The Real Appreciation (Dutch Disease) Problem A positive shock leads to real appreciation both when the exchange rate is fixed and when it is flexible (see chapter 3). With a positive shock functional finance can play a different role than in the negative shock case. There is no need to moderate or prevent a recession, as in the negative shock case; rather, the consequences of real appreciation must be considered. The theory of the Dutch Disease is relevant here. In a fixed exchange rate regime a capital inflow boom leads to an increase in demand for domestic goods and services, and thus to a rise in domestic prices and wages, and hence to real appreciation. The current account goes into deficit. The nontradable sector of the economy expands as a result of the increase in demand, but export industries and import-competing industries (the tradable sectors) are adversely affected by real appreciation. The adverse effect that real appreciation has on industries that produce tradables is the Dutch Disease effect. An alternative, but similar, story is that productivity improves in one part—the booming sector—of the broader tradable sector of the economy, or world prices for the booming sector’s products rise. Hence incomes rise. Spending thus increases, and the consequent real appreciation will then have an adverse effect on the other part of the tradable sector—the lagging sector. It is often pointed out that this Dutch Disease effect should not be a matter of policy concern. Real appreciation is simply part of the inevitable relative price adjustment process that goes with a favorable shock. But, if such a real appreciation or Dutch Disease effect happens very suddenly, or if it is likely to be reversed in due course, it is often regarded as undesirable, and policy-makers often wish to

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moderate at least temporarily adverse effects on export industries. The best example comes from an oil-exporting country. Oil prices rise, or new discoveries raise oil exports. Hence export income rises, spending on domestic goods and services increases, the prices of nontradables rise, along with wages, and again a real appreciation has adverse effects, this time on the other export and import-competing industries—for short, the lagging sector. This Dutch Disease effect is a difficulty only for the lagging sector. Increased imports and reduced lagging-sector exports offset in this case the initial improvement in the current account that resulted from higher oil income. While it could be disputed that an adverse effect on one sector, possibly a very large sector, is really a national problem, as I have just noted, it is frequently seen as one by governments. In a fixed exchange rate regime (with an independent monetary policy), or in a regime of managed floating with intervention designed to moderate appreciation, governments frequently try to sterilize the effects of the accumulation of foreign exchange on the domestic money supply. This can only be done for a limited period or to a limited extent because of losses to the central bank, but will succeed in slowing real appreciation and thus the Dutch Disease effect. The functional finance approach can affect the outcome in the following way. Fiscal contraction could reduce or avoid the Dutch Disease effect. If the reason for real appreciation was a private sector capital inflow boom, the net result of the combination of the private sector boom and fiscal contraction would be an increase in private borrowing partially or wholly offset by a reduction in public sector borrowing. Increased private spending owing to the boom would be offset by reduced public spending (or reduced private spending

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owing to higher tax rates). If the source of the Dutch Disease was a booming-sector boom (an oil price rise, for example) the net effect of this boom combined with fiscal contraction would be an improvement in the current account, and hence accumulation of foreign exchange. Functional Finance and the Exchange Rate Regime: A Unified Approach One can thus envisage a unified functional finance approach in a fixed exchange rate regime, with all the difficulties and qualifications discussed earlier. In particular, I draw attention to the assumption I have made about private sector behavior. It is not stabilizing—or at least not sufficiently stabilizing to obviate the need for functional finance. Fiscal policy would be contractionary in the boom in order to avoid or moderate real appreciation, and thus the Dutch Disease effect, and it would be expansionary in the slump, in order to avoid or moderate a recession. Furthermore, quite apart from the possible need to moderate real appreciation in the boom, there is the point I emphasized earlier when discussing the role of functional finance in moderating or avoiding a recession. It is desirable that fiscal policy be contractionary in the boom so that foreign exchange reserves can be built up so as to make possible fiscal expansion in the slump. Is this story any different when the exchange rate is flexible? That is the relevant question when we want to shed light on the choice of exchange rate regime. As already noted, in a flexible exchange rate regime there is less likelihood of a prolonged recession when there is a negative shock, and hence less need for functional finance, because the exchange rate would depreciate, thus increasing demand for home-

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produced products. On the other hand, with a positive shock the story is similar—though not quite the same—for the two regimes. With a flexible exchange rate regime, a capital inflow boom or a rise in foreign prices of exports, for example, will lead to nominal appreciation. Thus there will also be real appreciation, just as with a fixed exchange rate. Whether real appreciation results from domestic prices rising in a fixed exchange rate regime or from nominal appreciation in a flexible exchange rate regime, in both cases there will be a need for functional finance if it is desired to moderate or avoid the Dutch Disease effect. The difference between the two regimes is only that real appreciation in response to the positive shock may be slower with a fixed exchange rate regime. The reason is that the rise in domestic prices in the fixed exchange rate regime or the FBAR may well be slower than appreciation of the nominal exchange rate in the flexible regime. This is particularly likely when there is still an independent monetary policy in the fixed exchange rate regime, as with an FBAR. The increase in the money supply, and hence the rise in prices, may be slowed down at least temporarily by sterilization of the domestic monetary effects of the rise in foreign exchange reserves. It follows that, given a concern with the Dutch Disease, functional finance is needed more in the flexible (especially floating) exchange rate regime. Taking all this into account, what are the implications for the choice of exchange rate regime? Given a concern with avoiding recession, functional finance is needed more in the fixed exchange rate regime. On the other hand, to avoid the Dutch Disease effect functional finance is needed more in the flexible exchange rate regime. In my view, the disadvantages of recession in the fixed exchange rate regime normally outweigh the disadvantages of the Dutch Disease in the floating

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exchange rate regime. Hence the ready availability of functional finance weakens the case against (or strengthens the case for) choosing a fixed exchange rate regime. Functional finance can moderate or even prevent the recession that a negative shock might produce when the exchange rate is fixed. Fiscal Instability: How It Affects the Choice of Exchange Rate Regime I now move to a situation where fiscal policy is the source of the problem rather than a potential solution. Fiscal deficits are financed by the sale of bonds to the public. The deficits are unstable for political or other reasons. Periods of fiscal profligacy are followed by periods of fiscal stringency. There are periods of big fiscal deficits, often resulting from weak political control or from fallacious or populist economic beliefs. Then there are periods of fiscal stringency when deficits are reined in, possibly because the world capital market requires higher and higher interest rates and eventually the supply of new funds dries up completely. I shall now assume that fiscal instability is not offset—or not sufficiently offset—by stabilizing behavior by the private sector. When the government is profligate there is not an increase in private savings that is sufficient to keep national savings unchanged. Indeed, public and private profligacy may go together, as they did in the United States in the 1980s. The periods of big fiscal deficits thus lead to current-account deficits financed by capital inflow, and thus to real appreciations. This would be true both under an absolutely fixed exchange rate regime, under an FBAR, and under a flexible exchange rate regime. The subsequent periods of fiscal stringency lead to current-account surpluses, or at least to reduc-

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tions in deficits. Under a fixed exchange rate regime, periods of fiscal stringency would also lead to domestic recessions. By contrast, under a flexible exchange rate regime such periods of stringency would lead to nominal and real depreciations, which after a lag would reduce or even end the recessions. The important conclusion for the choice of exchange rate regime is that with a fixed exchange rate regime a period of stringency would inevitably lead to recession, possibly a prolonged one. There are qualifications to this last conclusion: as I have noted, there might be some offsetting movements by the private sector, and there may be some downward flexibility of nominal wages and prices of nontradables. Leaving aside these qualifications, the clear conclusion emerges that when fiscal policy is unstable, and periods of stringency are thus likely, the exchange rate needs to be flexible so as to avoid periodic recessions. This is no different from the argument that when private sector demand or capital inflows are unstable there is a strong case for a flexible exchange rate regime. If, for nominal anchor reasons, a country wishes to establish an absolutely fixed exchange rate regime, such as a credible currency board system, it should ensure that it can maintain a reasonably stable fiscal policy. Even better would be a consistent functional finance policy, as outlined earlier. To hark back to the initial distinction between fiscal policy being the problem and being the solution, in the case I am now discussing it is the problem and hence is one of the “fundamentals.” If the fundamentals are unstable the exchange rate needs to be flexible. Only if a fixed exchange rate regime could actually change the fundamentals—that is, succeed in generating fiscal discipline and stability—would there be a good argument for establishing such a regime. If the country has an FBAR regime the possibility of speculative crises must also be allowed for. It can be shown that

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either a period of fiscal profligacy or a period of fiscal stringency could lead to speculative crises. In the profligacy period at first a bond-financed fiscal expansion will lead to an increase in foreign exchange reserves as higher interest rates draw foreign capital into the country. But the expectation in the foreign exchange market that the deficits may eventually have to be monetized as foreign finance dries up will lead to expectation of devaluation or the end of the FBAR, and thus to a speculative crisis. In the period of stringency, the expectation that continued recession will not be acceptable may also lead the foreign exchange market to expect eventual devaluation, and thus, again, lead to a speculative crisis. Indeed, in the profligacy period a later period of stringency may be seen as inevitable, and it may also be foreseen even then that a period of stringency will lead to a pressure for depreciation so as to moderate or reverse the recession. Thus, when fiscal policy is unstable there is a strong case for preferring a flexible exchange rate regime to an FBAR because of the inevitable FBAR speculation crises with all their disadvantages. Out-of-Control Fiscal Deficits and Inflationary Financing It remains to consider the situation where fiscal deficits are not merely unstable, and perhaps occasionally out of control, but where they are really out of control and are initially financed by central bank credit—that is, they are monetized. The inevitable result is continuous inflation. Essentially the deficit is financed by the inflation tax. It is not difficult to show that a flexible exchange rate regime is then inevitable. This is a Latin American story. It is a familiar tale of woe, which, in somewhat simplified form, describes what has happened in Brazil, in Argentina before it moved to a currency

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board regime in 1991, and in many other Latin American countries, and also in Russia. To start with, the fiscal deficit determines the money growth rate, and the money growth rate determines (more or less) the rate of inflation of domestic wages and prices. This is sometimes described as a situation of “fiscal dominance” because the money growth rate is determined by the fiscal deficit. If the nominal exchange rate were fixed, or if it were depreciating at a lower rate than the rate at which domestic prices are rising relative to foreign prices—the result of an active crawling peg regime—there would be continuous real appreciation. Hence, with such inflation resulting from monetization of fiscal deficits, the nominal exchange rate will have to depreciate steadily if continuous real appreciation and growing current-account deficits and unemployment are to be avoided. In countries going through this inflationary process it has been widely believed that inflation was caused by exchange rate depreciation. Hence it has been common to use exchange rate policy as the principal disinflationary instrument. Sometimes the exchange rate has actually been fixed. More commonly there have been exchange-rate-based stabilization programs which included as key elements active crawling peg regimes where the exchange rates depreciate at a slower rate than the rate of inflation of wages and nontradable prices. But if exchange rate policy fails as a nominal anchor that successfully reduces the fiscal deficit and thus the rate of money growth, and if it additionally fails to reduce inflationary expectations and thus the rate of wage inflation, steady real appreciation will be the nemesis of such a regime. Before a deteriorating current account and increasing unemployment force a change of policy, speculation against the exchange rate will do so. This would be anticipating

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speculation. It is a typical FBAR situation. The underlying cause is the monetized fiscal deficit—itself boosted by high interest rates on public debt caused by high inflationary expectations. The simple point is that, subject to one proviso, the non-interest (primary) budget deficit has to be reduced. Until that is done the exchange rate should float or there has to be a passive (and not an active) crawling peg regime. As I noted in chapter 5, with a passive crawling peg regime the nominal exchange rate is automatically depreciated to compensate for inflation. The aim is to avoid appreciation of the real exchange rate. The proviso is that there might be a shift from monetization of the deficit to bond finance. The deficit would continue, but the immediate effect could well be a radical reduction in inflation, which will be seen as a triumph. This happened in Russia in 1994–1996 and in Brazil in 1995. While previously the deficit was financed by the inflation tax, now it will be financed partly by squeezing out private domestic investment and partly by foreign borrowing. In effect, the costs of the deficit will be shifted from the present to the future. With inflation reduced or even ended, it will be possible to maintain for some time a fixed exchange rate, or at least a crawling peg exchange rate regime with a modest rate of depreciation. But the new situation will not be sustainable. If a high primary deficit continues (so that the ratio of debt to GDP is steadily rising) the interest rate will rise as it becomes more and more difficult to borrow. The total deficit (including interest payments) will rise even more. Default, and thus the drying up of the supply of new funds, will be expected. Eventually the country will have to reduce or eliminate its fiscal deficit, and hence its current-account deficit, and that will require depreciation, which will therefore be anticipated.

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Thus there will again be an FBAR exchange rate crisis. Given the unsustainable deficit, speculation on the possibility of default and depreciation is inevitable. If such a crisis did not lead to a reduction in the deficit, the deficit would again have to be monetized. The expectation of monetization would accentuate the expectation of depreciation. The basic instability will not go away in the absence of sufficient reduction of the primary fiscal deficit. But exiting early from a crawling peg or FBAR regime and returning to a floating or flexible peg rate regime will at least avoid the social costs of an FBAR crisis, notably the losses of the central bank and the loss of credibility of the bank and the government. The moral is that it is not sufficient for an exchange rate regime to discipline monetary policy. A sole focus on inflation is not enough. Fiscal policy must also be disciplined. Ideally, fiscal policy should not be neutered with rules that make it quite inflexible. It should be converted from an out-of-control policy to one that follows the broad principles of functional finance. Can the Exchange Rate Regime Discipline Fiscal Policy? Which regime can best discipline fiscal policy? My own view is that an unstable or out-of-control fiscal policy must be faced up to directly. In a stabilization program designed to reduce inflation caused by monetization of fiscal deficits a policy package is required, which consists of some kind of nominal anchor arrangement (whether exchange-rate-based or inflation-targeting) plus a program of fiscal consolidation and all that the latter implies. Successful Latin American programs (such as those of Chile, Mexico, and Brazil, as well as Argentina’s program of 1991) have included both parts of the package. An earlier Argentine program of 1979–1981 failed on the fiscal consolidation front.

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Having said all this, let me explore possible links between the exchange rate regime and fiscal discipline. I shall assume, as usual, high capital mobility, and also that, in the absence of discipline, the fiscal deficit would be continuous and high, essentially “out of control.” I begin with a credible currency board regime or some other absolutely-fixed regime. A fiscal deficit can be bond-financed or monetized. With a currency board regime monetization—and hence financing by the inflation tax—is not possible. But bond finance (or some other form of borrowing) is still possible. Thus there is a loophole. A currency board regime does not necessarily provide fiscal discipline. If the fiscal deficit is excessive eventually there will be a debt crisis, and this will provide the discipline. But the discipline may be postponed for some years, a postponement that can be attractive to politicians. Three examples come to mind. The members of the West African franc zone (the CFA zone) have had a fixed exchange rate to the French franc for many years, with just one devaluation in 1994, and this arrangement is essentially a currency board. Nevertheless, several countries, notably Cote d’Ivoire, ran large fiscal and current-account deficits in the 1980s. Argentina, with its currency board, nevertheless landed in a debt crisis in 2001. Finally, India has always avoided inflationary financing (though it has not had a currency board regime), but has for many years run large budget deficits financed initially out of domestic savings, thus crowding out domestic investment, and then also, in the 1990s, by foreign borrowing. Next, consider a flexible or floating exchange rate regime. This time, both monetization and bond finance of fiscal deficits are possible. Either, or some combination, may be chosen. The government has two financing options, and not just one, so that, seen in this way, discipline must be weaker

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than in the currency board case. The tougher is the discipline imposed by the capital market, the more likely is it that the inflation option will be chosen. Inflation imposes an immediate cost in the form of the uncertainties and distortions it creates, as well as the cost of the inflation tax itself. Bond finance pushes the costs to the future. But there is another consideration, namely the discipline of the foreign exchange market. With a floating or flexible exchange rate, a fiscal expansion which is intended to be financed by bonds may immediately lead to depreciation of the exchange rate as the market anticipates an eventual debt crisis followed by monetization. The discipline of the foreign exchange market may work very quickly. Thus the costs cannot be pushed into the future. This is an argument that has often been made: the combination of a flexible exchange rate and capital mobility provides the most effective form of discipline. It is an argument that assumes, crucially, not only that there is anticipatory speculation but also that a depreciation of the exchange rate is unwelcome because it may ignite inflationary expectations, or because of distributional and other reasons. Yet depreciation may actually be welcome because, in the short run, it would improve the competitiveness of the economy. Finally, consider the FBAR regime. For a limited period fiscal expansion can be both monetized and bond financed. Foreign exchange reserves will decline, domestic investment will be crowded out by high interest rates designed to maintain the exchange rate, and growing foreign debt will be incurred. If the fixed exchange rate is maintained until a crisis forces a devaluation or an end to the regime, then all the costs will be pushed into the future. But at some stage— possibly very quickly—there will be a typical FBAR foreign exchange crisis, with all the familiar costs. Such a crisis often

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imposes so severe a shock and such severe costs that subsequently a policy of fiscal discipline will be followed. For those who believe that discipline can be achieved only through pain, and that exchange rate policy should not adjust to the fiscal situation but should try to change it, this is the right policy. My own preference is, in general, for a direct attempt at fiscal discipline, with the aim of avoiding a crisis, rather than using a crisis to bring about discipline. This is an issue of political economy, and one can find many cases where fiscal discipline has been brought about, perhaps gradually, by direct policies without a crisis, and others where it was done only under the stimulus of a crisis. References The term functional finance comes from Lerner 1947. The policy is, of course, subject to all the now-well-known objections to the desirability of policy flexibility, objections that Lerner, an early postwar expositor and advocate of Keynesian policy activism, did not discuss. On the Dutch Disease, see Corden and Neary 1982 and Corden 1984. For an extended discussion of the relationship between the real appreciation (Dutch Disease) problem and fiscal policy, see Corden 1994, chapter 4. My discussion of fiscal instability and out-of-control deficits is influenced by Latin American experience. (See chapters 10 and 11 and references cited there.) Krugman’s (1979) speculative attack model shows formally that a monetized fiscal deficit must lead to an FBAR crisis well before the foreign exchange reserves run out. The Stability Pact of the European Monetary Union has put constraints on individual member countries’ fiscal deficits, constraints that severely limit the scope for functional finance

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by individual members. This seems to go against the argument that the existence of a fixed exchange rate regime (monetary union) strengthens the need for functional finance. The motive has been a fear that some member countries (notably Italy) may run out-of-control deficits. (See de Grauwe 2000 and Eichengreen 1997, chapters 8 and 9.) De Kock and Grilli (1993) have a formal model which studies the choice of exchange rate regime from the point of view of optimal seigniorage policies. I have not dealt explicitly with the seigniorage issue in this chapter. I have assumed that monetized deficits are usually “out of control” for political or institutional reasons.

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8

Contractionary Devaluation and Unhedged Foreign-CurrencyDenominated Borrowing

Can a devaluation or depreciation be contractionary, and if so, does this present a special problem? In the simple theory presented in chapter 6 a depreciation or devaluation is expansionary. After a crisis resulting from a negative shock depreciation of the exchange rate may have little effect in the short run, so that a recession is inevitable, but eventually the switching effect allows output and real income (Y in figure 6.1) to be restored to its initial internal balance level. Hence the devaluation either has no effect or is expansionary. But the Asian crisis highlighted the fact that the depreciation itself can be contractionary. At least some part of the deep recession following from the sudden cessation of capital inflows was explained by the accumulation of unhedged liabilities denominated in foreign currency. This phenomenon has been described as “liability dollarization” (where “dollar” is shorthand for foreign currency). For short, I shall call it UFB (unhedged foreign-currency-denominated borrowing). Corporations and financial intermediaries, including banks, had borrowed massively in dollars while their loans and investments were denominated in domestic currency. Thus, as a result of sharp depreciations, they faced an immediate balance sheet crisis and inability to make the dollar (or

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yen) interest and amortization payments they owed. This bankrupted borrowers, especially banks, and intensified the financial crisis. In turn, it contributed to a reduction in aggregate demand, with the net effect of intensifying the recession. I shall come back to UFB later in this chapter, and to the lessons of the Asian crisis in chapter 12. First, I shall analyze more broadly the contractionary devaluation issue. Contractionary Devaluation It is worth recalling that the theory of contractionary devaluation goes back a long way. Its originator, Carlos DiazAlejandro (1963), focused on a different case, which continues to be relevant. A devaluation reduces real wages, shifting income from high-spending wage earners to relatively lowspending capitalists and landowners. Thus it reduces aggregate spending through the wages channel. Similarly, an appreciation raises wage income and can lead to a spending boom. Diaz-Alejandro’s theory was inspired by the Argentine devaluation of 1959, while the Chilean real appreciation of 1979–1981 provided an example of the second case. An immediate question must be: if there are losers from devaluation, who spend less, there must also be gainers who spend more. Precisely, who are they? Furthermore, a unified theory must embrace not only changes in current income but also changes in the values of financial liabilities and financial assets. In addition, account should be taken of the fiscal effects of devaluations when the government has dollar-denominated liabilities, though I shall not pursue this here. I shall now attempt to provide a unified theory, as well as explore the implications of UFB with some care. Finally, I shall address the inevitable question: how does all this affect the choice of exchange rate regime.

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Absorption-Reducing Devaluation and Switching: Diagrammatic Approach Figure 8.1 is the Swan diagram, already introduced as figure 6.1. As before, the vertical axis shows the real exchange rate, R, where R = ePf/Pn and where e is the nominal exchange rate. A rise in R is a real devaluation. The horizontal axis, E, shows real expenditure or “absorption.” The economy is originally at Q, with real income (equals output) at Y0 . As already noted in chapter 6, the negative slope of the Y curve and the positive slope of the C curve reflect the “switching” effects of devaluations. The less switching, the steeper these curves. Assume that e rises, and with it, R rises from R0 to R1. There is no change in fiscal policy. Also, assume that there is no change in the interest rate. I want to isolate the effects of the devaluation. Conceivably the rise in R might have no R C1

Real exchange rate

C0

R1

D

F

J

B

R0 Q

G

y1 y0 E

Absorption

Figure 8.1 Contractionary devaluation.

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effect on absorption—that is, it would be a pure switching instrument. In that case the economy would move to B. Real income would rise to Y1. Hence the outcome would be clearly expansionary because of the switching effect. If Y0 represented the initial natural rate of employment (internal balance), inflation would gradually erode the expansionary effect by raising Pn. The policy objective may be to bring about an improvement in the current account from C0 to C1 while maintaining internal balance. A deliberate policy of demand contraction, in the form, for example, of a reduction in government expenditure generating a fiscal contraction, would then have to be associated with the devaluation, bringing the economy to F. Now we come to the central theme of this chapter. The devaluation itself may change absorption. A devaluation that reduces E might be labeled an absorption-reducing devaluation. If this effect were so great as to offset the expansionary effect of switching and hence to lower Y, then it would be a contractionary devaluation. In figure 8.1 a devaluation that brings the economy to a point between F and B (such as J) is both absorption-reducing (lowers E) and expansionary (raises Y), while one that brings the economy to D, hence lowering Y, is contractionary. But, of course, a devaluation could also be absorption-increasing, bringing the economy to a point such as G. Since G could be to the right of C0, a devaluation could worsen the current account. It is likely that the switching effect works with a lag, perhaps because it takes some time for exports to increase as a result of an improvement of competitiveness. In that case the absorption-reducing or absorption-increasing effects of the devaluation will dominate in the short run, while eventually the switching effects will come into play. In terms of the dia-

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gram, in the short run the curves will be very steep, and gradually they will acquire their positive and negative slopes. Therefore, in the short run a devaluation that reduced absorption would be contractionary while in the longer run it might be expansionary. Absorption-Reducing or Absorption-Increasing Devaluation: Generalization A devaluation has redistributive effects, and these, in turn, will affect total spending or absorption. Gainers (producers of tradables and consumers of nontradables) will spend more and save more, and losers (producers of nontradables and consumers of tradables will spend and save less. The spending and savings effects may only be short run and will depend on how the devaluation affects expectations about future income changes. Distribution effects and their implications for national savings, as well as the pattern of spending, are likely to be quite complex, so absorption could rise or fall. Absorption for consumption will fall if the marginal propensity to consume of the gainers is less than the marginal propensity to consume of the losers. Even if absorption stayed constant and there were no switching effects at all, there could be a shift of consumption spending toward or away from tradables relative to nontradables, and hence there could be effects on income (Y) and on the current account (C). In addition, profits of some industries will rise and those of others will fall, and this will lead to increases in investment in some sectors and reductions in others. Diaz Alejandro (1963) highlighted the case where a devaluation reduces real wages in favor of profits and hence shifts income distribution away from

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income recipients with a low marginal propensity to save, and toward income recipients with a high one. Hence a decline in absorption and contractionary devaluation was likely, at least in the short run. But it is not inevitable even in this case, when there is no switching effect. A rise in profits might lead to substantial increased investment, especially in the tradables-producing sectors of the economy, so that there could well be a net rise in absorption. There can thus be no general presumption about the effects of devaluation on absorption. The same sort of analysis applies to changes in real asset and liability values. With the relative price of tradables to nontradables increasing as a result of devaluation, the real value of assets denominated in dollars (foreign currency) will rise and the real value of assets denominated in pesos (domestic currency) will fall. (I assume here that the peso prices of nontradables are constant.) The reverse applies to liabilities. Rises in real asset values and reductions in real liability values are likely to lead to increased spending, while the opposite applies to declines in real asset values and increases in real liability values. Liabilities denominated in dollars will rise as a result of devaluation, and it is these that created big problems in the Asian crisis. But one cannot just look at the effects of UFB (unhedged foreign-currencydenominated borrowing) on its own. The losers are not only the holders of foreign-currency-denominated liabilities. Important losers are holders of peso-denominated money balances. Furthermore, there are also gainers in asset-liability markets. The gainers include those holders of dollardenominated assets who are resident at home and thus spend part of their income on nontradables. There have been many of these in developing countries, notably in Latin America.

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How Bad Are the Effects of Contractionary Devaluation? To what extent is contractionary devaluation harmful? Does it provide an argument against devaluation when there is an FBAR, or against the choice of a floating exchange rate regime (which may lead to market-determined depreciation)? I shall now assume that a devaluation or a depreciation reduces absorption and that it has a switching effect only after a lag. Thus in the short run it is contractionary. The circumstance I shall have in mind is the typical crisis situation where capital inflow has turned into outflow or, alternatively, where the terms of trade have deteriorated. Private investment has declined and the multiplier has reduced private consumption. At the same time the exchange rate depreciates, or there is a devaluation. The following argument follows directly from my previous discussion. I shall start with putting it in rather bald form. With reduced capital inflow (or worse terms of trade) the current account has to improve. Hence absorption has to decline. The decline in absorption can result from some combination of investment decline associated with or caused by (or even causing) the crisis itself, and some automatic monetary contraction and multiplier, all supplemented, if necessary, by deliberate fiscal contraction. The more the devaluation or depreciation directly reduces absorption, the less need there will be for fiscal contraction. Another way of putting this is to say that the greater the rise in private sector savings or the decline in investment, the less will be the need for an increase in public sector savings. The decline in capital inflow or the deterioration in the terms of trade sets a current-account target, and this establishes the decline in absorption that is finally needed.

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In figure 8.1, the improvement in the current account required by the decline in capital inflow is represented by the movement from the C0 curve to the C1 curve. Finally the equilibrium must move from Q to F. Suppose that the devaluation itself reduces absorption, and that, when this effect is combined with the direct effect of the crisis in reducing spending, absorption falls to D. The decline in absorption is so great that the current account improves by more than is necessary. There is an unnecessary recession. A fiscal expansion is then needed to bring the economy to F. In some Asian-crisis countries, notably Korea and Thailand, there was indeed a very rapid improvement in the current account which did help to restore confidence more rapidly, but which resulted from a recession that was probably deeper than was needed. In principle, flexible fiscal policy can and should deal with such a problem (bringing the economy from D to F), though the danger of market expectations turning even more adverse as a result of fiscal expansion has to be borne in mind. Alternatively, absorption may initially only fall to J. In that case a fiscal contraction is needed to bring the economy from J to F. This line of thought does not mean that the extent to which devaluation reduces absorption does not matter at all. It affects the pattern of spending between different parts of the private sector and, indirectly, as between the private and the public sector. Thus it affects the allocation of resources. But the greater the absorption-reducing effect of devaluation, the less the required fiscal contraction, whether through tax increases or reduction in public spending, and hence the less is the political pain involved. That may be a significant effect in a crisis. Now I come to two possible qualifications to this line of thought. All of them are relevant for understanding

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the Asian crisis, though they do not really alter the main point. First, I may be over-simplifying when I assume that the decline in capital inflow, and hence the current-account target, is given, being independent of the degree and the pattern of domestic contraction. Capital inflow depends on confidence, such confidence reflecting expectations of future profitability. These expectations, in turn, are affected both by the condition of the financial sector and by the overall state of the economy—that is, the extent of the recession. In the short run (before the switching effect of depreciation shows its results) a recession is needed to achieve the currentaccount target, but the target itself will be influenced by the recession. It will also depend on sectoral effects. Some sectors will have been more integrated into the world capital market than others, and if the expected profits of those sectors increase, even though those of others decrease, capital inflow may revive more, or decline less. The second qualification is that the damage to the financial sector done by the combination of large depreciation with UFB affects the productivity of the economy, and cannot be avoided by a compensating fiscal expansion. This does not alter my main point, namely that fiscal expansion—functional finance—can, in time, compensate for demandcontractionary effects of devaluation. But the adverse impact on the financial sector—possibly having long-term effects— needs also to be taken into account. Unhedged Foreign-Currency-Denominated Borrowing (UFB): Causes and Effects During the capital inflow boom in East Asia in the 1990s banks, other financial intermediaries, and corporations,

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borrowed internationally in dollar-denominated form, paying dollar interest rates. At the same time they borrowed domestically in local-currency-denominated form, for example, pesos, baht, won, or rupiah. (I shall continue to use the term “pesos” as shorthand for domestic currency.) In Korea the main borrowers internationally were banks, in Thailand they were both banks and non-bank financial intermediaries, and in Indonesia they were corporations. This borrowing was not hedged against exchange rate changes. They then invested directly, or (in the case of banks and other financial intermediaries) lent on to domestic corporations for various purposes, whether financing the purchases of equities, real estate, or other activities. Inevitably a depreciation of the exchange rate would raise the peso value of the borrowers’ dollar liabilities. At the same time, the value of their assets would not necessarily rise, or rise to the same extent. For banks this would be true if the loans to their customers were denominated in pesos, and for corporations if their activities were in nontradable sectors. Focusing on banks, a depreciation would thus cause them to incur losses through a “currency mismatch.” Even when the banks’ loans to domestic borrowers are denominated in dollars, the risk to the banks may not be eliminated. Exchange rate risk to the banks’ customers will be converted into default risk to the banks. A qualification is that there may not be such exchange rate risk for the banks’ customers if their activities are in export industries (where peso prices would rise as a result of depreciation). Of course, not all borrowing by banks and corporations was denominated in dollars. Much of it was in pesos (that is, baht, won, etc.), since domestic savings were high in the Asian countries and local savers deposited much of their funds in pesodenominated bank accounts.

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When exchange rates depreciated sharply in 1997, the peso values of dollar liabilities suddenly increased, and borrowers were simply unable to meet interest and amortization payments. Their balance sheets deteriorated alarmingly. In effect, many banks went bankrupt, and they stopped lending. The financial system—insofar as one can describe it as a system—broke down. It is important to remember that the difficulties of the financial system, notably those of banks, were not caused solely by this currency mismatch. In some countries there was already a high level of non-performing loans before the actual crisis in the latter part of 1997. Borrowing and lending had been excessive anyway, and some of it was patently unwise because of connected or politically determined lending. Some of it turned out to be excessive as a result of deteriorating terms of trade and finally as a result of the recession itself (which was caused by the declining profitability of new investment and by panic in the capital market). Thus the combination of UFB and massive real depreciation was only one reason for the crisis of the financial system. I shall discuss all of this further in chapter 12. UFB had particularly adverse effects in Indonesia. There were two macroeconomic effects of this combination of UFB and exchange rate depreciation. The first was that it severely damaged the financial system, and so clogged up all financial intermediation. Notably, it became difficult to obtain short-term trade credit for exporting even though exporting had become more profitable. Second, it led to spending being reduced, whether directly by corporations that had borrowed abroad themselves, or indirectly because banks and other intermediaries were unwilling or unable to make new loans. This was the absorption-reducing effect that I have already discussed.

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One might ask why banks and others did not hedge their foreign borrowing. Indeed, why did they not borrow internationally in peso-denominated form? If they were unable to hedge on international markets, or to borrow overseas in pesos, why did they not restrain their borrowing? Why did they run such risks, which eventually led to disaster? The answer is that exchange rates had been (almost) fixed to the dollar, or at least had been relatively stable, for many years, and governments had provided at least implicit assurances that such stability would continue. Until the crises of 1997 it was hard to imagine that there would be real depreciations of 50% or more. Hence it seemed quite reasonable to attach a low probability to the expectation of a large depreciation. At the same time, a motive for borrowing abroad on a large scale in dollars was that dollar interest rates were significantly lower than domestic interest rates (facing the same borrower for the same maturities). This interest differential suggests that the foreign exchange market did allow for the possibility of devaluation or depreciation. It was not a high probability, but it was perceived as positive. Thus borrowers did run some risks. In fact they gambled, believing that the chance of significant loss was low. As it turned out, they gambled and lost. There are some interesting further issues here, which possibly take me beyond the main concerns of this chapter. It has been argued that neither hedging nor borrowing internationally in domestic-currency-denominated form has been possible for emerging market countries. The necessary markets do not exist. The answer surely is that, if there were a demand, such markets would come into being. But the cost of hedging, and interest rates charged for local-currencydenominated loans, would be high. Before the crises borrowers were not willing to pay the up-front costs. In

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addition they may have expected to be rescued by their governments if in trouble. This was certainly true of Korean and Thai banks, but surely non-bank borrowers could not have felt at all confident about the possibility of rescue. Unhedged Foreign-Currency-Denominated Borrowing (UFB): Implications for Choice of Regime If the exchange rate were absolutely fixed (through dollarization, monetary union, or an absolutely credible and committed currency board), the problem of UFB would not arise. There could be no devaluation or depreciation, and thus no financial sector crisis could be caused through that channel. If the problem could not be dealt with, or could not be averted, under flexible rate regimes (floating or a very flexible peg), then we would have an additional consideration in favor of choosing an absolutely-fixed exchange rate regime. Let me consider two arguments about the possible benefits of floating from this point of view, yielding opposing conclusions. Both are based on the belief that UFB has created problems under FBARs. The first argues that UFB would also create problems under a floating exchange rate regime. Hence the only way out is an absolutely-fixed regime. This is the Calvo-Hausmann argument. The second argues that the problem would be solved or moderated if there were a floating rate regime. I shall call this the endogenous hedging argument. The Calvo-Hausmann argument runs as follows. There are positive and negative shocks, whether through fluctuations in capital flows or in the terms of trade. Positive shocks lead to domestic expansions and negative shocks to domestic contractions. These are the standard effects through the usual demand and multiplier channels. If exchange rates

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floated, positive shocks would lead to appreciation and negative shocks to depreciation. This argument grants that, allowing time for switching effects, these exchange rate changes will moderate and possibly offset completely the initial expansionary and contractionary effects of the shocks. This is standard and was expounded in chapter 6. But—the argument goes on—in the short run exchange rate changes will actually exacerbate the domestic expansionary or deflationary effects. Because of UFB, appreciation will increase absorption and depreciation will reduce it. All this follows from our earlier analysis. The focus, of course, is on depreciation and its absorption-reducing effect. There are two assumptions in this argument. First, it is assumed that functional finance cannot offset excessive expansions or deflations—insofar as they actually are excessive. Second, it is assumed that UFB does not depend on the choice of exchange rate regime. UFB is simply treated as a given. This is where this argument differs from the alternative “endogenous hedging” argument. In addition, of course, it ignores the favorable switching effects of exchange rate changes, presumed to come into play only after a lag. The endogenous hedging argument is radically different from the Calvo-Hausmann argument. The simple argument is that floating would induce borrowers to hedge against exchange rate changes. In countries that have floating rates hedging is normal. Borrowing in foreign currency would then not have the destabilizing effects on the financial sector, and possibly on domestic demand, just discussed. I find this argument rather more convincing, but I do have one reflection. Assuming that hedging was actually possible, borrowers in Asia chose not to hedge because they considered the risk of devaluation under their FBAR to be slight. So they gambled, and it just happened that the gamble did not come off. In ret-

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rospect, perhaps, they should have been less certain about exchange rate prospects. The recommendation based on the endogenous hedging argument is, then, to create more uncertainty and thus more risk. Such uncertainty is brought about by floating the exchange rate. The point is that floating exchange rates provide information content, namely that exchange rates cannot be relied upon to stay stable. Can it be socially optimal for public policy to deliberately increase risk, or should the aim be to provide more direct information or education under an FBAR—both about the possibility of devaluation and about the likelihood of rescue? If a local community is failing to insure against fire because fires have been very rare, is it necessary to start many little fires in the locality so as to remind people of what might indeed happen? In any case, now that there has been a big fire such reminders may no longer be needed. Applying this analogy to the Asian case, one would expect that, if some of the Asian countries return to something like an FBAR, their private borrowers will feel less certain than in the past about their (temporarily) fixed exchange rates. They will hedge against the possibility of devaluation, or they will spread their risks by partly borrowing in domestic currency. As I have remarked above, markets would develop to allow them to hedge or to borrow in domestic currency. But the costs might be high, reflecting a correct assessment of risk. Borrowing would then be less than otherwise, which would be a thoroughly appropriate outcome. References This chapter draws heavily on Corden 1993. The theory of contractionary devaluation was pioneered by Carlos DiazAlejandro (1963) and first consolidated by Krugman and

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Taylor (1978). See also Edwards 1989, chapter 8. Reisen (1989) first analyzed systematically the effects of devaluation on the fiscal balance. The Calvo-Hausmann argument against floating (and in favor of dollarization) can be found in various papers by Calvo and Hausmann. Good references are Calvo 2001 and Hausmann 1999.

9

Openness and the Size of the Economy: How Do They Affect Regime Choice?

Should small and very open economies choose fixed exchange rate regimes while relatively more closed and larger economies should choose flexible exchange rate regimes? This question gets to the heart of issues first discussed in the classic optimum currency area literature. I shall show that the answer is by no means as straightforward as is sometimes suggested. At a high level of generality, there are two principal considerations: (1) the degree of openness of the economy and (2) the extent to which asymmetric shocks are likely, and the size of those shocks. These two considerations will often give opposite answers to the specific question whether a particular country should have a flexible or a fixed exchange rate regime. To anticipate, a small economy is likely to be very open, and hence, on that account, to be a good candidate for a firmly fixed exchange rate regime. At the same time it is more likely to be subject to asymmetric shocks, and so be a good candidate, for that reason in isolation, for a flexible exchange rate regime. The crucial issue is whether a firmly fixed exchange rate regime should be chosen in preference to a flexible regime of some kind. The firmly fixed regime may be of the absolute type—dollarization or joining a monetary union—or the near-

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absolute one of a credible currency board. The flexible regime need not be a pure float and could even be an FBAR. But if one regards the FBAR as ruled out by the speculation problem, we can think of the flexible regime category as including various in-between regimes as well as a pure float. The decision to establish a firmly fixed regime is a fateful decision involving a very long-term commitment. There is little point in establishing such a regime unless it is intended to last for a very long time. Hence, the subject of this chapter is crucial for countries that are conceivable candidates for such a regime. Of course, the decision to choose the fixed exchange rate regime may have been historically determined or may be just a by-product of a politically motivated movement toward complete economic union, as in the European case. Alternatively, the decision or inclination not to choose it may reflect a belief in the symbolism that an independent currency provides, comparable to having a national flag, a national airline, or a Queen. Here I analyze only the purely economic aspects. It must also be added that I am concerned with the practical question whether a particular country with given boundaries would be better off with a firmly fixed exchange rate regime or with some kind of flexible regime. This is not the same as asking whether it is an “optimum currency area” in the traditional sense, since the establishment of an optimum currency area may require redrawing national boundaries. If I say that a country is, or may be, an optimal currency area I simply mean that, given its existing boundaries, it would be better off with a flexible than a firmly fixed regime. One reason why a country may choose a firmly fixed exchange rate regime is based on the Nominal Anchor Approach. I have already discussed the full implications of this approach in chapter 3. It explains why Argentina has chosen a currency board regime and, to a great extent, why

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Italians have seemed particularly enthusiastic about European Monetary Union. The nominal anchor objective may override all other concerns. Here I leave it aside and rest my analysis on both the Real Targets Approach and the Exchange Rate Stability Approach. Finally, in the following discussion the frequently used term openness refers to the ratio of tradables to nontradables in the consumption and investment (absorption) basket of a country. Alternatively, it could be interpreted as referring to the ratio of imports of goods and services to GDP. The latter statistic is easily obtained and may be a sufficiently useful indicator. The Feasible Currency Area A very open economy (for example, one where the import/GDP ratio is 70 percent or more) is unlikely to be a feasible currency area. Wages, other contracts, and most prices will tend to be expressed in terms of a foreign currency (the dollar) rather than the domestic currency (the peso). There will be a reluctance to hold the peso as a store of value. Insofar as the peso is used for transactions, peso prices will be indexed to the movement of the dollar. Inevitably, currency substitution will lead to a shift from peso holdings to dollar holdings, leading to a loss of seigniorage to the domestic monetary authorities. From this point of view, the country would be better off establishing a currency board or joining a monetary union, in which it will get some seigniorage out of the common union pool. As noted in chapter 4, the only argument for not choosing an absolutely fixed rate regime follows from the Real Targets Approach. This approach assumes that real wages can be reduced by a depreciation of the nominal exchange rate even when the labor market (perhaps the labor unions) is unwilling

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to reduce them explicitly by declines in nominal wages, measured in pesos. It assumes thus that a nominal depreciation leads to a real depreciation that “sticks” for some time. There is some degree of money (peso) illusion or nominal rigidity, but there is not real rigidity. The key “Keynesian assumption” (see chapters 3 and 6) is that nominal wages are rigid or sticky downward, although real wages are flexible. In an infeasible currency area this requirement for the Real Targets Approach is absent. When the economy is so open that it is infeasible as a separate currency area, wage contracts are likely to be indexed in dollars. Even if they are not formally indexed, there would be informal indexation. Any real devaluation, brought about initially by nominal devaluation, would quickly be eroded by compensating increases in nominal wages. There would simply be no point in using the exchange rate, or indeed independent monetary policy in a floating rate regime, as an instrument of policy. It is difficult to judge what degree of openness would make a potential currency area infeasible, or nearly so. There is scope for more empirical work on small open economies that do have their own exchange rates to see how effective nominal exchange rate adjustments have been in bringing about real changes. The real effects of a nominal depreciation may last for a little while, and then be eroded, so that a clear line between a feasible and an infeasible currency area cannot in practice be drawn. But it is a useful concept to keep in mind. For very small economies the central issue is indeed whether they are feasible currency areas. If they are not, then they should choose monetary union (with a suitable low-inflation trading partner), dollarization, or a credible currency board. In the remainder of this chapter I shall assume that the country is a feasible currency area, even though it may not (with given boundaries) be an optimal one.

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Openness and the Real Targets Approach When a country suffers a negative shock, a crucial question is: To what extent will the demand for nontradables fall when there is a reduction in aggregate expenditure that is necessary to improve the current account? If the decline in the demand for nontradables would be very small (the marginal propensity to spend on nontradables being very low), very little unemployment would be generated by the reduction in expenditure. There would then be little need to avoid such unemployment or recession by a switching policy—that is, by a real devaluation. The recession effect, on which so much emphasis was placed in earlier chapters, would be small. In terms of figure 6.1 a movement from Q to G would lead to a quantitatively very small decline in Y, so that the gain obtained by moving from G to B would then not be great. In the extreme case, if the whole of the decline in demand were to lead to an equal decline in imports (the marginal propensity to import being 100%) there would be no gain at all from lowering the relative price of home-produced goods. The inability to reduce the real wage would not impose any cost. Thus a high degree of openness reduces the need for real exchange rate adjustment in response to shocks, and so weakens the case for flexible rates. This familiar argument is based on the Real Targets Approach. Openness and the Exchange Rate Stability Approach The Exchange Rate Stability Approach is based on the view that instability and volatility of exchange rates in a floating rate regime have adverse effects on economies. This view would also apply to those in-between regimes in which exchange rates are quite liable to change in response to capital market

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pressures. The basic idea is that uncertainty and instability inhibit both trade and long-term international investment and, in addition, create erratic and perhaps undesirable domestic redistributive effects. This means that the more open the economy, the stronger is the case for fixing the exchange rate. The more open the economy the more important are trade and international capital movements to it, and hence the bigger the adverse impact on the economy of fluctuating exchange rates. Thus the case for a fixed exchange rate regime relative to a flexible rate regime is strengthened when an economy is more open not only on the basis of the Real Targets Approach but also on the basis of the Exchange Rate Stability Approach. Asymmetric Shocks and a Diversified Economy I now come to a topic that plays a prominent role in the analysis of the desirability of two or more countries forming a monetary union. The central issue is whether they are subject to similar shocks, requiring similar real exchange rate and real wage reactions, or whether the shocks are different or “asymmetric.” Similar shocks with similar impact would call for similar policy reactions. The problem arises when the shocks are different or “asymmetric.” If there is a consumer boom in Germany and a consumer slump, and thus recession, in France, so that interest rates should be raised in Germany but reduced in France we have an asymmetric shock situation. A monetary policy that would suit one country would not suit the other. If Mexico were to dollarize, an important question would be whether it would be likely to suffer negative shocks different from those of the United States. If recession and perhaps long-term unemployment are to be avoided the central issue is simply whether the country will need to have a real depreciation

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relative to its partner countries in a monetary union, or relative to the United States if it has fixed its currency to the dollar. The various cases of negative shock that I have referred to in earlier chapters have all been implicitly asymmetric, requiring adjustment of the real exchange rate. It has been argued that very large economies, such as the United States, Germany, and France, have very diversified production and export patterns, so that shocks that affect particular industries (reflected in relative price changes) are asymmetric as between industries but not as between countries. There may well be asymmetric product (or industry) shocks originating in technological or demand-side developments, but these will not have noticeable asymmetric effects on such countries. Therefore such shocks will not require changes in the real exchange rate. The costs of forgoing independent monetary and exchange rate policies will be low for diversified economies. On the other hand, many developing countries are highly specialized in their export patterns and are likely to suffer asymmetric shocks, as indicated by changes in the terms of trade. On the basis of this latter argument monetary unions should be formed only between structurally similar economies, and not between economies that differ markedly in their output and export patterns. A curious conclusion emerges. Bearing in mind the familiar advantages of a large area of exchange rate stability, large diversified economies, such as Germany and France, should form a monetary union, though small specialized economies should not join it. But if a group of specialized economies, each having a different specialization, actually do form a union, this union will become a diversified economy. This is the first step. This first step may not, seen on its own, have been optimal for them because the specialized economies have forgone their exchange rate or monetary freedom.

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However, once they have formed their union, which is now diversified, it will be optimal for them to take another step and join with other diversified unions to form a larger union. On this principle, once some countries subject to asymmetric shocks ignore the disadvantage of giving up their independent exchange rate or monetary policies and form a union, they may as well go on and expand the union further. This does not alter the fact that they incur losses when they forgo their monetary independence at the first step. Finally the gains from exchange rate stability in being part of a very large monetary union (perhaps eventually a worldwide union) may outweigh the costs from the initial step of giving up monetary independence. Asymmetric Policy Shocks and the Capital Market I now introduce the concept of the asymmetric policy shock. This is distinct from the asymmetric product shock, just discussed. The literature on monetary integration and choice of regimes has ignored the simple point that asymmetric shocks with a nation-wide impact do not come only from product markets. A diverse production or export pattern does not ensure that a country avoids asymmetric shocks that require real exchange rate adjustment. Asymmetric shocks requiring adjustment of the real exchange rate or of monetary policy may come from general economic conditions influenced by political and especially fiscal developments. They may also originate in the labor market. The less trade unions are integrated between the countries, the more likely is it that exchange rate changes are occasionally needed to offset differential wage pushes. This issue was important in the 1970s, when trade unions in Europe were very strong, but is hardly important now. Trade unions have become much weaker.

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Focusing on shocks that are caused by government policy changes, there may be a change of government which leads to—or is expected to lead to—greater budget deficits, higher or lower taxes, or a change in regulations affecting foreign investment, the environment, or anything else. Possibly there may be a change in domestic security or levels of crime. Capital inflow will then decline or rise. Hence the real exchange rate will have to change. In particular, a sudden reduction in capital inflow will require real depreciation. Such an asymmetric policy shock can be felt by a small or a large economy—even by a large one with a highly diversified product base. The likelihood of asymmetric policy shocks will be reduced the more integrated and constrained the individual economies are with respect to all the matters mentioned above. For example, harmonization of regulations affecting industries or new investment will reduce asymmetric policy shocks. Thus asymmetric policy shocks of this kind are likely to be somewhat less—though not absent—within the European Monetary Union, because it is part of a more general economic union. It is worth bearing in mind that, owing to the highly volatile reactions in the international capital market and the openness of so many countries to this market, the main asymmetric shocks are likely to come through this policy channel, rather than through the product market channel. This has been amply illustrated by many crises. Large and Small Economies: The Choice of Regime I shall now pull the preceding discussion together in a series of simple (perhaps over-simple) propositions. Figure 9.1 lays out the various alternatives. I ignore here all the arguments for firmly fixed rates that are based on the Nominal Anchor Approach.

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Currency area is

Feasible

Openness

High choose fixed

Small economy

Low choose flexible

Not feasible (very open) choose fixed Likelihood of asymmetric shocks

High choose flexible

Low choose fixed

Large economy

Figure 9.1 Openness and asymmetric shocks. (Broken lines represent probabilities only.)

First, extremely open economies—likely to be very small economies—are unlikely to be feasible currency areas, and therefore should choose a firmly fixed exchange rate regime (a currency board or an absolutely-fixed regime). The points to follow all refer to feasible currency areas. Second, economies should (other things equal) choose a firmly fixed exchange rate regime if they are very open. There are two reasons for that: open economies have a low marginal propensity to spend on nontradables; and exchange rate instability is more harmful for very open economies. The first reason follows from the Real Targets Approach and the second from the Exchange Rate Stability Approach. Third, economies subject to significant asymmetric shocks should (other things equal)

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avoid firmly fixed exchange rate regimes, and thus settle for flexible rates. Fourth, asymmetric shocks can originate both from product market fluctuations and from policy changes affecting capital inflows and outflows. I have not emphasized the following somewhat agnostic conclusions, but they follow naturally from the above. First, small economies are likely (though not certain) to be both very open and highly specialized. The first characteristic suggests that a fixed exchange rate regime would be best, and the second that a flexible one would be. There is a tradeoff and nothing in general can be said. It must be added that one can think of small economies that are not very open and perhaps there are some that are not highly specialized. Second, large economies are likely to be less open and more diversified. Again, a trade-off is indicated. And again, one can think of moderately large economies (for example, the Netherlands) which are very open and other large economies (for example, China), which are not very diversified in their export patterns. Third asymmetric policy shocks affecting the economy through international capital movements can affect both open and more closed economies, and both small and large economies. As just noted, such shocks are somewhat less likely in monetary unions that are associated with economic unions—of which the only significant example is the European Union. This is as far as one can go in general. There are three criteria, namely degree of openness, product diversification, and diversity of policy shocks. I would give heavier weight to the first and the third than to product diversification. In addition the considerations of the Nominal Anchor Approach must be taken into account. I shall refer to particular country cases in later chapters, and now turn to trade policy.

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How Does Trade Liberalization Affect the Choice of an Exchange Rate Regime? I now turn to the two-way relationship between trade policy and the choice of exchange rate regime. The first question is: how does trade policy affect the optimal choice of exchange rate regime? The second question is: how does the choice of exchange rate regime affect trade policy? The answer to the first question has two opposing aspects. First, trade policy is an important determinant of the degree of openness of an economy. For all the reasons discussed above, the more open is an economy, the stronger is the case for, or the weaker is the case against, a firmly fixed exchange rate regime. On this account, the liberalization of trade is likely to strengthen the case for the fixed exchange rate regime. A good example comes from Europe. Undoubtedly the establishment of the European Union’s customs union, later extended more ambitiously to become, to a limited extent, a single market, has been an important factor in the decision to move to European monetary union. The more two or more countries trade with each other, the stronger is the case for a firmly fixed exchange rate regime between them. Second, trade liberalization is likely to lead to more specialization in production and thus to more asymmetric product shocks. This follows from basic trade theory, and there is much evidence for it. On this account the case for a firmly fixed exchange rate regime is actually weakened by trade liberalization. It seems highly likely that, if products are sufficiently narrowly defined, product specialization would increase with trade liberalization, and for this reason there could be an increase in asymmetric shocks. On the basis of this line of thought, Krugman (1991b) has argued that increased trade and general economic integration

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are likely to increase specialization within the European Union area, and thus to increase asymmetric shocks. This argument weakens the case for monetary union. It actually implies that the more trade integration there is, the less monetary integration is desirable. But one must distinguish product shocks from policy shocks. Krugman’s argument is concerned with asymmetric product shocks. In the European Union case, the effect of the single-market program and the general tendency toward more economic integration would be to reduce asymmetric policy shocks. It is possible that in Europe at least increased trade integration has led to more general economic and policy integration. If that is so, trade integration may have increased asymmetric product shocks but reduced asymmetric policy shocks. My hunch is that asymmetric policy shocks are generally much more important than asymmetric product shocks. How Does the Choice of an Exchange Rate Regime Affect Trade Integration and Trade Policy? The question just discussed has treated trade liberalization or the establishment of a customs union or a free trade area as exogenous, and then asked how the choice of an exchange rate regime would or should be affected. The second, very important, question is: How does the choice of an exchange rate regime actually affect trade policy, either through helping trade liberalization or through leading to more protectionism? The two questions are actually connected in the following way. Let us assume or believe (as I believe) that, in general, trade liberalization is desirable while an increase in trade protection is not. In that case, if it could be shown that firmly fixed exchange rates, for example, are harmful for trade liberalization, one would have an argument against

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fixed rates. Conversely, if it could be shown that flexible rates lead to an increase in protectionism, one would arrive at the opposite exchange rate regime conclusion. Therefore, the answer to the question “How will the exchange rate regime affect trade liberalization and protection?” should influence the choice of exchange rate regime. Surprisingly, it turns out that there are two separate and apparently contradictory answers to this question, the first of which I regard as completely valid and empirically supported, while the second is logical but has less empirical support. I shall attempt to reconcile the two. The first argument rests on the overwhelming evidence in Krueger 1978, Papageorgiou et al. 1991, and Little et al. 1993 that successful large-scale liberalizations in developing countries have been associated with substantial devaluations. If the exchange rates had been firmly fixed, trade liberalization would have been much less likely to happen. Liberalization would have led to too much unemployment in import-competing industries. Large-scale unilateral trade liberalization requires simultaneous or previous devaluation in an FBAR, or depreciation in a floating rate regime. This is necessary to prevent currentaccount deterioration and maintain internal balance. It is also necessary or desirable to make liberalization politically acceptable. When devaluation makes exporting more profitable, new employment opportunities open up which makes the squeeze on import-competing activities brought about by liberalization more acceptable to the community. In formal terms, trade liberalization is an exogenous asymmetric shock that requires real exchange rate depreciation on the basis of the Real Targets Approach. Its macroeconomic effects are similar to those of a decline in capital inflow or a deterioration in the terms of trade. The conclusion is that those countries

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that still have a high degree of trade restrictions should not commit themselves to a firmly fixed exchange rate regime. It is clear that in the Bretton Woods era, when developing countries faced current-account crises they usually imposed or increased import restrictions. When their exchange rates became more flexible in the 1970s and the 1980s this was no longer a common response because they were able to devalue instead. Indeed, the “new liberalization” in developing countries in the 1980s (Little et al. 1993) involved simultaneous devaluations and trade liberalizations in response to currency crises. Thus exchange rate flexibility has been conducive both to the avoidance of increased protection and to trade liberalization. Most recently, Argentina has faced a recession and a balance-of-payments problem and, given its currency board regime, has been unable to devalue. Hence a package of crisis policy measures has included an increase in tariff protection. All this evidence supports the conclusion that flexible exchange rate regimes are more favorable to trade liberalization than fixed exchange rate regimes. The second argument concerning the effect of the exchange rate regime on trade policy is quite distinct and leads to the opposite conclusion. It rests on the Exchange Rate Stability Approach. The argument goes as follows: Exchange rate fluctuations lead to pressures for protection in countries that suffer from real appreciations. Floating rates are inevitably unstable, and thus stimulate protection. An asymmetry is implied. Appreciation leads to pressures for increased protection, while depreciation does not lead to reduced protection. When the dollar appreciated sharply in the early 1980s there was certainly evidence of increased pressure for a revival of protection of those US industries that were damaged by real appreciation. To some extent these pressures

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were headed off by the subsequent dollar depreciation. The change in US policy in 1985, initiating coordinated intervention in the foreign exchange market designed to bring the dollar down, was motivated by the concern over the revival of protection. Nevertheless, US trade restrictions increased subsequently. Furthermore, there was little evidence of significant trade liberalizations by major developed countries where the currencies depreciated. In fact, the one exception was Japan, which liberalized under US pressure. In any case, this is the argument: Fluctuating exchange rates stimulate protectionism in those countries where exchange rates appreciate. It is an argument for fixed rates, or for deliberately moderating fluctuations with target-zone or other in-between arrangements. The argument has also been used in Europe, where it has often been said that the customs union or free trade area could not survive fluctuating exchange rates. This was one motive for the initiation of the European Monetary System in 1979 and for the movement toward EMU later. I am inclined to dismiss the second argument because of the implicit asymmetry and the limited empirical support. But a conceivable rationale is as follows: The exchange rate fluctuations in a floating rate regime are implicitly assumed to be disequilibrium ones. They are seen as misalignments, and they give rise to asymmetric protectionist pressures. Depreciation does not lead to reduced protection, but the countries whose exchange rates appreciate do not accept appreciation as necessary and are therefore likely to impose restrictions. By contrast, when developing countries liberalize, or when they face balance-of-payments problems, their devaluations are accepted as being equilibrium adjustments and thus do not give rise to protectionist pressures in the countries whose exchange rates appreciate as a result.

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The Costs of Trade and the Choice of an Exchange Rate Regime Finally, I come to a relationship between trade integration and the choice of exchange rate regime that is quite independent of the degree of trade liberalization. I have already noted that firmly fixed exchange rate regimes, and especially monetary integration, reduce the costs of trade because of the advantages of exchange rate stability. This follows from the Exchange Rate Stability Approach. Now it must be added that, with reduced costs of trading, trade will actually increase, and this will increase the openness of the economy. The endogeneity of trade integration—the latter depending on the degree of monetary integration—is empirically most strongly supported by the Canadian case. Canadian provinces trade far more with each other than they do with neighboring US states, even though trade with the United States is relatively unrestricted as a result of the North American Free Trade Agreement. It seems plausible to deduce that it is the absolutely-fixed exchange rate between British Columbia and Ontario that explains why the former trades more with Ontario than with the state of Washington. We have, then, the following relationships: The greater is exchange rate stability, the greater will be trade integration, and the greater is trade integration, the greater will be the openness of the economy. Finally, the greater is openness, the stronger is the case for a fixed exchange rate regime. This chain of reasoning has an implication here for the monetary integration issue. In deciding whether monetary integration is desirable, one consideration is the degree of openness. The more open the economies that intend to form a monetary union are to one another, the stronger the case for monetary integration. But, for the reason just given,

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monetary integration will itself increase the degree of openness, no doubt after a lag. Thus openness is endogenous. The reaction of openness to the actual establishment of monetary integration must be taken into account in making the initial decision to join a monetary union. The basic idea is expounded in figure 9.2. The vertical axis shows the degree of monetary integration or, better, the degree of commitment to a fixed exchange rate. The initial level of monetary integration is M0 and complete integration is at M1. The horizontal axis shows the degree of trade integration or openness. The initial level of openness is G0. As the degree of monetary integration increases, openness increases. This relationship is shown by the relatively flat curve AE. With full monetary integration at E, openness would be G1. The steeper line BD shows the extent of monetary integration that is desirable at each level of openness. The greater is

Degree of monetary integration

Y

M1

D

E

C M0

A B

G0

G2

Degree of trade integration (openness)

Figure 9.2 Trade integration and monetary integration.

G1

X

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openness, the more desirable is some exchange rate commitment. At degree of openness G2, full monetary integration is desirable. At a higher level of openness, say G1, it continues to be desirable. As drawn, at the initial level of monetary integration, which yields the very low level of openness G0, the desirable level of monetary integration is actually less than M0, the existing one. (The point B is below the point A.) In other words, with such low openness the exchange rate should be more flexible. But if a move to full monetary integration were made, openness would reach G1, and at that level of openness full monetary integration is indeed desirable. Indeed, even at the lower level of openness, G2 , full monetary integration would be desirable. The point E in this case is a stable equilibrium, while C is unstable. If AE were steeper than BD a stable equilibrium would be reached at C. It follows that, in the case represented in figure 9.1, a decision about future monetary integration made at a time when the actual level of monetary integration (degree of fixity of the exchange rate) is M0, will produce a wrong answer if the degree of openness is taken as given at the current one, namely at G0. There is thus a two-way relationship between trade integration and monetary integration via openness, and this is the reason for the conclusion that a decision as to whether to form a monetary union—or to move toward a fixed exchange rate regime of some kind—should not necessarily be based only on the existing degree of trade integration. Now, it must be added that, according to Frankel (1999), there is possibly an additional reason why there may be a two-way link of this kind. Frankel and Rose (1998) provide evidence that increased trade integration leads to increased income correlation between countries. In turn, increased income correlation means that there are fewer asymmetric shocks between the countries

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(and the shocks are less asymmetric), and hence that the case for monetary integration is strengthened. Thus, as in the previous (“Canadian”) argument, monetary integration reduces the costs of trade and thus increases trade integration; at the same time, increased trade integration strengthens the case for monetary integration, this time not through openness but through income correlation. Trade Policy and the Choice of Exchange Rate Regime: Summary With regard to the relationship between trade policy and the choice of exchange rate regime, there are two main points and one minor one. First, countries that still need to liberalize their trade unilaterally on a large scale should not commit themselves to a firmly fixed exchange rate regime. Second, once liberalization has taken place, and if the economy is very open, such a commitment can be considered. Openness itself will have been increased by liberalization, and possibly a fixed exchange rate commitment may discourage a reversion to protection in countries that would otherwise suffer from real appreciations caused by exchange rate misalignments. This second point reflects a common European view. The minor point is that, in deciding on the choice of regime, policy makers should take into account that openness will itself be increased by the adoption of the firmly fixed exchange rate regime. References This chapter draws on the theory of optimum currency areas (Mundell 1961; McKinnon 1963; Kenen 1969), and also on Corden 1972. For recent surveys, see Tavlas 1993 and

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de Grauwe 2000. For a profound review of all the issues, see Frankel 1999. For a critique of the theory, see McKinnon 2001. Edwards 1989 is the most systematic empirical study (of which I am aware) of how long it takes for the real exchange rate effects of a nominal devaluation to be eroded. Edwards analyzed 39 devaluation episodes over the period 1962–1982 and found that when real exchange rates after devaluation are compared with the rates one year before, in general some net effects remained, but there was significant erosion. There is also some evidence in Little et al. 1993, pp. 230–231. They found that, in general, there was very little, or only partial, erosion after the devaluations of the 1980s, the main exception having been Mexico. McKinnon (2001) makes the paradoxical argument that the greater is the likelihood of asymmetric shocks the stronger will be the case for an absolutely-fixed regime. This is contrary to the standard view from optimum currency area theory, expounded in this chapter, that asymmetric shocks weaken the case for an absolutely-fixed exchange rate regime. The first step in the argument is the familiar point that flexible exchange rates make international capital movements more costly and thus discourage a country’s diversification of its bond and equity portfolios. The second step is that such international diversification is particularly necessary if the country is subject to asymmetric shocks.

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10

Lessons from Latin America: Chile, Brazil, Mexico

Latin America is littered with the corpses of FBARs. Its countries have experienced every kind of crisis and have tried every conceivable exchange rate regime. There has been no shortage of lessons here. Usually the fundamentals—notably fiscal policy—have been weak, and there has been a need for exchange rate policy either to adapt to the fundamentals or to change them. Things have been worst when attempts at change have failed. Here I shall discuss the experiences of the three largest economies in the region—Brazil, Mexico, and Argentina—and, in addition, Chile. Three of these countries now have floating rates with inflation targeting, while Argentina (discussed in the next chapter) has a currency board regime. Only Chile can be said to have been a success story during the 1990s. Chile: From Fixed Rate to Target Zone to Floating Chile is interesting for a number of reasons. First, it has really tried everything, so that we have no end of experiments. Second, from 1984 it has been patently a success story, with the highest per capita growth rate in Latin America. Finally, there is a remarkably comprehensive literature on its

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macroeconomic experience because it has many high quality professional economists, and, in addition, has attracted the interest of US-based economists. Chile managed to get the inflation rate down from 90% in 1977 to 20% by 1981. This was helped or even caused by an exchange-rate-based stabilization policy, where the exchange rate is used as a nominal anchor, which was implemented from 1978. It is an episode that has been closely studied and, while it did reduce inflation, it ended in crisis. It was a precursor of the later Mexican and Asian crises, having remarkable similarities with these later episodes. There was real appreciation; real wages were rising; a consumer, real estate, and investment boom was being financed by bank lending; and a high current-account deficit was being financed by massive private capital inflows, the latter encouraged by international euphoria about the economic reform policies of the Pinochet government. Banks, essentially unregulated, were owned by conglomerates that financed their firms (as in Korea before the Asian crisis, and to some extent even now). The budget deficit of earlier years actually turned into a surplus. The episode turned into a crisis when world market conditions changed. For a year the government tried to keep the exchange rate fixed, but a recession in 1982 (leading to a growth rate of minus 10%) finally forced the government to allow the exchange rate to float. The recession was intensified by large-scale bank failures. In 1983 the recent period of stabilization and eventually high growth rates began. Exchange rate policy changed drastically in a sharp reaction to the fixed rate nominal anchor regime that had ended in disaster. The use of the exchange rate as an anchor was completely abandoned. Getting the inflation rate down was no longer seen as a priority. Essentially a passive crawling peg regime was instituted

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(designed to avoid real appreciation), with occasional steep devaluations and some appreciations, and supplemented in due course by a band around the peg. Hence it was now a particular kind of target zone regime. In 1992 the peg was changed from a dollar peg to one based on a dollar-DM-yen basket, so that Chile had a band-basket-crawl (BBC) regime. The width of the band was gradually expanded to 10% either side of the peg in 1992. The inflation rate from 1983 to 1991 averaged 22% but was gradually reduced in the 1990s, and by 1997 was 6%. A tight fiscal policy regime and a conservative monetary policy were maintained when a democratic government succeeded the Pinochet regime in 1990. Eventually the crawling peg and the target zone were ended. Since 1999 Chile has had a floating rate regime combined with inflation targeting carried out by an independent central bank. The growth rate averaged 6.5% in the 1990s. There have been two moderate recessions and capital market problems, all caused by external developments; however, in spite of considerable fluctuations in the growth rate, the whole period since 1984 must be rated as a great success—especially because it included the transition from an autocratic to a democratic regime. The focus was on getting the fundamentals right. What have been the lessons for the choice of exchange rate regime? If one took a short-term view and looked only at the period 1978–1982, one might say that the exchange ratebased stabilization policy initiated in 1978 did succeed in reducing inflation drastically. That was its primary objective, given the high starting point, but a mistake was made in 1981. The mistake was a failure to exit from that exchange rate regime quickly when severe external shocks were encountered. The fundamentals had changed. There was a

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severe deterioration in the terms of trade, the US dollar appreciated (and along with it, the Chilean peso), and it became more difficult to finance the current-account deficit. Borrowing had been quite excessive and the banking system had been inadequately regulated. A crisis was inevitable. A switch from the Nominal Anchor Approach to the Real Targets Approach was needed. Finally, in 1982, the nominal anchor regime was brought down by a turn-around in the capital market associated with the world debt crisis that began with Mexico’s threatened default. Capital-market speculation brought forward the inevitable exit from the nominal anchor regime, so that speculation was simply anticipatory. As I have said, the flexible exchange rate regime from 1984 to 2000 was a great success. It consisted first of a passive crawling peg, readily modified by further exchange rate changes, and later a pure or managed float. This success undoubtedly depended on monetary and fiscal policies having a conservative bias, with the central bank being independent. A certain degree of pragmatism and practice of functional finance has also been helpful. Can one then conclude, at least in retrospect, that the policy during that period was also superior to the earlier nominal anchor policy that ended in crisis? I am sure it was superior to the counterfactual of returning to a fixed exchange rate regime (or active crawling peg) from 1984. The question remains whether a flexible (or passive crawling peg) regime would have brought down the inflation rate from 1977 to 1981 to the same extent as the nominal anchor policy had done. Probably it would have been less effective in this respect. One could then conclude that the nominal anchor policy was appropriate for a few years, but, to avoid a crisis, there should have been an earlier exit. This case illus-

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trates the exit problem. I shall come back to this general issue again when discussing the Brazilian experience. Can one arrive at a judgment about the target zone regime? The central rate was very flexible, with several devaluations or appreciations beyond the rate of crawl. Furthermore, whenever there was market pressure the band was widened, and when pressure became too strong the regime was abandoned. There was unwillingness to intervene or to change interest rates at the limits. Therefore, I doubt that the target zone made much difference. This is my main conclusion here on this matter. Perhaps the target zone regime prevented excessive exchange rate movements. But I suspect that the main stabilizers were the cautious fiscal and monetary policies, once they were clearly seen to be in place after the transition to a democratic political regime. Given that there was such a target zone regime, and that the inflation rate was significantly positive, it was clearly necessary that the central rate crawled, and given the switch from the Nominal Anchor Approach to the Real Targets Approach it had to be a passive crawl. In the period 1990–1997 the central problem was caused by capital inflow, leading to nominal and real appreciation and thus to potential Dutch Disease effects. Naturally this was associated with current-account deficits, though these were considerably less than capital inflows because central bank intervention had absorbed part of the inflows in increases in foreign exchange reserves. A part of what the private sector was borrowing abroad the central bank was lending. This intervention was partially sterilized with the aim of avoiding domestic inflation. In fact, as I have noted, the inflation rate decreased in that period, getting down to 6% in 1997. All the usual difficulties of sterilization—notably losses incurred by the central bank—were encountered.

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Chile’s Tax on Capital Inflow The most interesting Chilean experiment was an attempt to reduce foreign borrowing, especially short-term borrowing, through an Unremunerated Deposit Requirement (UDR). This measure reflected three concerns. One was with the adverse effects on export and import-competing industries of real appreciation. The second was with the possibility that— as so often in the past—capital flows were unstable, and that there could be a quick reversal, causing a crisis similar to the severe and traumatic crisis of 1982. The third concern was to insulate, as far as possible, domestic interest rates from foreign interest rates. To reduce inflation, domestic interest rates had to be kept high; but this would, with an open capital market, lead to more capital inflows, and more need for costly sterilization. These concerns led to the imposition in 1991 of a particular type of control on capital inflows—the UDR—that has attracted much attention, as it might be a model for other countries. It was essentially a tax on foreign borrowing. It has been of particular interest because Chile did avoid both an exchange rate and a banking crisis after 1991, and because Chile was notably committed to free market-oriented economic policies. The UDR applied to almost all foreign borrowing except foreign direct investment inflows and trade credit. It applied to both short-term and long-term loans and to portfolio investment, such as purchases of stocks. At first 20% of the relevant foreign borrowing had to be deposited in noninterest bearing deposits with the central bank for a minimum of one year. The implicit rate of tax would fall the lengthier the maturity of the loan—which reflected the objective that short-term inflows should be reduced more than long-term inflows because the former are normally more volatile. In

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1992 the proportion was raised to 30%; later it was reduced again, and finally, in 1998—when there was more concern about outflow rather than inflow—the UDR rate was brought down to zero. Edwards (1999) has analyzed the effects of the Chilean UDR in detail. While there are various econometric difficulties in arriving at these conclusions, it appears that the UDR did lead to some shift from short-term to longer-term borrowing. It is also possible that the UDR had some effect on short-term interest rate differentials. But it did not make any significant difference to total inflows, and hence to the rate of real appreciation. This does not mean that more severe controls, such as those that China and India had, could not have made a difference. Most likely a 75% UDR would have made a difference, though it would also have stimulated more efforts at avoidance. If the effect was genuinely to raise longterm inflows at the expense of short-term inflows, while leaving total inflows unchanged, one should count that as a benefit. Short-term inflows are more volatile and thus more likely to turn rapidly into outflows and cause a crisis. During the capital inflow boom period before the 1982 crisis Chile had a somewhat similar UDR scheme. But in the 1990s Chile avoided a crisis—especially a banking crisis—principally because of better supervision of the banking system and the big role that foreign banks played in the banking system. In addition, as already noted, fiscal policy, monetary policy, and the exchange rate regime were all conducive to maintaining the confidence of markets and to avoiding a crisis. Mexico: From FBAR to Crisis to Floating The story of the Mexican crisis at the end of 1994 and early 1995, and the run up to it, is extraordinarily similar to that of

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the Chilean crisis of 1982. There had been an exchange-ratebased stabilization program involving an active crawling peg with a band. The exchange rate depreciated within the band by about 10% at the beginning of 1994, but from then on there was effectively a fixed rate. The program successfully brought the inflation rate down from 100% in 1988 to 20% at the beginning of 1994. At the same time the real exchange rate appreciated, as it always does in these programs and as was in any case inevitable because of the revival of capital inflows. A current-account deficit that rose to 8% of GDP at the beginning of 1994 was financed by private capital inflow. This is a standard story. In the boom period of capital flows to emerging markets from 1990 to 1993, Mexico received onethird of all inflows. Markets were optimistic about Mexico because of major reforms and membership of the North American Free Trade Agreement (NAFTA). This rate of capital inflow could not go on, if only because it reflected in part a stock adjustment that occurred when international investors sought to increase the share of emerging market investments in their portfolios. A small stock adjustment leads to a large but temporary change in flows. In addition, lending by Mexican banks to consumers had become excessive, with a growing proportion of non-performing loans. By 1994, the banking sector was quite fragile. In 1994 there were several domestic political shocks that affected confidence, including the assassination of the ruling party’s presidential candidate. In addition US interest rates rose as the US economy boomed. So capital inflow slackened, and foreign exchange reserves started falling. Given the FBAR regime, three policy options for the first half of 1994 were conceivable. For the moment I rule out the possibility of shifting to a free float which, at that time, would have been a radical step.

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There might have been a devaluation. Owing to dollardenominated debts of banks and their customers (the UFB problem), devaluation would have damaged a fragile banking system. Furthermore, it would have required renegotiating a pact with the trade unions that had been crucial to obtaining wage restraint, and it might thus have been difficult to prevent wage increases. There was indeed a very high current-account deficit; but because of the continued growth of exports, the need for an exchange rate adjustment was in some doubt. Hence, apart from a 10% depreciation within the band, it was decided not to devalue. •

The gold standard “rules of the game,” which were needed in a fixed exchange rate regime if there was to be automatic balance-of-payments adjustment, might have been allowed to work. The foreign exchange reserves would have declined, the money supply would have been reduced, and interest rates would have risen. Such a policy would have caused a recession, would have damaged the banking system, and would have been politically harmful, particularly because a presidential election was due in November. However, it would have improved the current account and possibly, through the rise in interest rates, also slowed down the decline in capital inflow and hence eventually stopped the decline in reserves. •

The fixed exchange rate might be maintained, the foreign exchange reserves might be allowed to run down, and the domestic monetary effects might be sterilized. This is actually what happened. Recession and banking crisis were avoided. The third path was thus the one chosen, and this choice rested on the belief that capital flows would eventually revive.

•

Once it became known in late 1994 that foreign exchange reserves had fallen to very low levels, and that the new government was not planning drastic remedial measures,

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speculation turned capital inflow into outflow. At first the exchange rate was devalued by 15%, which was clearly inadequate and which led to expectations of further devaluation or depreciation. Thus the exchange rate had to be floated. The FBAR had broken down. This was the first Mexican crisis that originated in private sector, not public sector, borrowing. There is much more to this story, but these are the bare bones. It is similar to the Thai story, described in chapter 12. There can have been little surprise that some exchange rate adjustment was needed and took place, but it was surprising that market sentiment shifted so drastically and the exchange rate depreciated so much. In a short period the peso lost 50% of its value. Owing to the loss of confidence, capital outflow, and the banking crisis, a huge recession resulted. The inflow of capital up to early 1994 had been excessive and was bound to slow down, so that a decline in the currentaccount deficit was required. Excessive borrowing and lending also weakened the banking system, a weakness that naturally led to a crisis once the recession set in. But it is worth noting here that many of the Mexican fundamentals were sound, or reasonably so. There was no significant fiscal deficit; the ratio of public debt to GDP was moderate (at 51% in 1994), much lower than in many OECD countries; inflation was low; and many market-based reforms had been introduced. Private savings were low, reflecting the bankfinanced consumer boom, so a turn-around was inevitable. But one might have thought that a 25% devaluation, or depreciation in the market, would have been enough. And there was no reason to question the ability of the government to service its debt provided existing debt was refinanced when it came due. What happened after the immediate crisis and the IMF rescue? Do these further events offer any lessons? Since the end

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of 1994 the peso has floated. There seems to have been little or no intervention, so it has been close to a pure float. Nevertheless, the exchange rate did not fluctuate wildly. Domestic monetary policy conducted by an independent central bank was targeted on inflation, which did mean that the exchange rate had to be taken into account. There were periods of real appreciation, which is unavoidable when the aim is to keep inflation low. But it seems that for a considerable portion of the period 1996–1997 monetary policy effectively stabilized the exchange rate. The most important outcome was a remarkable export boom, obviously induced by depreciation. While a continued domestic credit squeeze was caused by the damage that previous events had done to the banking system, this did not hold back export industries since they were able to obtain foreign financing. By 1996 the growth rate had recovered. Fiscal policy has continued to be cautious. Various measures to improve bank supervision have been introduced, and this may prevent a repetition of the over-borrowing and over-lending of the boom of the early 1990s. How the Mexican Government took on Foreign Exchange Risk One reason for the severity of the Mexican crisis was the shift in the debt management policy of the Mexican government in the middle of 1994. The government replaced short-term bonds denominated in pesos (called cetes) with short-term bonds denominated in dollars (called tesobonos). The government thus increased its foreign-currency-denominated liabilities. The interest rate payable on cetes was higher than that on tesobonos, this differential reflecting the market’s assessment that there was some probability of devaluation of the peso. In

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effect, the government took over exchange rate risk from holders of cetes, both local and foreign. This switch reduced the interest bill in the budget, and so produced a fiscal improvement that was really artificial (since the contingent liability of an increased peso cost of interest payments if there were devaluation was not included). It has been argued that, by taking over the exchange rate risk, the government would be assuring the market that it did not intend to devalue. Thus credibility would be established and speculation against the exchange rate would be avoided. The patent weakness of this argument (perhaps clearer in retrospect) is that the government may not have the capacity to actually fulfill what it intends, however well meaning the intention. Risk is risk, and the government took it over. It acquired a significant UFB problem. The government acquired short-term dollar liabilities that exceeded its foreign exchange reserves. When the market panicked and declined to refinance short-term government debt that became due in January 1995, the government was unable to meet its obligations. Official default would have been inevitable had it not been for a rescue operation by the IMF and the US and Canadian governments. This was a liquidity crisis and not a solvency crisis—hence fully justifying such a rescue—since (as I noted earlier) the ratio of public debt to GDP was not high. The fundamentals of the Mexican economy did not justify the extreme reactions in the market both in pushing the exchange rate so low and in refusing to refinance public debt. The decision of the government to take over a significant proportion of Mexico’s exchange rate risk meant that a crisis that was essentially caused by excessive private sector borrowing and lending, and not by a fiscal deficit, was converted partially into a public sector crisis. The two can never be clearly separated, but in this case much of

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the exchange rate risk was taken over not just from domestic holders but also from foreign holders of Mexican debt. The government gambled and lost when it acquired unhedged short-term dollar liabilities. Mexico: The Floating Rate Alternative I want to replay this story assuming two alternative exchange rate regimes. (I shall do a similar exercise in the next chapter for Thailand.) First, I shall assume a floating rate regime instituted in 1992 or earlier, and then an absolutely fixed rate regime, such as a credible currency board. I assume that there would still have been a capital inflow boom in 1990–1993, for all the reasons noted above, and that in 1994 inflow would have declined. Possibly initial capital inflow would have been somewhat less, owing to greater perceived exchange rate risk resulting from the floating rate regime. I assume that the domestic political shocks and the external shocks would have been the same. I begin with imagining that the exchange rate had floated from 1992 or even earlier. In the euphoria-boom period it would then have appreciated in nominal terms owing to capital inflow, and the inflation rate might have fallen more. But there would still have been real appreciation, so that the real outcome would have been much the same. The exact outcome in nominal terms would have depended on domestic monetary policy, which, no doubt, would have been governed by the objective of steadily reducing the rate of inflation. Once capital inflow slackened, the exchange rate would have depreciated. It is impossible to say whether the depreciation would have been gradual, whether it would have happened in jumps, or whether the rate would even have overshot. But it is unlikely that it would have overshot as

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much as it did early in 1995. The switching effects of depreciation would, as usual, have worked with a lag, so at first there might still have been a recession. But if a serious crisis were avoided it might also have been more difficult to avoid wage increases that would have prevented nominal depreciation from turning into adequate real depreciation. The banking system might still have been damaged, but with a floating rate regime there might have been more hedging, more borrowing in pesos, and thus less of a UFB problem. All these issues will arise again when I discuss the Asian crisis in chapter 12. We know what happened when the exchange rate floated in 1995 and subsequently; the question is how different the outcome would have been if it had floated earlier. In retrospect one can say that a massive crisis of the 1994–95 magnitude would have been averted because adjustments would have taken place earlier, thus moderating the build-up of private debt. Also, surely, an earlier real depreciation would have moderated the recession. Mexico: The Currency Board Alternative I come now to the other alternative regime choice. Mexico might have committed itself during the capital inflow period to a currency board system. In the boom period the story would have been much the same as what actually happened—monetary expansion, real appreciation, and currentaccount deficit. When capital inflow slackened the money supply would have automatically contracted, interest rates would have risen, and there would have been a recession. A sufficient recession would have reduced the current-account deficit to the level of lower capital inflow, and it might have had to be a very deep recession, possibly even as deep as that

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of 1995. Because of the earlier boom and the subsequent recession the banking system would still have been fragile, but there would have been no UFB problem. Furthermore, there would have been no exchange rate speculation and no crisis. I am assuming here that the standard rules of the game of the currency board regime would have been adhered to, and that the regime would have remained fully credible. Essentially, the currency board outcome would have differed from what actually happened in two ways: First, the recession would have come earlier and possibly more gradually. A major crisis might have been avoided. But finally a deep recession would still have been needed. Second, in the absence of any nominal depreciation, there would have been little real depreciation (even with a deep recession), and thus there would have been little or no benefit for the current account and domestic demand from an export boom stimulated by the switching effect of real depreciation. In the Mexican case there was indeed such an export boom, playing a major role in the rapid recovery from the crisis. As noted in earlier chapters, it follows from the Real Targets Approach that the major—perhaps only—cost of choosing an absolutely-fixed exchange rate regime is that in a recession the switching effects of devaluation or depreciation have to be forgone. In the Mexican case that would have been a very big cost. The suggestion was made in 1995, once the crisis had begun, that Mexico move to a currency board regime. An alternative idea, often floated, is that Mexico join in a monetary union with the United States (and possibly also Canada). Since US policies would undoubtedly dominate such a union, the latter proposal is much the same as dollarization. The question then is, essentially, whether Mexico should adopt an absolutely-fixed exchange rate regime, pegging to the dollar.

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There is only one argument in favor of a permanent dollar peg for Mexico, and there are at least five arguments against. One cannot resolve such an issue by counting arguments, but on present evidence the balance is surely against the idea. The argument in favor is that Mexico is highly integrated with the United States both in the movement of capital and in trade (with 75% of its trade with the US). The first argument against Mexico adopting an absolutely fixed exchange rate regime (permanent dollar peg) is that, overall, Mexico is only a moderately open economy (with imports 25% of GDP). Second, Mexico has suffered in the past, and may well suffer in the future, from asymmetric policy (political) shocks. Third, since its export and production patterns are very different from those of the United States, Mexico is (or has been) subject to significant asymmetric product shocks. Here it has to be observed that the current trend in the Mexican trade pattern is likely to reduce such asymmetric product shocks. There has been growing intraindustry trade in manufactures with the United States, and the share of oil exports in total exports has declined to only about 10% of total exports. Fourth, figures from 1995 to 2000 of the real depreciation of the Mexican peso and of Mexican export growth have shown that nominal depreciations lead to real depreciations, and that—as I have just observed—real depreciations do have significant effects in increasing exports. Fifth, Mexico has clearly shown since 1995 that the exchange rate is not needed as a nominal anchor. The job is being done by monetary policy conducted by an independent central bank. Inflation targeting seems to work. A sixth consideration is that since 1995 there have not been extreme movements in the Mexican exchange rate determined by market speculation, perhaps because domestic monetary policy has been partially directed toward main-

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taining some degree of exchange rate stability. So far at least, the familiar instability argument against floating rates does not find support from the behavior of the Mexican peso. This may change, and if the idea of a currency board or that of dollarization is revived in the future it may well be because of the instability argument. Brazil: From Hyperinflation to Crawling Peg to Floating In 1994 Brazil embarked on an exchange-rate-based stabilization program called the Real Plan. The real, a new currency pegged to the dollar at a crawling rate, was established. Thus, it was an active crawling peg regime, with the dollar as the nominal anchor. There was the usual real appreciation, but inflation did fall drastically—from over 2000% to below 2% in 1998. Monetization of fiscal deficits stopped completely, and at first fiscal policy was tightened. Real wages rose, partly as a result of minimum wage and government wage increases. But the fatal flaw was that soon the fiscal situation deteriorated again. This was an example of a case I described in chapter 7. A bond-financed fiscal deficit was somewhat out of control, and when combined with a fixed exchange rate regime or an active crawling peg it was bound to lead to a crisis. By way of background, Brazil has a long history of inflation and of failed stabilization plans. Essentially, inflation had been caused by money-financed fiscal deficits and then was reinforced by deeply entrenched inflationary expectations. After three failed stabilization plans beginning with the Cruzado Plan of 1986, Brazil slid into hyperinflation in 1989. Inflation peaked at 84% per month in March 1990. More failed stabilization plans followed. Most of these plans involved, for a short period, a fixed or an active crawling peg exchange

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rate. Finally, in 1993 Brazil was back in hyperinflation. The Real Plan was launched in December 1993 by Minister of Economy (later President) Cardoso. Coming back to the five years of the Real Plan, this exchange-rate-based stabilization differed from the Chilean episode of 1977–1982 and the Mexican one of 1990–1994 in that the eventual breakdown was caused by excessive public borrowing, not private borrowing. This was reminiscent of the situation in most countries of Latin America (though not Chile) that gave rise to the debt crisis of 1982 and later. In 1998 Brazil’s fiscal deficit (including deficits of the state governments) was 8% of GDP and the current-account deficit was 4.5% of GDP, so that the private sector was actually in financial surplus. It was partly financing the fiscal deficit, but at the cost of low private investment. Interest rates were extremely high, rising to 40%, reflecting default risk, exchange rate risk, possibly continued inflationary expectations, and deliberately tight monetary policy designed to support the exchange rate regime. The high interest bill was a major cause of the big fiscal deficit. The primary (non-interest) fiscal deficit was only 1% of GDP in 1998, though it rose to 3% in 1999, the year that the regime was abandoned. The bigger the deficit, the less sure lenders felt about Brazil being able and willing to pay debt service, and thus the higher the interest rate had to be. Loss of confidence (reinforced by the Russian debt crisis in 1998) played a major role in increasing the interest rate that the government had to pay to attract the funds to cover its deficit, which in turn raised the deficit again. It was an unsustainable situation and would have led to a crisis even in the absence of speculation. Essentially there were two fundamental problems, namely the fiscal deficit and the real appreciation. The primary deficit needed to be turned into a surplus. Even strong liquid-

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ity support from the IMF and the United States could not prevent a breakdown of the Real Plan. In January 1999 the exchange rate was floated, and subsequently a new formal inflation targeting monetary policy regime was instituted. Thanks to the shock of the exchange rate crisis and the earlier explosive interest rate increases, President Cardoso was able to get political support for cuts in public spending. The primary deficit was turned into a surplus, and, in addition, the overall fiscal deficit fell because of reduced interest rates. From 10% of GDP in 1999 it fell to about 4% in 2000. Furthermore, a “Fiscal Responsibility Law” was enacted. Thus in 2000 the news looked good, with the growth rate about 4% and the inflation rate surprisingly low at about 6%. This was the situation after less than two years of the new floating-rate inflation-targeting fiscal-responsibility regime. I do not presume to speculate what the future will bring. Brazil: Lessons for the Choice of an Exchange Rate Regime What lessons does Brazilian history have for the choice of exchange rate regime? First, if the fiscal deficit is out of control and is monetized, there is no alternative to a flexible exchange rate regime. Attempts to fix the exchange rate or to implement an active crawling peg are doomed to failure, owing to continuous real appreciation leading to loss of competitiveness, loss of foreign exchange reserves, and eventual crisis. For much of its history Brazil did have very high inflation and, with it, high and entrenched inflationary expectations. Except during the brief failed stabilization episodes, its governments wisely chose to allow the exchange rate to adjust—often with a passive crawling peg—so as to avoid excessive, or any, real

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appreciation. This was particularly true during its “miracle” growth period (1968–1973), and helps to explain Brazil’s high growth rate up to 1980. A flexible exchange rate policy combined with indexation of wages and of financial assets made high inflation tolerable, so that Brazil was an almost unique case (along with Turkey) of a country where long-period high inflation was associated with high or at least moderate growth rates. Second, if fiscal deficits are no longer monetized and if a return to such a policy is unlikely, and if inflationary expectations have been squeezed out, the country is in a non-inflation world, a world of normality. That is where Brazil appears to be now (2001). There are then two possibilities: Fiscal instability caused by a loss of control of fiscal deficits (which are now bond-financed) may still be quite likely, as it is currently in Brazil. The choice must then again be for a flexible exchange rate regime. Alternatively, fiscal policy might be fully under control, and likely to stay that way. Perhaps in time Brazil will get to that stage. In that case there will no longer be an argument for a flexible exchange rate regime, owing to fiscal instability. Other factors, discussed in chapter 9, should then decide the choice. The choice is then between an absolutely-fixed exchange rate regime (or a currency board) and some kind of flexible (floating or in-between) regime. I rule out the FBAR for all the reasons discussed in chapter 4 and because of Brazil’s many bad experiences with such a regime. For Brazil the answer seems to me pretty clear. Brazil—a large, rather closed, economy, subject to asymmetric shocks and not highly integrated with the US economy—must be one of the last countries to be considered for an absolutely-fixed exchange rate regime. Finally, there is the tricky issue of whether a stabilization program beginning with high inflation should be exchange-

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rate-based. Such programs—which involve an FBAR or its active crawling peg version—seem invariably to end in crisis, and all the arguments discussed earlier against FBARs apply to them. We have the evidence of Chile in 1982, Mexico in 1994, and Brazil itself in 1998. These three cases were all programs that did succeed in sharply reducing the rate of inflation from very high levels. Thus they achieved their principal purpose. The benefit was the reduction of inflation and the cost was the crisis at the end. Let me now turn to the much-discussed exit problem. Could a crisis have been avoided by an earlier exit from the FBAR regime? The difficulty with a planned or preannounced exit is that the whole program depends on the new fixed exchange rate or crawling peg regime being credible right from the beginning. Presidents, finance ministers, and central bank governors have sunk a lot of their political capital into this task. If they had announced at the beginning that the fixed exchange rate regime might be ended they would not only be inviting speculation but might also fail to establish credibility to begin with. Certainly, if there is to be an exit to a flexible exchange rate regime, it is best that it happens when the market pressure is to appreciate the exchange rate. Stabilization from high inflation could be brought about not by fixing the exchange rate (or an active crawling peg) but by floating the rate and imposing a policy of monetary contraction, perhaps achieved by an independent central bank. As noted in chapter 3, a floating exchange rate regime is still compatible with a nominal anchor policy in the form of targeting of the money supply or of inflation. But how credible would such a regime have been in the Brazilian situation of 1994, where credibility of the commitment to reducing inflation was crucial? It is credibility in the labor market that is particularly important here. Without initial credibility,

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inflation would still have been reduced, provided monetary discipline had been achieved, but it would have been reduced at greater temporary cost in unemployment and in loss of output. The real exchange rate would still have tended to appreciate, though the adverse impact would initially have been mainly on nontradables rather than tradables. On balance, exchange-rate-based stabilization programs will probably be avoided in the near future. Too many have ended in crisis. This conclusion is simply a special case of the view that FBARs will be avoided. Inflation targeting with an independent central bank will become the preferred nominal anchor. The best advice, of course, is that countries should not get themselves into a high-inflation trap to begin with. Something should be said about “the dog that didn’t bark” when the Brazilian real depreciated in 1999. Wages did not rise to compensate for higher prices caused by depreciation. Brazil has a long history of indexation of wages, a result of its inflationary experience. Continuous inflationary expectations generated by a long experience of inflation are always likely to lead to formal or informal indexation of wages (and also of financial assets), and that is what had earlier happened in Brazil. Thus one might have expected in 1999 that a devaluation or depreciation would quickly lead to increases in wages that would erode the real effects. This expectation explains the policy makers’ reluctance to give up the nominal anchor exchange rate policy. As it turned out, this wages reaction did not happen. One reason may have been the effects of the recession on the labor market, but another, no doubt, was that the five years of the Real Plan really had reduced or killed inflationary expectations. Perhaps trade unions were also influenced by an awareness of the seriousness of the crisis and by the desire of trade union leaders not to return to the instability of the years before 1994.

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References For this chapter and also the following three chapters I have drawn extensively on IMF sources, in particular on the accounts of crisis developments in The World Economic Outlook, on Public Information Notices, and on IMF reports on “Article IV” and similar consultations (all available on the IMF Web site). In addition, on Brazil, see Cardoso 2000, on Mexico, see Sachs et al. 1996, Allen 1997, and Krueger and Tornell 1999, and on Chile see Edwards 1999 and Williamson 1996. Edwards (1998) compares the Chilean crisis of the 1980s, and the lead-up to it, with the Mexican crisis of the 1990s. Edwards (2000) analyzes Mexican exchange rate policy since 1995. The “exit problem”(created by exchange-rate-based stabilization programs) is discussed in detail in Eichengreen et al. 1998, and also in Sachs et al. 1996 and Edwards 2000. An overview of the Brazilian, Chilean, and Mexican macroeconomic and exchange rate histories from the mid 1960s to 1991—stories of numerous crises and macroeconomic adventures—is in Little et al. 1993, chapter 7. For this earlier period, see also Coes 1991 on Brazil and Edwards and Edwards 1991 on Chile.

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11

Argentina’s Great Currency Board Experiment

Argentina has provided one of the great laboratory experiments for the choice of exchange rate regimes. In 1991, it established what was essentially, with some variations, a currency board regime. It was called the Convertibility Plan, established by the Convertibility Law of 1991. The new currency board regime was to be managed by an independent central bank, and the peso would be fixed to the dollar. The Convertibility Plan: Origins, Success, Problems Argentina is not a country that one would normally expect to choose an almost absolutely-fixed exchange rate regime. While its capital markets are now open and closely integrated with the United States, in trade it is definitely not open, with imports being only about 13% of GDP. Unlike Mexico’s trade, Argentina’s trade is not dominated by trade with the United States (20% of total imports). It is subject to asymmetric product and policy shocks. By the criteria of the Real Targets Approach it would be one of the last countries to be a candidate for a currency board regime. Yet, at the time I am writing this, the regime had lasted ten years, surviving the shocks that resulted from the Mexican, Asian, Russian, and

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Brazilian crises. I would not dare to predict whether it will still exist by the time this book is published. There was, even in early 2001, strong support from the Argentine public and from politicians of all major parties for the maintenance of the regime. The reason is that Argentina has a long and horrendous history of macroeconomic instability—of monetized fiscal deficits causing inflation, of numerous failed stabilization programs, and of several episodes of very high or even hyper- inflation. Both the inflation rate and, at least as important, the real exchange rate have been highly unstable, much more than those of Brazil. The shift to sustained high inflation (more than 100%) began in 1975. In only one year from then up to 1991 was the annual rate below 100% (in 1986). Economic policy has been similarly unstable, that having been the cause of instability in both the inflation rate and the real exchange rate. As a result of all this and other factors, especially protectionist and regulatory policies, Argentina experienced low growth for the whole period since 1952. Its “miracle” years were in the early years of the twentieth century. From 1975 to 1991 per capita GDP fell almost every year. A consistent feature up to 1991 has been the monetization of fiscal deficits. Variations in the inflation rate can be traced to variations in the deficit as a ratio of GDP. Argentine economic history from the 1950s to 1991 is a sad tale of lack of macroeconomic policy discipline, and especially fiscal discipline, a lack that was grounded in difficult political and social situations. By mid 1989, when President Menem took over, the economy was clearly breaking down and at last society seemed ready for drastic measures. A crucial factor was complete loss of confidence. Nineteen-ninety was a year of endlessly changing plans and crises, though major structural reforms were achieved. In February 1991 the monthly rate of inflation

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was 27% (annual rate of 1660%). In this situation of hyperinflation Minister of the Economy Domingo Cavallo introduced his radical Convertibility Plan. The exchange rate of the new currency, the peso, would be permanently fixed, one for one, to the dollar. The money base would vary (subject to qualifications) with the foreign exchange reserves, and the central bank would not be allowed to monetize fiscal deficits. The loyalty of Argentinians since 1991 to the Convertibility Plan, and especially to the fixed exchange rate, has been similar to the persistent loyalty of Germans to their anti-inflation commitment. Both are rooted in their countries’ bad histories of inflation. Many would argue that low inflation in Germany since 1950 and in Argentina since 1991 are owed to institutional commitments—the independence and legislated commitments of their central banks. But I suspect that such independence and commitments have survived only because of the support of public opinion that has its roots in historical memory. The implementation of the Convertibility Plan was possible for two reasons. First, the foreign exchange reserves that were needed initially to back the money base were not large, because inflation had greatly reduced the demand for pesodenominated real money balances. There had been both private dollarization and a move into interest-bearing and real assets. This is a typical market response to high expected inflation. The money base was only 4.2% of GDP in 1991. Second, serious fiscal reforms involving major structural changes, including privatization of public enterprises, were embarked upon, and were achieved quickly. Otherwise, there would have been a clash between the requirements of the Convertibility Plan and its implementation with regard to fiscal discipline. I shall come back to the fiscal aspect below,

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but it is worth emphasizing that it is easier to make laws imposing discipline than actually to achieve discipline. If monetization had stopped but the fiscal reforms had not been achieved, the inflation crisis would have been transmuted into a debt crisis as the government tried to finance its deficit by borrowing on the market. The Convertibility Plan (with the associated policies) was a quick success. The recovery of the US economy in 1992, and the boom in capital flows to emerging markets helped, but particularly important was the restoration of confidence in the Argentine economy. The inflation rate dropped drastically, down to 4% in 1994, and from 1991 to 1994 the average growth rate rose to 9%. This success cannot be attributed entirely to the new fixed exchange rate regime. There were a whole series of market-based structural reforms, including privatization of public enterprises, deregulation, and trade liberalization. The picture changed from 1995 onward. There were external shocks that created severe problems—the overspill through the capital market of the Mexican, Asian, Russian, and Brazilian crises, the appreciation of the dollar relative to the Euro, and especially the devaluation of the Brazilian real. Most important, while Argentine inflation had indeed fallen drastically, as was inevitable with a currency board regime, wage inflation did not fall quickly enough to prevent significant real appreciation, and especially to counteract the effects of dollar appreciation and of Brazilian devaluation. Thus Argentina lost competitiveness and unemployment increased. Both in 1995 and in 1999 the growth rate was negative. The average growth rate from 1995 to 1999 was only 2.3%. Thus the familiar disadvantages of an exchange-rate-based stabilization program clearly emerged in the period 1995 to 2000, namely real appreciation and increasing unemployment.

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Departures from the Orthodox Currency Board Concept While the most important feature of the Convertibility Plan was that the central bank could not monetize fiscal deficits, certain other features should also be noted. The Plan did not really establish an orthodox currency board regime, but something near it. First, the exchange rate can be altered, but only by legislation passed by the Congress. This makes it difficult to alter the exchange rate, though not impossible. It is a more limiting constraint than when an exchange rate can be altered by administrative decision of the government or the central bank. Argentina thus has an almost absolutely-fixed exchange rate regime, with the emphasis on “almost.” Second, under the Convertibility Plan the money base is not actually required to change one for one with the foreign exchange reserves. Increases in the reserves above the minimum required can be sterilized and need not lead to increases in the money supply. Third, declines in foreign exchange reserves can be sterilized to a very limited extent. This is a pragmatic modification of the usual scheme, but, because of the limits, it does not alter the essential characteristics. Government securities can back the money supply, but only to the extent of one-third of the central bank’s assets, and with a limit of a 10% increase in one year. Essentially, what the first and the second modification together mean is that at least two-thirds of the money base must be backed by foreign exchange, but it can be (and has been) a higher proportion. In addition, there is the 10% limit on increases in the proportion that is backed not by foreign exchange but by government securities. One should bear in mind here that when a government runs a fiscal deficit and issues securities to finance the deficit, and these securities are

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then bought by the central bank so that it can increase the money base, the deficit is being monetized. Under this scheme there are severe limits on such monetization because of the 10% rule. The central bank cannot create money to finance a lenderof-last resort facility for the banking system. There have been big banking crises in Argentina in the past (the crisis of the early 1980s cost 55% of GDP), and there have been crises during the ten years so far of the Convertibility Plan. But alternative ways of dealing with the problem have been found. Most important, the banking system has been opened to foreign banks, which, as a result, accounted in 1998 for 64% of deposits in private banks. In these cases the head offices are the lenders of last resort for their local branches. In addition, a so-called Contingent Repurchasing Facility was created. This boils down to an arrangement with a group of foreign banks that they will provide emergency liquidity in case of a crisis. The central bank manages this fund, the resources from which would then be passed on to Argentine banks in need of liquidity. Thus, in a sense the central bank is a potential lender of last resort; however, it finances such activities not by money creation but by foreign borrowing, and the available funds are clearly limited. Role of Fiscal Policy Fiscal policy is crucial for the effective working of a currency board regime. Fiscal policy must not be out of control, and functional finance must be implemented. This means that surpluses are accumulated in good times, when the terms of trade improve or there is a domestic consumption or investment boom. These surpluses will allow the government to reduce its foreign (dollar) debt, or even to build up its dollar

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assets independent of the central bank. When a slump sets in, the government can run deficits financed by running down its reserves and by increasing its domestic and (above all) foreign borrowing. The slump would in any case increase the fiscal deficit. That is the automatic stabilizer. But functional finance requires the deficit, and hence borrowing, to be increased beyond that. If there have been adequate surpluses during the boom, such increased foreign borrowing in the slump will not lead to higher interest rates or even eventually to an inability to borrow more. What happened in Argentina? Initially, when the currency board was established, Minister of the Economy Cavallo achieved tremendous fiscal reforms. Tax collections were raised, and both losses of public enterprises and various forms of spending were reduced. It was a major political achievement which was only possible because the public and the populist President Menem recognized the severity of the crisis and the need for reforms in many respects. Without these reforms the currency board could not have been established. As I have already noted, if monetary financing of fiscal deficits had to stop there would have had to be bond financing instead. However, at that time it was impossible to sell Argentine bonds other than at extremely high interest rates, even though they were dollar-denominated. The default risk was seen as too great. Hence the fiscal deficit had to be reduced or even eliminated. It was not just the discipline of the currency board that brought this about, but additionally the discipline of the world capital market. In later years, holding down public spending, especially by provincial authorities, became difficult, and the debt was not reduced sufficiently during boom times. Perhaps fiscal policy was not fully “out of control,” but it was not fully under control. When a recession developed in 1999 and deficits

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increased owing to the automatic stabilizer, increased borrowing required higher and higher interest rates, and by 2000 Argentina was thought of as being in danger of default. This was a fiscal crisis, not an exchange rate crisis. As usual, the IMF came to the rescue—justified by the fact that there was an immediate liquidity problem—but the condition of IMF assistance was that further fiscal reforms be implemented. These would reduce the deficits. The success of such a program would restore credibility and hence would lower the premium for risk on interest rates that Argentina had to pay. How does this experience relate to my discussion in chapter 7 of the relationship between fiscal policy and the exchange rate regime? There were three negative shocks in 1999 and 2000: the appreciation of the dollar relative to the Euro, the 40% depreciation of the Brazilian real, and the decline in grain prices. Hence the trade-weighted real exchange rate appreciated while it actually needed to depreciate. Given the exchange rate regime, a functional finance policy needed to be followed if a recession was to be avoided. As I have said, this required surpluses in the boom and deficits beyond the automatic stabilizer effect in the slump. In the long run, if the negative shocks were not reversed, the only solutions would be productivity improvements or declines in nominal wages. The failure to produce the necessary surpluses and debt reduction in the boom made it impossible to practice functional finance policy in the slump. Because of the automatic stabilizer effect in the slump the fiscal deficit did increase, and the public debt relative to GDP increased. As in the case of Mexico on the eve of its 1994 crisis, this ratio was about 50%, which is not high by European standards. But the deficit and debt had been increasing, the growth rate was low, the political situation was difficult because of the reces-

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sion, and creditors, rightly or wrongly, perceived growing default risk. Default would take the form of a compulsory restructuring of the debt. So interest rates faced by Argentina rose steeply, hence intensifying the debt problem. Where should the blame be placed for the crisis of 2000–2001: on fiscal policy or on the exchange rate regime? Given the exchange rate regime, the failure or inability to follow a functional finance policy in the good times made it impossible even to allow the automatic stabilizers to work in the slump, let alone to pursue an actual fiscal expansion. Hence a difficult contractionary policy is forced on Argentina at a time of recession. If there were a flexible exchange rate regime, a devaluation or depreciation might, after a lag, have ended or moderated the recession. The automatic stabilizer effect would have turned positive, and could even have been supplemented by some fiscal contraction, so that the debt crisis would be averted. Fiscal policy has not been “out of control” in the way it had been before 1991, but the functional finance test was failed. Hence the problem of an absolutelyfixed exchange rate regime when wages are inflexible downward could not be solved, even in the short run, by fiscal policy. In summary: The crisis was the result of the combination of a fixed exchange rate regime and the failure to pursue a functional finance policy in the boom years. In terms of my discussion in chapter 7, the fixed exchange rate regime created the problem—which, indeed, is the standard argument against such regimes—and the potential solution to the problem—functional finance—was not practiced. This relationship between the exchange rate regime and fiscal policy suggests an interesting point about the relationship between the exchange rate premium on interest rates and the default risk premium. The two premiums might be substitutes. Specifically, an expectation of depreciation

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would raise the exchange rate premium but might reduce the default risk premium. Suppose the markets came to expect that the peso was likely to be devalued substantially, or that there would be an exit to a floating rate regime. Obviously, the exchange rate premium would rise, and peso interest rates would thus increase sharply. But what would happen to default risk, and thus to the premium on dollar-denominated Argentine bonds relative to US bonds? Possibly the expectation of the end of the exchange rate regime might lead to a complete loss of confidence in Argentine policy makers, in which case the default risk premium would also rise. But another possibility is that the stimulating effect of depreciation would be expected to end the recession and thus improve the fiscal outcome. Debt could be reduced, and the default risk premium on interest rates facing Argentina would actually decline. In that case the exchange rate premium and the default risk premium are substitutes. A debt crisis would be converted into an exchange rate crisis. In reverse, establishing a credible currency board can avoid an exchange rate crisis, but eventually it may produce a debt crisis instead. Enthusiasts for currency boards or dollarization have tended to overlook this possible relationship. Dollarization Proposal At this point something must be said about the proposal, made in 2000 by the central bank and some economists, that Argentina be completely dollarized, the peso being abandoned as an official currency. The market still has had some doubts about the maintenance of the fixed peso exchange rate. Hence there has been continued expectation of possible devaluation or depreciation. This lack of full credibility of the

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currency board regime added a premium to interest rates on peso-denominated debt. This exchange rate risk premium was additional to the premium due to default risk. It was argued that if this exchange rate premium could be reduced or eliminated, investment and thus growth might be stimulated. For those who believe that the firmly fixed exchange rate regime should be maintained at all costs, conversion to an absolutely-fixed regime in the form of dollarization seems the obvious answer. With dollarization the exchange rate risk premium would disappear. From this point of view, the only cost of a switch from a currency board regime to dollarization would be the loss of seigniorage. Yet, such a loss would not be great for Argentina, since money holdings are low to start with because of the earlier experience of high inflation. Seigniorage has been estimated to be only 0.22% of GDP. Such a small cost could well be outweighed by the growth benefits from lower interest rates. Dollarization would turn an in-between regime that is almost an absolutely-fixed regime into a straightforward absolutely-fixed regime. The country is already partially dollarized in practice because dollars are held privately on a large scale for transactions and as a store of value, so—it has been argued—why not go the whole way? In assessing this proposal one must be aware of the tradeoff involved. I have just stated the advantages. But dollarization means that two alternative options would be permanently ruled out. The first option is to devalue the peso by legislative action while keeping the Convertibility Law. This would certainly affect the credibility of the new exchange rate in the future, and it would effectively make the system more like the classic FBAR, with all the advantages and disadvantages that I have discussed at length earlier. The second option is to abandon the regime and move to a flexible

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or floating rate regime with some kind of nominal anchor provided by monetary policy. This is the exit option discussed in the preceding chapter. This option was available all the years since 1991, and exists now. It must be seriously considered, and it raises an even bigger issue. Was Argentina’s Choice of a Currency Board Wise? Would it not have been better if the currency board regime had never been established in 1991? Did it not tie the hands of the government too much? One might concede that, on the basis of past history, Argentine governments’ hands certainly needed tying, but given that Argentina is not a natural candidate for a currency board regime on the basis of the criteria discussed in earlier chapters, was establishing the currency board regime not rather overdoing it? This is not just a “what might have been” question but should be helpful in thinking about options for other countries that may be caught in an inflation-instability trap as Argentina certainly was in 1991 and for many years before that. The three keys to Argentina’s success both in practically ending inflation and in restoring the growth rate were first the fiscal reforms, second the various other structural reforms I referred to earlier, and third the firm establishment of a nominal anchor through the Convertibility Law. Suppose the first two kinds of reforms had been implemented under the shock of the hyperinflation crisis, but instead of the Convertibility Law an independent central bank had been established, with a strict legislated instruction that it could not monetize fiscal deficits, and with an inflation targeting commitment. Would that have imposed the same discipline and had the same credibility as the Convertibility Law? The exchange rate

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would have been flexible, and changes in the money supply through open market operations (but not through monetization of fiscal deficits) would have been possible. Given Argentina’s history it certainly needed a firm and very visible nominal anchor. Would such an inflation-targeting regime have filled that need adequately? At the time one certainly could not be sure. The favorable experience of Mexico since 1995 and the (brief) experience of Brazil since 1999 were not yet known. But it is possible that it might have been enough. As a variant, an active crawling peg regime might have been established initially, with an eventual exit, preferably without crisis, to a flexible exchange rate regime. In other words, could Argentina have followed successfully what (after crises) subsequently were the Mexican and Brazilian paths? I am assuming here the same fiscal reforms that actually took place. One has to remember here that social disruption, lack of fiscal discipline, and endless failed experiments, all leading to a long period of low growth rates, made Argentina a much sicker patient than Mexico and Brazil. Nevertheless, this type of flexible exchange rate inflation-targeting regime might have worked. In my view, a country in a similar situation (if there ever again will be such a country) would be wise to avoid the currency board option unless it fulfills the long-term requirements for such a regime set out in earlier chapters. Under the Real Targets Approach, a rather closed economy with an inflexible labor market and subject to asymmetric shocks of the kind that Argentina has been subject to is not a good candidate for an (almost) absolutely-fixed exchange rate regime. If the exchange rate were to be used initially as a nominal anchor, an exchange-rate-based stabilization program with a relatively early exit when times are good would be preferable.

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Should the current system, which (as of 2001) has lasted 10 years, be modified or abandoned, with a move to a floating rate inflation-targeting regime? One may favor such an exit even if one agrees that, on balance, the establishment of the currency board regime originally was sensible. The persuasive arguments in favor of an exit are implicit in what I have just said. But let me now state two arguments for not making a change. You, dear reader, will know which arguments have prevailed by the end of 2001. The first argument is that a depreciation of the peso would bring about substantial redistributions within Argentina, producing both gainers and losers. Some debts are fixed in dollars and others in pesos. Some individuals, some firms, and some banks have net dollar-denominated liabilities; others have net peso-denominated liabilities. For example, banks have borrowed internationally in dollars, while some or most of their deposits are denominated in pesos. A devaluation could have very adverse effects on the financial system. The government, of course, has dollar-denominated international debts but collects taxes in pesos. This is simply the UFB problem. If the regime were to be abandoned, so that the peso would depreciate in the market, possibly drastically, it would be desirable that domestic and foreign dollar-denominated debts be revalued, so that their peso values would not rise sharply. As their dollar values would have to fall, it would be a form of default, with practical and legal difficulties. Another argument against changing the regime is that its maintenance for ten years has been a costly investment in credibility not just in the foreign exchange market but also in the labor market. Any switch to a new regime, even if it is a carefully specified, legislated inflation-targeting regime, is likely to lose some of that credibility. A system that can be changed once can be changed again. It may seem that

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Argentina is back on its old wobbly policy path. Hence the investment in credibility should not be thrown away. But it has been achieved at a cost. The refusal to abandon the currency board regime has probably worsened the recession and, with it, increased the budget deficits and hence the dollar interest rates facing Argentina, which in turn worsened both the deficits and the recession further. This cost has itself steadily reduced the credibility of the regime. The dilemmas of Argentine policy makers are very evident. Argentina is a victim of its history. Its policy makers chose the exchange rate as a rigid nominal anchor, and chose to stay with it, because of Argentina’s history of lack of macroeconomic discipline. Given such a rigid regime, both functional finance and sufficient wage flexibility have been needed. Neither has been politically possible on a sustained basis. References This chapter draws primarily on IMF material and on newspaper reports, especially from the Financial Times. See also Wise 2000 and Pou 2000. On the details of the Convertibility Plan, see Hanke and Schuler 1996, Hanke and Schuler 1999, and Gosh et al. 2000. On currency boards in general, see Williamson 1995 and Perry (ed.) 1997. On the macroeconomic history of Argentina before 1991, see Dornbusch and De Pablo 1990 and Little et al. 1993 pp. 185–192. Both of those works describe in detail the muchstudied “Martinez de Hoz” stabilization episode of 1976–1980, which was the principal Southern Cone experiment of “international monetarism,” a forerunner of later exchange-ratebased stabilization programs with active crawling pegs. The term tablita (meaning scale of pre-announced crawling peg) comes from this episode.

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12

Lessons from Asia

A prolonged private sector boom ends in a banking crisis and then a currency crisis. The exchange rate depreciates severely and then rebounds somewhat. There is a deep recession, and recovery takes a long time. The financial sector is in ruins. Until the currency crisis the country had what was essentially an FBAR regime. As a result of the crisis the exchange rate floats. That, roughly, is the story of the fivecountry East Asian crisis that began in 1997. The question is: would the story have been different with a different exchange rate regime initially and during the crisis? Does the fact that this boom-and-bust episode happened under an FBAR regime condemn that kind of regime? Or were there fundamental factors that would have operated under any of the alternative regimes? The five “Asian crisis” countries were Thailand, Indonesia, Malaysia, Korea, and the Philippines. I shall begin with Thailand. Then I shall look at Indonesia, Korea, and Malaysia, followed by the two largest Asian economies: the People’s Republic of China and India. The last two countries did not have similar crises. Did that have something to do with their exchange rate regimes or with the exchange control regimes? I shall look particularly at the role played by controls on capital

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inflows and outflows. On that subject much is to be learned from the Asian experience. Finally, I shall look at Hong Kong, one of the two classic currency board economies, the other being Argentina. I should add that I have much more to say on two small economies, Malaysia and Hong Kong, than on two of the largest, China and Korea. This is due to my lack of detailed knowledge of the Chinese experience and to the similarity of the Korean and Thai experiences. I do not discuss the Philippines, where the crisis was relatively mild and where the economy had returned to its pre-crisis growth path by the first quarter of 1998. The Crisis in Thailand Thailand has a long history of an exchange rate formally or informally fixed to the dollar, with very infrequent adjustments. This meant that variations of its real exchange rate depended not only on its inflation rate relative to the United States and other trading partner or competitor countries, but also on variations, in particular, in the yen-dollar rate. There was a long-lasting boom from 1988 to 1995, with a high level of investment financed by a high level of domestic savings (about 30% of GDP) and by growing capital inflow. The investment boom helped to develop a manufacturing sector that contributed to the diversification of Thailand’s exports, but about half of the funds went into construction, financing a real estate boom that eventually got out of hand. During this remarkable boom period Thailand had one of the world’s highest growth rates—8 to 10% a year. Naturally there was a growing current-account deficit, reaching 8% of GDP in the last stages of the boom, and the real exchange rate appreciated somewhat. It was a private sector boom, with bank and non-bank domestic financial intermediaries as

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borrowers, and with foreign funds coming primarily from international banks. Capital inflow was liberalized and encouraged in 1993 by the establishment of the Bangkok International Banking Facility. There had been over-investment in real estate, and an asset-price bubble had burst already in 1994, but the situation really deteriorated in 1996, when the terms of trade worsened severely. The Japanese banking crisis led to a slowing down of capital inflow, and the depreciation of the yen relative to the dollar (to which the Thai currency, the baht, was still tied) did not help. Booms always come to an end, sometimes quite suddenly, so I need not pursue the details here. Monetary policy in Thailand has traditionally been very conservative, and it was such a conservative policy that sustained the fixed exchange rate regime that tied the value of the baht (the Thai currency) to the dollar. Possibly in the past the exchange rate regime had actually served as a nominal anchor, thus disciplining monetary policy. But by 1996 such discipline had gone. As financial institutions got into difficulties the Bank of Thailand extended credit to troubled institutions, and this led to monetary expansion, which, in turn, reduced the foreign exchange reserves. Hence the foundations were laid for the currency crisis. Given the fixed exchange rate regime one can thus give a simple monetarist explanation for the crisis. First there was a crisis for financial institutions (above all, banks); then credit was provided to rescue them, and thus the foreign exchange reserves (including commitments to the forward market) declined; finally there was a currency crisis. In addition, in early 1997 reserves fell further because of speculation against the currency. The important point to note is that there were fundamental factors making devaluation or depreciation inevitable, given the willingness to guarantee the troubled financial sector and

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the unwillingness to raise interest rates sufficiently. The crisis was triggered by speculation against the currency, but in a fundamental sense did not depend on it. The foreign exchange reserves were bound to run out, given the monetary policy. Speculation was purely anticipatory. Capital inflow declined from 1996 but, remarkably, overall it stayed positive right up to the July 1997 devaluation. Foreign banks continued lending and local banks continued borrowing right up to the time of the crisis. Once the exchange rate was devalued there began a massive outflow of capital from the banking sector. It was at this stage that the foreign panic set in, which affected, above all, banks. Foreign banks wanted their money back as quickly as possible. I have yet to underline one crucial—and now familiar— element in this story. Most of the capital inflow—especially to banks—was quite short-term, and hence highly volatile, much more so than portfolio inflow. There was a maturity “mismatch,” which actually reflected the normal role of banks on the basis of which they make their profits. Banks borrow short term and lend long term. Whether they actually make profits depends to a great extent on the care with which they choose their customers and the projects that they finance. It is at this point that banks in Thailand turned out, at least after the event, to have shown a lack of care. Portfolio investment and, even more, foreign direct investment was much less volatile than short-term capital inflow, and it is widely accepted that at the core of the Asian crisis was excessive short-term foreign borrowing which then financed domestic investments that turned out to have been unwise or excessive. Furthermore, foreign borrowing was unhedged, which led to the UFB problem (see chapter 8). After depreciation, the consequences of UFB played an important role in Thailand. It intensified the difficulties of

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banks and other financial intermediaries, and thus it added to the recession. One can summarize by saying that Thailand was pushed into devaluation by deteriorating fundamentals. After devaluation in 1997 there was outright collapse owing to both a local and an international banking panic. Hence the baht had to be floated, and it depreciated from 26 baht to the dollar to 47, though later recovering somewhat, reaching 37 at the end of 1998. With investment spending suddenly ceasing, and troubled banks unable to provide credit, the economy went into a deep recession. Replaying Thailand with Different Exchange Rate Regimes Suppose Thailand had established a currency board regime— with the baht firmly and credibly fixed to the dollar—right after the devaluation of the baht in 1984. The regime would have been credible, since Thailand had ample foreign exchange reserves and a long-term commitment to low inflation. The Thai economy has also been historically characterized by a remarkably flexible labor market. I shall now assume that it would have been, and seen to have been, an absolutely-fixed exchange rate regime, backed up by the usual restraints on monetary policy that go with a currency board system. I shall also suppose that from about 1987 to 1994 or 1995 there would have been the same sort of boom, culminating, as it actually did, in euphoria and excessive borrowing. Foreign banks would have lent, and domestic banks and other financial intermediaries would have borrowed short term, and funds would have been on-lent to various enterprises, notably, but not exclusively, the real estate sector. Because of the availability of a supply of rural underemployed

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labor at first real wages would not have risen, but eventually real wages would have increased and there would have been real appreciation, which would have led to a decline in competitiveness. The money supply would have increased as a result of the accumulation of foreign exchange reserves. In fact the story would have been much the same during the boom as it actually was under the actual FBAR regime. This was also my conclusion in chapter 10, where I told a counterfactual story for Mexico. The boom would have ended for all the reasons that the actual boom ended: the financial sector would have accumulated non-performing loans, demand would have declined, and capital inflow would have slowed down. While much would have been the same in this counterfactual story, we come now to the point where history would have been different. First, there could not have been rescues of troubled financial institutions by the central bank (or currency board). Conceivably the government might have financed such rescues directly and borrowed abroad to do so, but if this had not been possible or likely there would have been more, and earlier, defaults. A banking crisis and a recession might then have come a year earlier. Second, there would not have been any speculation on the exchange rate, given that the currency board system would have been well established by 1997 and thus utterly credible. Thus there would not have been any actual “currency crisis” involving financial losses by the central bank and loss of prestige and credibility by the government and the central bank. This is the main respect in which the currency board regime would have been preferable to the FBAR. It should be emphasized here that the nominal anchor argument—which usually provides the main case for the choice of a currency board regime—is not really relevant for Thailand. It is a country

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that has had a strong historical commitment to low inflation (in spite of the brief period of monetary expansion from 1995 resulting from financial sector rescues). Third, since there would not have been any devaluation or depreciation, there would have been no UFB problem, and for this reason the depth of the recession would have been less. But a deep recession would nevertheless have been inevitable because of all the adverse fundamentals noted earlier. This leads to the fourth and final point. The recession would not have been offset or modified eventually by the stimulating effect on exports—the switching effect—of depreciation. I emphasized this point when discussing Mexico. In the case of Thailand there has been some automatic adjustment through the downward flexibility of wages, so that the real exchange rate would have depreciated to some extent even if the nominal exchange rate had stayed fixed. The mobility of labor between Bangkok and the rural hinterland has provided an additional adjustment mechanism. Nevertheless, recovery from recession would have been much slower without depreciation. As an alternative counterfactual exercise, suppose that, instead of an FBAR or a currency board regime, the baht had been floated, without much intervention, after 1984. Again, I assume the same kind of boom, culminating in euphoria and then ending in a slump. The special difficulties created by an FBAR regime—the loss of political credibility and loss of central bank income that result when an exchange rate commitment cannot be maintained—would also have been avoided. I now look at other respects in which events might have been different under a floating rate regime compared with what actually happened. First, during the period of capital inflow the nominal exchange rate would have appreciated, rather than the

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money supply rising because of the accumulation of foreign exchange reserves. There would thus have been the same sort of real appreciation, though it would have happened more quickly than under the FBAR regime. Second, when the financial sector began to get into difficulties the Bank of Thailand would have undertaken the same sort of rescue operations, involving increases in the money supply, and because of this, the exchange rate would undoubtedly have depreciated earlier, possibly even in 1995. Third, the exchange rate would certainly have depreciated in 1996, when export income declined owing to deterioration in the terms of trade and to loss of competitiveness. In retrospect, at least, such an earlier depreciation would have been preferable to the later depreciation that took place in crisis conditions in 1997. The beneficial switching effects of depreciation might have set in earlier. Whether depreciation would have been smoother and thus less traumatic, perhaps occurring in several steps, is not clear. Fourth, the experience of floating would have been likely to induce borrowers who acquired dollar-denominated (or yendenominated) debt to hedge against the possibility of depreciation. They would not have gambled that there would not be any devaluation, as they did under the FBAR regime. Such hedging might have been costly, but it would have avoided a UFB problem, with all its adverse effects, in the case of a depreciation. Fifth and finally, during the boom the nominal exchange rate, while generally appreciating, would have been unstable—as is usual with floating rate regimes—and this would have had the usual adverse effects on which the Exchange Rate Stability Approach focuses. Such instability is particularly likely when foreign exchange markets are thin, with a

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shortage of stabilizing speculation, as in many developing countries. The central bank would have felt obliged to intervene in the market, or to manage interest rates, so as to achieve some stability. At this point one might ask whether exchange rate instability is really undesirable. Perhaps instability has actually certain advantages. I leave aside the argument that it encourages hedging, and so avoids the UFB problem. Here I note another argument that did emerge after the Asian crisis. It was said that the fixed exchange rate commitments of the five Asian crisis countries under their FBAR regimes had over-encouraged both domestic borrowers and foreign lenders. It gave them a false sense of security if they borrowed in dollars or lent in baht, or indeed if they invested in equities. Upon reflection this turns out to be a curious inversion of a familiar argument in favor of fixed rates and monetary union. Usually it is argued that fixed exchange rate regimes are desirable precisely because they reduce the costs of trade and of international capital movements. The novel argument I am referring to here is a second-best one. It is implied that certain distortions have led to excessive capital inflows. Probably the distortions had to do with lack of information, herd behavior in capital markets, or just ignorance or stupidity. This may well have been true in the last years of the Asian boom. Hence, something that discourages capital flows, such as an unstable exchange rate, is actually desirable. Thus a fixed (FBAR) exchange rate regime that is generally thought to be favorable because it reduces the costs of international trade and capital movements turns out, at least at the margin, to have been unfavorable. The policy proposal is then to create some instability and thus uncertainty by floating the exchange rate. It is a form of throwing sand in the

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wheels of capital mobility. I regard this as a doubtful argument for floating. There must be better ways of coping with the initial distortions. The Extraordinary Indonesian Crisis The Indonesian crisis began in 1997, set off by contagion from Thailand. It reached its peak in 1998, and now, in 2001, is not at an end. There was remarkable nominal and real depreciation of the currency and a massive recession. Before the crisis, in July 1997 the rupiah was worth 2500 to the dollar. By March 1998 it was 8325 and, after rising to about 15,000 during the year, was back to 8000 in December 1998. (In May 2001 it was around 11,500.) I shall focus on the issue of whether the exchange rate regime mattered and on whether a different exchange rate regime, or a different exchange rate policy, would have reduced the impact of the crisis. It is certainly arguable that, whatever the exchange rate regime, there would have been a severe crisis, even though the actual crisis caught everyone—or at least anyone who wrote about such matters—by surprise. Before the crisis the Indonesian private sector engaged in a short-term international borrowing binge similar to that of Thailand. In the Indonesian case a high proportion of international borrowing was done directly by non-financial corporations, though banks also borrowed internationally, and such borrowing was denominated in dollars and not hedged. The lenders were principally international banks, as also was the case in Thailand. Unlike in the case of Thailand, the extent of the borrowing binge was not realized before the crisis, because of the lack of adequate data. The currentaccount deficit relative to GDP was, at 3.4% (1990–1996 average), considerably less than that of Thailand, but this

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can now be explained by the higher level of foreign direct investment (FDI) inflows into Thailand. Before July 1997 Indonesia did not seem an obvious candidate for a crisis. It had a target zone exchange rate regime (with a modest rate of crawl of the central rate), and shortly before the crisis the rupiah actually floated at the lower (appreciated) limit of the band. Contagion from Thailand changed market expectations about Indonesia. The exchange rate band was widened from 8% to 12%, with the value of the rupiah immediately dropping (depreciating) within the band as international funds moved out of East Asia. As pressure on the rupiah mounted, the Indonesian authorities quickly gave up the target zone regime and allowed the rupiah to float. Thus, by not trying to defend an unsustainable exchange rate, they avoided losing reserves or losing credibility. They avoided the principal difficulties created by FBARs. This seemed to me at the time, and still seems to me now, to have been a very wise policy, and different from that of Thailand. In thinking about Indonesian policy it is important to remember this. Then came a series of developments that led, in steps, to the huge depreciation of the rupiah that I have already mentioned. This depreciation created in turn an equally huge UFB problem for corporations and banks, in effect bankrupting them. At first, Indonesian corporations sought to acquire dollars as they realized that the exchange rate could depreciate further, then a banking crisis led to a loss of confidence, and to the issue of emergency credits by the central bank. Hence the money supply expanded. Finally, there were political, economic management, institutional, and social problems that I cannot even begin to describe briefly. Perhaps the main point was that all power was in the hands of elderly President Suharto whose likely retirement created great

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uncertainty and who, while still in control, seemed to react unwisely to the situation. In retrospect one can see that an economic crisis of this kind was neither predicted nor predictable, but the possibility of a political crisis associated with the transition to a new president was evident in advance. For many years Indonesia had been an exceptionally well-managed economy, essentially because the President took the advice, at least on macroeconomic policy, of a very competent team of local economists. Now they were shut out, and the Suharto family played a crucial role instead. The extreme movements of the exchange rate, much greater than in Thailand and other Asian crisis countries, can be explained by a complete loss of confidence in Indonesian policy making and eventually in social stability. It is hard to fault the exchange rate regime before the crisis. One can hardly say that it caused or contributed to the crisis, except insofar as the relative stability of the central rate’s rate of crawl, combined with a fairly narrow band, gave borrowers a false sense of security. They failed to hedge their foreign dollar exposures, and this greatly intensified the crisis when it came. But it seemed to be a model target zone regime, with an appropriate element of flexibility both in the rate of crawl of the central rate and in the width of the band. If the exchange rate had been completely fixed by a currency board arrangement or if it had floated, there would still have been a borrowing boom. In general, the analysis of the counterfactual that I have given for Thailand applies also to Indonesia. When the crisis came, caused initially by contagion from Thailand and then by loss of confidence, the FBAR problems were, as I have said, avoided. After a brief widening of the band, the rupiah was floated. No attempt was made to sustain an unsustainable rate. Was there then any alternative to

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floating? For example, could the target zone regime have been maintained? Could extreme depreciation of the rupiah have been prevented by widening the target zone band, both intervening at the upper (depreciated) limit and raising interest rates appropriately? Certainly the extreme movements of the exchange rate greatly exacerbated the crisis through the UFB problem. In addition, the extreme depreciation added to political and social problems by raising the rupiah prices of imports. The answer must be that, with any regime, there would have been not just an end to capital inflow but extreme capital outflow, given the political and other problems referred to above. Higher interest rates could moderate extreme exchange rate movements but have their own costs. Foreign exchange intervention did take place, but reserves and foreign support were insufficient to bring about credible results. Extreme movements could have been prevented and credible target zone limits might have been maintained if the central banks of Japan and the United States had been prepared to intervene to an unlimited extent. They certainly had the resources to do so. But such intervention was not politically practical, and would have made these central banks hostages to the monetary policy of Indonesia. The IMF had neither the resources nor (while President Suharto was in charge) the power to ensure that its conditions would be fulfilled. What is the conclusion? The exceptional severity of the crisis was caused neither by the initial exchange rate regime nor by the inevitable floating rate regime that emerged once the crisis began. It was caused by a combination of two factors. First, there had been, as in the case of Thailand, initial unhedged foreign-currency-denominated borrowing which led to a UFB problem for corporations and banks, how much depending on the extent of depreciation of the exchange rate.

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Second, an extreme depreciation of the exchange rate was caused by a loss of confidence that, in turn, had a variety of causes which I have listed. If the depreciation had not been so extreme the effects of UFB would not have been so severe. Subsequently, the crisis was further intensified by political and social breakdown. Would the crisis have been so severe if Indonesia had established an operating currency board regime before 1997? This is the same counterfactual question I asked in the case of Thailand. I have only one point to add here: Owing to the extreme loss of confidence in the case of Indonesia, leading inevitably to a very large outflow of funds, there would have had to be an extremely large monetary contraction if a currency board regime had been adhered to. In particular, the currency board could not have been a lender of last resort. There would still have been a political and social crisis, and the system could not have been sustained. Finally, there would just have been an FBAR crisis. At the peak of the crisis a Johns Hopkins University professor, Stephen Hanke, had the ear of President Suharto and advocated a switch to a currency board regime. This proposal, strongly opposed both by the President’s own economic advisers and by the IMF, was not implemented. Hanke’s basic argument was that the establishment of a currency board would restore confidence and the regime would then be credible. The currency board would be established at an exchange rate that was significantly depreciated relative to the original value of the rupiah, as determined by an initial period of floating. This exchange rate would reverse the extreme movement of the exchange rate that had actually taken place, an extreme movement that was not justified by fundamentals. To be specific, it might be established at a rate of 5000 or 6000 rupiah to the dollar, which

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would be considerably depreciated relative to the pre-crisis rate of 2500 rupiah but would be appreciated relative to the then-prevailing market rate of around 9000 rupiah. The criticism of this proposal can be put as follows: Everything would hinge on successful establishment of credibility. The market would have to be convinced that the exchange rate chosen was justified by fundamentals. But political uncertainty and lack of confidence would throw doubt on any concept of fundamentals. Could lender of last resort activities be given up in the midst of a drastic banking crisis and recession? Could the monetary discipline required by a currency board regime actually be maintained? It is more likely that a currency board regime would turn out to be just another FBAR case, leading to losses by the central bank to the benefit of successful speculators or inside traders. Above all, the demand for dollars would deplete the commercial banks’ reserves. Of course, if the exchange rate chosen were at the highly depreciated rate that existed at the time of the proposal the currency board regime could have survived, but naturally the aim was to stabilize the exchange rate at a much more favorable level. Finally, establishing such a regime at a time of crisis, apart from being difficult institutionally, raises the question whether it is meant to last for the long-term. Indonesia is not an obvious candidate for such a regime for all the reasons discussed in chapter 9. A Few Words on Korea The economy of the Republic of Korea is by far the largest of the five Asian crisis countries. Furthermore, the economic development of Korea (along with that of Taiwan) is the outstanding economic success story of the postwar era. Nevertheless, I shall be brief here, because there is a great similarity

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with the pre-crisis and crisis experiences of Thailand. The discussion of counterfactual exchange rate regimes that I have given for Thailand also applies in this case. Korea has been through many ups and downs, notably a severe currency crisis and recession in 1980, which followed a boom and was followed by a quick recovery. The inflation rate has generally been higher than that of Thailand, but exchange rate policy during the Bretton Woods period was quite flexible, so that prolonged periods of real appreciation were avoided. Liberalization of the capital market began in the early 1980s. A rigid exchange rate peg was instituted in 1974 and ended in 1980. In the 1990s, up to the crisis, the exchange rate regime was formally a managed float, but the value of the won (the Korean currency) was in practice very stable relative to the US dollar. While there were some exchange controls on short-term capital flows, these did not apply to non-residents. During the boom period there was massive short-term international borrowing by commercial banks and non-bank financial institutions. Most of the latter were owned by the large corporations or conglomerates (chaebol). At the same time there was also large-scale international lending, including to the Southeast Asian crisis countries. Compared with Thailand and Indonesia, Korea had a much lower total debt ratio relative to GDP but it had by far the highest ratio of short-term debt to total debt. On the eve of the crisis it also had the highest ratio of short-term debt to foreign exchange reserves. The latter were much depleted in the attempt to maintain the exchange rate. In 1996 the terms of trade deteriorated, and all the signs of financial fragility of some of the chaebol and of banks were already visible. The banks had been lending too much to the over-leveraged and overexpanded chaebol.

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Two points should be noted. First, a deterioration in the fundamentals, leading to indications of a financial crisis, clearly preceded the currency crisis. Owing to excessive lending to unsound borrowers there would have been a financial crisis whatever the exchange rate regime. Second, while the accumulation of foreign-currency-denominated debt was significant, it has to be borne in mind that the main borrowers, the chaebol, were exporters, so that depreciation should not necessarily have had severe balance sheet effects. Furthermore, by contrast with Thailand, the banks also had foreigncurrency-denominated assets close to the value of their liabilities, so that one would expect less of a UFB problem as a result of depreciation. The crisis was set off in October 1997 by contagion from Southeast Asia, primarily affecting the banks, and by a gradual realization of the extent of financial fragility. It had the same characteristics as the Thai crisis. Short-term capital flows sharply reversed. Exchange controls did not prevent non-residents from withdrawing deposits in banks or from demanding repayment of outstanding loans. The exchange rate was reluctantly allowed to float after a familiar and vain attempt to maintain it. The government took over or guaranteed private foreign debts, and, given its low foreign exchange reserves, had to call for rescue by the IMF and (mainly) the United States. The belief during the boom that the government would avoid or counteract crises, and that if there were to be a crisis the government would rescue the chaebol and the banks linked to them, was partially justified. After a delay, justified by the fragility of the banking system, interest rates were raised and a policy of fiscal contraction was pursued. A deep recession in 1998 was followed by partial recovery in 1999. Even now, in 2001, banks and many chaebol have not fully recovered. After one has looked at

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Thailand, all this seems very familiar, although some important details, of course, differ. Let me move on to a country where there were significant differences. Malaysia: Very Different, and Yet Much the Same Malaysia has had a very open capital market, and in the financial world it became famous or notorious during the crisis because its government, after a sharp policy shift, imposed strict controls designed to limit or prevent outflows of short-term capital. I shall review this episode later. Here I am concerned with the lead-up to the crisis. Malaysia is another great success story, with a long period of very high per capita growth (averaging 7.8% from 1987 to 1996) and surprising social and ethnic harmony, given the ethnic divisions (Malay, Chinese, Indian). It had the same kind of euphoria boom as Thailand, but during a long period of capital inflow in the form of FDI it built up an impressive sector exporting manufactured goods. Its high currentaccount deficit from 1990 to 1996 (averaging 7% of GDP) was to a large extent (about 70%) financed by FDI inflows. Malaysia had been on a currency board regime up to 1967, and then, with the establishment of a central bank, switched to a dollar peg. In 1978 it switched to a basket peg. In 1986 the exchange rate became a little more flexible. From 1986 to 1993 there was a 25% real depreciation, which certainly aided the export-oriented industrialization process. The boom reached its peak from 1993 to 1997, and during that period the ringgit (the Malaysian currency) was virtually (though not formally) pegged to the dollar; the result was a real appreciation of about 20%. It follows from my earlier analysis that such a real appreciation goes naturally with a current-account deficit, which in turn was financed by capi-

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tal inflow. If the exchange rate had floated there would also have been real appreciation. In various ways the lead-up to the crisis was much the same as in Thailand, Korea, and Indonesia. An investment boom began in 1993, partly financed by foreign capital and partly by local banks and funds. Stock market prices and real estate values eventually rose sky high, and much of the investment was “connected”—that is, corporate management was not transparent, and political factors influenced investment allocation. But the stock market boom was greater than in any of the other countries. On the eve of the crisis some indicators of vulnerability were much the same as for the other countries: considerable real appreciation, high currentaccount deficits financed by private capital inflow, and (above all) financial fragility, resulting from unwise lending by banks, which led to a high level of non-performing loans. The boom was bound to come to an end; therefore, high short-term capital inflow was bound to turn into outflow, and a real depreciation would be needed. All that is familiar. It is more interesting to look carefully at the particular way in which the Malaysian story differs from the stories of the other Asian crisis countries. Malaysia has a long history of openness to international capital, especially to foreign direct investment (FDI) and portfolio capital. But it has had controls of various kinds, above all foreign exchange regulations that set ceilings on foreign currency borrowing and lending by residents. During the boom the central bank made use of these legal borrowing limits to keep such borrowing by banks within manageable limits. It monitored bank borrowing internationally very closely. At the same time it maintained prudential regulations on foreign borrowing by the corporate sector. The net result was that there was very little accumulation of

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foreign-currency-denominated debt. The Malaysian central bank did exactly what many reformers have recommended that a central bank do in a boom. The low level of accumulation of foreign debt had two implications. First, it meant that Malaysia had no debt crisis. It did not face a situation in which private banks and corporations suddenly found they could not service their international debts and meet their repayment obligations, so that those obligations would have to be taken over, partly or wholly, by the government. Hence Malaysia did not need to call in the IMF when the crisis came. Second, because there was little or no unhedged foreign debt, the crisis devaluation did not create a UFB problem for Malaysia. In discussions of lessons learned from the Asian crisis much emphasis has been placed on the harm done by shortterm international borrowing by local banks, especially unhedged borrowing in foreign currency. The need for strict supervision of banks, or possibly for controls, has been urged. Hence it is worth noting that Malaysia did have such supervision and controls, and thus its banks and corporations did not borrow significantly in foreign currency. Nevertheless, Malaysia still had its crisis. Its banks borrowed domestically, drawing on the ample savings of Malaysians, and ended up in trouble. Malaysia had an old-fashioned boom-and-bust episode; which, as such episodes always do, harmed its banks. The episode had nothing to do directly with exchange rates, though the bust had consequences for the exchange rate. The virtual absence of unhedged debt-creating foreign borrowing did not mean that Malaysia failed to borrow shortterm internationally. The banks incurred a small amount of short-term foreign debt, but this was primarily trade related and was hedged. More important, short-term inflows took

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the form of portfolio flows into the stock market. These were massive and just as volatile as short-term debt-creating funds. The flows contributed to the stock market boom. And their sudden reversal, triggered by contagion from Thailand, set off the crisis. To what extent can the (effectively) FBAR regime from 1993 to 1997—and the earlier long history of considerable exchange rate stability—be blamed, or part-blamed, for the crisis? As I have just noted, capital inflows were not debtcreating. Therefore, the earlier apparent fixed exchange rate commitment, followed by depreciation in the crisis, did not lead to a UFB problem. That was a big difficulty that Malaysia escaped, by contrast with the other Asian crisis countries, especially Indonesia. No doubt the apparent fixed rate commitment did give more confidence to foreign investors and played some role in making the boom excessive. I have discussed this already. But it also contributed to the high rate of FDI, which was surely beneficial for Malaysia and which did not at all contribute to the crisis. The failed attempt to hold the exchange rate for a brief period brought losses to the central bank and no doubt embarrassed the finance minister. But the authorities did not try to hold on for long. If the exchange rate had floated a more modest turn-around might have come somewhat earlier, but during the boom there would still have been real appreciation. On balance, it seems to me that little or no blame can be attached to the FBAR exchange rate regime in this case. Malaysia’s Controversial Capital Controls In 1998 Malaysia was in a deep recession. GDP contracted by 7.5% in that year. In September a radical policy shift was initiated. Capital controls were introduced, designed to slow up

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or stop speculation against the currency and, specifically, to allow interest rates to be reduced. These measures did not affect current account transactions (with the exception of some limits to expenditure on foreign travel), nor did they affect FDI, profit remittances from FDI, or repatriation of capital by foreign firms operating in the country. The controls were designed to eliminate all opportunities for taking speculative positions against the ringgit. Restrictions were imposed on the transfer of capital by residents and on dealings in ringgit with the “offshore” (actually Singapore) market, where much of the speculation against the ringgit had taken place. Most important, the repatriation of portfolio capital held by nonresidents (including interest and dividends earned on such investment) was blocked for twelve months. The ringgit had floated since July, and now it was again pegged to the dollar. The new exchange rate was much depreciated compared with the pre-crisis rate, but it was somewhat appreciated relative to where the market had brought it before the controls were imposed. These measures were not radical by the standards of earlier years in the many countries with exchange controls, or (for example) in India. But they shocked the financial community by their suddenness, coming in a country that had been a favorite of the international capital market and had been exceptionally open. The verbal assaults on financial markets by Prime Minister Mahatir added to the psychological impact. Hence I have described the measures as “controversial.” One might say that they were strong measures, but narrowly focused. They were designed to eliminate shortterm speculation against the ringgit, and to allow the exchange rate to be stabilized while breaking the link between domestic interest rates and foreign interest rates and market expectations.

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Since the imposition of the controls there has been much discussion about their impact. One can distinguish three views. The first view was that the measures made little difference. Capital had already flown out and the ringgit had already depreciated. In the Asian crisis region pressures for capital outflow were coming to an end anyway. The subsequent recovery of the Malaysian economy was much the same as that in Thailand (which also had some controls on capital outflows, but less effective or draconian). It was a case of “locking the stable door after the horse had bolted.” Hence this episode was not really a test of the ability of such controls actually to stem speculation, since speculative pressures had moderated in any case. Nor was it a test of the overall benefits of such controls assuming they did succeed in breaking the link between domestic and foreign interest rates. This is a plausible line of thought, though a detailed analysis by Athukorala (2001) has convinced me that it has weaknesses, as I shall note below. The second view, strongly held by many people in financial markets when the controls were first imposed, was that the controls would be very harmful, especially by discouraging new investment. Furthermore, they would eventually be easily circumvented, while meanwhile they would impose undue costs on investors. The markets did indeed switch to a very unfavorable view of Malaysia at the time, by reducing its credit rating. The expectation was that FDI would be radically reduced, as would eventually inflows of new portfolio investment. The loss of credibility by Malaysia would have long-term adverse effects. Perhaps I exaggerate when I summarize the position of some (I have no ready quotes available) that they saw it as a road to disaster. In fact, it did not turn out that way at all.

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The third view is that the effects were favorable. This view is developed most fully by Athukorala (2001) in a detailed and convincing analysis. There are three main points here: (1) The interest rate differential was indeed reduced and then turned around, and more so than in Thailand. At first domestic interest rates greatly exceeded foreign (US) rates, and by 1999 they were actually less. (2) FDI did not decline, but actually rebounded from the low 1998 level (though by the end of 2000 had not returned to the high pre-crisis level). (3) The insulation of the domestic capital market from the world market (with respect to short-tern flows) allowed Malaysia to engage both in fiscal and in monetary expansion. This ensured a more rapid recovery than in Thailand. The recovery was led by public investment—in effect, by fiscal policy—and was later followed by some rebound of private investment. Such a Keynesian demand expansion would hardly have been compatible with an open capital market, bearing in mind both that markets would have viewed a steeply increasing fiscal deficit very unfavorably, and that rising interest rates could have choked off a private sector recovery. The recovery and the relatively lower interest rates also made the restructuring programs of banks and companies easier. Malaysia made much more progress in this respect than Thailand. The controls provided a breathing space that helped the speedy recapitalization of banks. Controls were not evaded, and they allowed favorable macroeconomic policies to be pursued. There is much more to this story, as to all the stories I have told in this chapter. Inflation stayed low and there was a substantial real depreciation relative to the pre-crisis level, and this greatly stimulated exports, so that an important feature of the recovery was strong export performance. This had little or nothing do with the controls. In early 1999 a crucial part of

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the controls was amended. No longer was a time limit imposed on repatriation of portfolio capital. Rather, a graduated tax on repatriation (an “exit levy”) was imposed, the tax rate declining the longer the funds had been in the country. Hence a very transparent market-based discouragement of capital outflow replaced a quantitative control. Financial markets viewed this change very favorably. Finally, in the management of the controls it also helped that Malaysia had both a disciplined banking system and a competent central bank. Not all countries are so blessed. Capital Controls in China The People’s Republic of China (PRC) is the largest economy in Asia, and one of the largest in the world. But I shall be brief here because of my lack of familiarity with details. The PRC has maintained a fixed by adjustable exchange rate regime. That regime is best described as a low-speculation FBAR—though I must add, not a “zero speculation” one. (All references to China or the People’s Republic of China here and above exclude Hong Kong, which became a Special Administrative Region of China in July 1997 and which is discussed separately below.) Right through the Asian crisis the PRC managed to maintain a fixed rate of the yuan (the Chinese currency) to the dollar. The high level of foreign exchange reserves and the low level of short-term foreign debt (35% of reserves at end 1998) no doubt explain much of this. Controls on outflows were strict, but there was nevertheless evidence of speculation against the currency through illegal transactions and misstatements of import values. Capital controls have, to some extent, been circumvented, though in this case not to an extent to threaten the stability of the currency. The intensified

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enforcement of controls designed to reduce such evasion did apparently affect legitimate activities adversely. Clearly, the long-standing and extensive controls, even though they were partly evaded, did play a role in allowing the exchange rate to stay fixed. In particular, before the crisis controls had discouraged short-term foreign borrowing. Thus, there were two reasons why China managed to maintain its FBAR regime. First, the fundamentals—as reflected both in the low ratio of short-term debt to reserves and in the positive current account balance—reduced the incentive to speculate against the currency. Second, the controls made speculation more difficult. India: Exchange Rate Stability, Capital Controls, and No Crisis India’s exchange rate regime before the Asian crisis was not so different from those of the five Asian crisis countries. Furthermore, many of the “fundamentals” in India were similar, or even worse. But India did not have a crisis. This suggests that one cannot blame the Asian crisis on the exchange rate regimes of the affected countries before the crisis, or even on the “fundamentals.” Yet this may be too simple a conclusion. The crises of the “Asian five” may have been caused by other factors, but the exchange rate regime and the fundamentals may have made it worse. In any case, India provides something of a counterfactual for understanding the Asian crisis. I draw here extensively on the analysis of Indian exchange rate and capital control experience in Joshi 2001. In earlier years India has had, essentially, a fixed-butadjustable exchange rate regime. The regime that was inaugurated in March 1993 was officially described as a “market-determined unified exchange rate,” but when one

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looks at it closely one finds, as in the case of so many other countries, that official descriptions are misleading. There was heavy intervention, and for considerable periods the exchange rate relative to the dollar was quite stable. The regime is best described as an exchange rate pegged or almost pegged to the dollar, with occasional bouts of depreciation. The willingness to adjust the rate quite often was a factor in averting a crisis. Thus, I would describe the regime as an FBAR. Adjustments did not respond primarily to speculative pressures because these were kept in check by capital controls. At the same time the regime was close to a flexible peg, because the fixed rate commitment was informal and not strong. A balance of payments crisis in 1991 was caused by a high fiscal deficit, and this led to a devaluation. Beginning in 1993 capital inflows surged, just as in the Asian crisis countries. About a quarter of the inflows were FDI and the rest portfolio (equity) capital. But—as in the other countries—the nominal exchange rate was not allowed to appreciate. Rather, from March 1993 to mid 1995 the nominal exchange rate was practically fixed and the monetary effects were partially sterilized. During the Asian crisis there was some downward pressure on the rupee and a 10% devaluation. Thus, on the whole, exchange rate policy was quite flexible. India’s FBAR was not as rigid as Thailand’s. But because of the low level of private foreign debt as well as the modest degree of devaluation, these devaluations did not produce UFB problems. On the eve of the Asian crisis, in 1996, India’s fundamentals were not particularly good. Its financial system was still in poor health, and there was plenty of “crony capitalism” and politically influenced lending by the largely state-owned banks. In comparison with the Asian crisis five, India had the highest ratio of fiscal deficit to GDP, the highest rate of inflation, the highest ratio of non-performing assets of commercial

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banks to their total advances, and close to the average ratio of current-account deficit to exports. Because India is a much more closed economy it had a considerably lower ratio of current-account deficit to GDP. Undoubtedly, India’s capital controls played an important role in averting a crisis. This does not mean that controls did not have adverse side effects or that they did not impose administrative costs both on the bureaucracy and private firms. It has to be remembered that until the 1990s India has been a heavily controlled economy, which undoubtedly helped to explain its low growth rate. Controls on international capital movements were just part of the story. Major reforms took place in the 1990s. Restrictions on FDI had been very severe until 1991. Since then there has been considerable liberalization, though restrictions imposed by State governments still make FDI difficult. Foreign portfolio investment began to be liberalized in 1992, and now repatriation of capital, income, and capital gains is freely allowed. The important features are that foreign borrowing by Indian corporations and by banks has been and continues to be severely controlled and that short-term borrowing has been discouraged. Banks are not allowed to accept deposits in foreign currency, and there are strict controls on their foreign asset and liability positions. Capital outflows by residents are strictly prohibited, with some minor exceptions. All these restrictions meant first that India did not accumulate private foreign debt, and second that speculation against the rupee was made more difficult, even though it could and did take place, primarily through leads and lags in current account transactions. Finally, it is worth comparing Malaysia and India in one particular respect. In both cases capital inflows in the form of FDI and portfolio capital had been liberalized. In both cases there had been restrictions on debt-creating short-term

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borrowing, so that inflows of short-term capital took the form primarily of portfolio capital. Neither country suffered from the problems created in Thailand, Korea, and Indonesia by a high ratio of short-term foreign debt to foreign exchange reserves. (In 1996 this ratio was 27% for India, 40% for Malaysia, 97% for Thailand, and 193% for Korea.) Yet Malaysia had a crisis and India did not. The basic explanation seems to be that Malaysia had a stock market boom that was bound to end in a bust, while India did not. Inflows into the Indian stock market had not reached euphoria levels, essentially because liberalization and reforms were more recent in India. The news coming from Malaysia before the crisis had been too good, and not all of it had been based on sound information. In any case, the exchange rate regime played no role in explaining the difference between developments in the two countries. Hong Kong’s Currency Board Regime Hong Kong has had, and has maintained, a completely open capital market. Until Argentina joined the party (leaving aside the special case of the various francophone countries of Africa), it was the only really significant economy to operate a currency board regime after the ending of the various colonial regimes in the 1960s and the 1970s. Hong Kong, then a British colony, had a currency board regime until 1974, when the Hong Kong dollar was floated. In 1983 the present currency board regime was established. The currency is “linked” or fixed to the US dollar and has stayed that way. For some reason it is called the “linked exchange rate system.” There are certain complications, the main one being that some sterilization of the domestic monetary effects of changes in foreign exchange reserves is permitted and has been practiced. The

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currency board can act, and has acted, as lender of last resort to commercial banks, at least up to a modest limit. To that extent Hong Kong has not followed the supposed rules of a “pure” currency board regime. The Asian crisis did reduce the demand for Hong Kong services, and that led to a brief but severe recession. In 1998 GDP fell 5.3%, but by 1999 growth was positive again, at 3%, and in 2000 it was about 10%. Hong Kong had vast foreign exchange reserves, far greater than its base money supply, and, in addition, the system was backed by the even greater reserves of China. Nevertheless, there was speculation against the Hong Kong dollar in the Asian crisis. Thus the regime was not immune to speculation, irrational as it might seem, even though such speculation did not last long. Speculation took the form of a so-called “double play” in which speculators short-sold both Hong Kong dollars and Hong Kong stocks. Because of partial sterilization and lender-of-last resort activities (providing limited liquidity to domestic banks), the interest rate did not normally rise as much as would have resulted from a pure currency board system. An interesting episode was the entry of the government into the stock market in 1998. Sterilization took the form partly of the government buying Hong Kong stocks, so moderating the decline in the stock market by exactly neutralizing the speculators’ “double play.” This was a form of sterilization: Instead of increasing the money supply by buying bonds, stocks were bought. Later they were off-loaded, and the government made a profit. This kind of action was only possible because reserves were high. The system has been a great success. There are three reasons for this. First, the system—and specifically the commitment to a fixed exchange rate—have been very credible, apart from the

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brief Asian crisis episode. This is in spite of the fact that the exchange rate has not actually been fixed by law. This credibility has rested on the high level of reserves, on the length of the period during which the rate has stayed fixed, and on the strong support of the Hong Kong public for the system. The fact that China’s yuan was fixed to the dollar must also have played a role. Second, the pragmatic fiscal, sterilization, and lender-oflast resort policies of the Hong Kong government have moderated recessions. High fiscal surpluses accumulated during good times have allowed it to engage in counter-cyclical fiscal policy during the Asian crisis, thus making its recession quite brief. Third, and most important, the downward flexibility of wages and prices has greatly moderated recessions. During the Asian crisis there was absolute price deflation, and so competitiveness improved, overcoming to some extent the adverse effects of reduced demand from Asian countries. Absolute declines in nominal (and hence real) wages have thus brought about real depreciation even though the nominal exchange rate was fixed. It was even likely to have offset the trade-weighted real appreciation that would otherwise have resulted from the appreciation of the US dollar relative to the yen and other currencies. As I have pointed out in chapter 3 and later, such wage-price flexibility is crucial to the survival of a fixed exchange rate regime in a country subject to asymmetric shocks. The case for a flexible exchange rate regime derived from the Real Targets Approach (chapter 3) is weaker when there is significant downward flexibility of nominal wages. In the case of Hong Kong wage flexibility was not sufficient to avoid recession completely during the Asian crisis, but—together with the policies I have mentioned—it did allow the recession to be brief.

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References As already noted in the references for chapter 10, I have drawn extensively on IMF sources for all the countries. In many cases these have been the basic sources for the facts given here. In particular, Lane et al. 1999 is an informative review by IMF staff members of IMF-supported crisis programs in Indonesia, Korea, and Thailand, and this has provided me with much useful information. There is a vast literature on the Asian crisis. Here I note particularly Fischer 1998, Radelet and Sachs 1998, and Goldstein 1998. An analysis not of the causes of the crisis but of the domestic consequences and of possible policy responses, is in Corden 1999. Thorough descriptions are in many issues of the IMF’s twice-a-year report World Economic Outlook. On Thailand’s crisis and exchange rate experience, see Warr 1999 and especially Rajan 2001. On Indonesia see World Bank 1998, Hill 1999, and many articles in the Bulletin of Indonesian Economic Studies. On Korea, see Smith ed. 2000. Krueger and Yoo (2001) develop the convincing argument that fundamentals made a financial crisis in Korea inevitable and that one cannot really blame the exchange rate regime or the depreciation. On the Malaysian crisis and controls, see Athukorala 2001; on India, see Joshi 2001; on controls in China, India, and Malaysia, see Ariyoshi et al. 2000. I have drawn particularly heavily on the book by Athukorala and the article by Joshi. On Hong Kong’s currency board system and experience, see Fane 2000.

13

Lessons from Europe

The two most important international monetary arrangements since the breakdown of the Bretton Woods regime in 1973 have been the Exchange Rate Mechanism of the European Monetary System, which lasted from 1979 to 1999, and the European Monetary Union (EMU), which was inaugurated in 1999. Indeed the latter has been an epoch-making choice-of-exchange-rate-regime event in Europe, and possibly the world. But I shall be brief here on EMU because it is too early to draw many lessons from it. Its progress, of course, is important not only for its members but also for the rest of the world, both as an example of monetary union and because of its direct influence on the international monetary system. There has been a large literature on whether the EMU countries and possible future members, notably Britain, or a sub-set of them, form an optimum currency area, or at least are closer to an optimum than existing monetary arrangements. The Real Targets Approach (which is implicit in the theory of optimum currency areas) focuses especially on the likelihood of asymmetric shocks for members of a monetary union. The one significant asymmetric shock affecting a member country since the establishment of EMU has been

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the Irish productivity boom. Therefore I shall discuss that in detail here. It may have lessons for other, especially small, members or potential member countries. Lessons from the European Monetary System The Exchange Rate Mechanism (ERM) of the European Monetary System had three stages, and each produced its lessons. The first stage lasted from 1979 to January 1987. Member countries other than Germany essentially committed themselves by mutual agreement to a fixed rate relative to the DM, and then were allowed a margin of fluctuations around that rate—2.25% each way, except for Italy, where it was 6%. The fixed rate was frequently adjusted by small amounts; in that period there were eleven realignments. Thus it was a target zone regime with an FBAR where adjustments were frequent, so that it came close to a combination of a target zone regime and a flexible peg regime. The objective was to avoid extreme exchange rate fluctuations. Thus this regime was motivated explicitly by the Exchange Rate Stability Approach. It was highly successful, with no major crises. There were two primary reasons for this success: First, frequent realignments of the central rate avoided serious crises. The lesson here is that an FBAR that comes close to a flexible peg exchange rate regime can avoid crises. Second, France and Italy (the two countries with significantly higher inflation rates than Germany, where frequent devaluations of the central rates were needed) had capital controls that were not fully effective, but were effective enough to prevent speculative crises. A third, less important, factor, was that quite extensive credits were provided to help countries sustain their exchange rates in the short run in case of speculative

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crises. Primarily such credit came from Germany. The availability of credit, even when it was rarely used, strengthened the credibility of the regime. In my view the crucial feature was the frequency of small realignments, so that the operation of the system made it more like a flexible rate (rather than an FBAR) regime. Perhaps the target zone aspect prevented extreme speculative movements, though the successful attainment of this objective was helped both by capital controls and by the availability of short-term credit. The second stage began after the January 1987 realignment and ended with the famous ERM crisis of September 1992. This was the first of the big FBAR crises of the 1990s. During that period, from January 1987 up to the crisis, there were no more realignments. The central rate was fixed, and in 1990 the size of the band for Italy was reduced to that of the other countries, to 2.25% each way. Now it was clearly an FBARplus-target-zone regime, with a strong commitment to the fixed central rate. Particularly important was the franc fort (strong French franc) policy, designed to discipline French monetary policy and to bring France’s inflation rate down to that of Germany. In 1990 Britain had joined the system with a 6% margin each way. The primary motivation clearly came now from the Nominal Anchor Approach. After a time fundamentals suggested that several exchange rates should be devalued, or, at least that it might be in the interests of governments to engage in monetary expansions which would inevitably lead to devaluations. Over the period the real exchange rates of Italy and Spain had appreciated, even though their inflation rates had fallen. In the cases of France and Britain high unemployment or domestic recessions suggested that governments might wish to make a break with the high-interest-rate policy of the Bundesbank at that time. The latter was a by-product of German fiscal

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deficits caused by German reunification, which was a major asymmetric shock. The ERM system required the monetary policies of all countries to be anchored to those of Germany (subject to exchange rate realignments), and a German asymmetric shock effectively, if not formally, ended the system. The details I need not pursue here. Speaking for myself, I was certainly not surprised that this mini-Bretton Woods system ended in crisis. I was old enough to remember the Bretton Woods crises—both the British crisis of 1967 and the breakdown of the system in 1973. But I was indeed surprised that this period of European exchange rate stability took so long to end. An FBAR that managed to maintain a fixed central rate with narrow margins for over five years was remarkable. This was particularly true because in 1990 French and Italian capital controls had been removed, and Britain had ended its controls in 1979. It was the market’s faith in the fixed central rates as steps toward the establishment of EMU that played a crucial role in the latter part of the period. The loss of that faith as a result of French and Danish referenda contributed to the timing of the crisis. The main lesson is elementary: with high capital mobility, an FBAR is likely to end in crisis. Britain and Italy left the system, Spain devalued within the system, while in 1992 France was able to maintain its central rate thanks to extensive support from the Bundesbank. In 1993 there was a further run on the franc, and this time the Bundesbank was not willing to support it. France did not leave the system, but the margins of the target zone were widened to 15% each way, so that little constraint on exchange rates was now imposed by the system. When speculators seek to move from francs to marks, the exchange rate can always be maintained if the Bundesbank is willing to lend the funds back again to the Banque de France.

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In 1992 it was willing to do so, and in 1993 it was not willing. This makes the general point that the maintenance of an exchange rate is not necessarily limited by the willingness of the “losing” country to raise interest rates, or by the size of its foreign exchange reserves. The central bank of the “gaining” country may be willing to buy the currency of the losing country to a sufficient extent, and thus either to allow its money supply to increase, and its interest rate to fall, or to accept the risks and the losses of sterilized intervention. In the final post-crisis stage of the ERM, when Italy rejoined the system while Britain stayed out, exchange rates were stabilized not by the ERM system but by the commitment of countries to prepare for European Monetary Union—a commitment that required stability of exchange rates for several years. These commitments—implying a willingness to adjust monetary policies appropriately—had credibility in markets because of the strong political commitments to the establishment of EMU. Many economists, including myself, were surprised that there was such a smooth crisis-less transition from this new FBAR system to EMU. The lesson is that the fixed rate period of an FBAR regime can survive if the political commitment is sufficiently strong. This is the lesson also of the survival (so far) of the Argentine currency board regime. European Monetary Union A lengthy transition to monetary union in Europe was initiated by the Maastricht Treaty of 1991, though the process of monetary convergence had already started with the ERM. Interest rates had to converge, exchange rates had to be stabilized, and various preconditions, especially with regard to inflation rates and fiscal deficits, had to be fulfilled by the

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potential members. From a purely economic point of view such a transition process was hardly necessary, as the process of getting to German monetary union has shown. The motive for the slow transition process was primarily to give governments time to decide whether they really wanted to proceed to completion of this radical venture and, above all, to prepare their voters for it. The elaborate convergence process reflected uncertainty, especially on the part of Germany. But the political commitment in all the countries turned out to be strong, which is surely the key prerequisite for the establishment of a monetary union. In January 1999 the exchange rates of the eleven members of “Euroland” were irrevocably locked together and the new European central bank (ECB) was given the responsibility of maintaining the exchange rate parities through intervention. After that, there could be no point in speculating between the various currencies, since the ECB would always be able to recycle funds to an unlimited extent that moved, say, from francs to marks. Three years later the Euro would fully replace the currencies of the member countries. Greece joined in 2001, and other countries, notably the United Kingdom, Sweden, and some ex-socialist (transition) countries, might join later. At the time of writing it is simply too early to draw many lessons from EMU. One has to wait until there is a recession or a major asymmetric shock to see how it works out. So far there has been just one asymmetric shock, namely the Irish boom. Though the Republic of Ireland is a very small economy, I shall analyze this experience in detail because of the broader lessons it might have. Some fuss has been made about the initial depreciation of the Euro relative to the dollar. But one should not be surprised. EMU monetary policy is explicitly committed to a domestic objective—primarily a

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low rate of inflation—while US monetary policy is similarly committed to the domestic objectives of keeping US inflation low and at the same time avoiding or minimizing a recession. Hence the exchange rate between the Euro and the dollar is bound to fluctuate in the light of market conditions. This has been no different from what happened to the DM-dollar relationship since the end of Bretton Woods in 1973. The monetary policies of the dominant economies have been primarily, and usually wholly, committed to domestic objectives, not to stabilizing or influencing exchange rates. I have no doubt that the European Monetary Union will survive, whatever its tribulations. It will be an area of absolute exchange rate stability, with all the conveniences for trade and capital movements that exchange rate stability brings. Hence, whenever there is troublesome exchange rate instability in other parts of the world, people may ask: “ Why not avoid all this and move to a currency board, dollarization, or monetary union?” What is good enough for Europe should be good enough for, say, East Asia. Thus, European experience may have a powerful effect on what happens elsewhere. In this respect it is a very important development for the choice of exchange rate regimes worldwide. Of course, the uniqueness and, above all, the political basis of the European integration process, and the length of time it has taken to get there, should never be forgotten. The Irish Boom: The First Asymmetric Shock The first significant asymmetric shock in the new monetary union was the Irish boom. Beginning in 1993 Ireland’s economy has been transformed. By 1999 employment had grown 40% over 1990. Productivity growth in the manufacturing sector (2.4% annually) was the driving force. It was partly

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caused by, and in part it caused, a remarkable inflow of direct investment, primarily from the United States, mostly or wholly involving the establishment of new enterprises or subsidiaries that produced goods and services for export. Hence the current account was either in surplus or in near balance. The details of the causes of this boom go beyond the main issues I am concerned with here. Ireland has been one of the poorest countries in the European Union (EU), so there was an opportunity for catching up. An open economy, an elastic labor supply, moderate wage inflation ensured by a national wage agreement and by the high mobility of labor between Ireland and Britain, and the availability of a well-educated workforce, were all important. A taxation policy that exempted profits derived from exports from corporation tax, and other rules-based and transparent incentives, may also have played a role, as did the US economic boom and Ireland’s membership of the EU single market. US firms planning to use Ireland as a base for exporting to EU countries were attracted by the prospect of an absolutely fixed exchange rate regime within the EMU. The restoration of fiscal balance in the late 1980s through expenditure cuts rather than tax increases increased investors’ confidence. Finally, Ireland benefited from European Union structural funds that financed infrastructure improvements. It is also worth noting that while the boom began in the late 1980s, it accelerated in 1993, the same year in which there was a 10% nominal devaluation of the Irish currency. Possibly, this also helped. If this is so the interesting implication follows that a nominal devaluation can have significant real effects even in an economy as open as Ireland. One by-product of the Irish boom was inflation. By 1999 the inflation rate was 5%, well above the rate of inflation in

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Euroland as a whole. The net result was that the Irish real exchange rate appreciated by 6% from 1996 to 1999. Such real appreciation happened in spite of the depreciation of the Euro relative to outside countries (notably Britain) beginning in 1999. Real estate prices boomed. The traditional way of toning down a boom—namely a rise in interest rates—was not available to the Irish central bank. Yet the Irish inflation rate has not been anchored to the EMU inflation rate. Here indeed is a asymmetric case that deserves fuller analysis. The Irish episode is an example of the Balassa-Samuelson effect (Balassa 1964). Productivity growth in the tradables sector of the economy has allowed wages to rise in that sector without reducing competitiveness. At the same time it has led to inflation of prices of nontradables, including real estate. Higher wages spread from tradables to nontradables, and increased demand for nontradables was generated by the higher real incomes, the latter caused essentially by employment and productivity growth. Thus there has been inflation of the average domestic price level, and thus real appreciation, but there has not been a loss of competitiveness. If the productivity growth rate slowed down—as it surely will—the rate of inflation would naturally decline, but an absolute decline in real wages would not be needed. High inflation would have been temporary. It would have reflected essentially a relative price adjustment that might not continue but would not need to be reversed. That is an optimistic scenario. In fact, it is quite likely that wage increases as well as real estate prices have overshot, or will overshoot. When productivity growth slows down real wages may then need to fall if unemployment is not to increase. That would happen even if demand for nontradables were given. But, in addition, a fall in real estate prices would lead to a decline in perceived wealth, and thus it

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would reduce the demand for nontradables, which would require a further fall in real wages. There is no rational reason to be concerned about inflation in Ireland. In the past there would have been concerns that fiscal deficits might be monetized, or that a monetary policy would be pursued that was designed to ratify rising wages in order to maintain high employment. But such concerns for Ireland can now be dismissed. After all, monetary policy is no longer in Irish control. Insofar as Irish inflation has simply reflected an appropriate relative price adjustment to relatively higher productivity growth than in the rest of Euroland, it is not a problem. Yet, there is a qualification to such an optimistic view. A belief that exceptionally high growth will continue could lead to inflationary expectations, and hence to increases in wages and in real estate prices that would eventually come up against the slowing down of growth and the fundamental restraints imposed by the monetary policy of the ECB. A recession would then result. A number of lessons can be derived from the Irish episode, an episode that, at the time of writing (2001), was not at an end. First, relatively small peripheral economies in a monetary union cannot expect the union’s monetary policy to take into account their own special circumstances. That is really obvious, and applies also to Portugal, Greece, and various prospective member states, principally the ex-socialist transition countries. Second, those very same countries, having per capita real incomes below the EU average—in some cases greatly so—are likely to go through a productivity catchingup process, just as Ireland did. Hence they will be subject to asymmetric shocks. This catching-up process is highly likely to be helped by membership of the European Union, including participation in EMU. Thus the Irish episode does have lessons for other countries. Third, for the reasons I have dis-

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cussed, such a boom, while it lasts, may present no major macroeconomic problems, and one should not be misled by the temporarily higher inflation rate. But in the downturn unemployment is likely to increase. The issue is then whether the boom (and the associated capital inflow) contains the seeds of a downturn. To avoid overshooting of asset prices and wages during the boom, the government and the European Union can warn the private sector and especially the trade unions of the possibility of a downturn while the boom is still in progress. Apart from that, and relying on downward wage flexibility and high mobility of labor between Ireland and Britain, the only way the government can deal with unemployment caused by a downturn is through functional finance. This is the fourth principal conclusion. Large budget surpluses during the boom may be needed, so that large deficits can be run during the slump. Contrary to this precept, when budget surpluses increase during the boom owing to the automatic stabilizer, the understandable reaction is to increase public spending and reduce taxes. For example, at the time of writing, while the boom was still in progress, the Irish government committed itself to a fiscal expansion (for which it was censured by the European Commission). But—and here I must again introduce a qualification to a simple message— conceivably, the lagged effect of fiscal expansion may come just when the boom ends and the downturn begins. In that case Ireland’s timing will have been admirable. It must be added that the rules of the EMU’s Stability Pact limit the size of budget deficits relative to GDP. Hence the practice of functional finance is constrained. The main rule is that the deficit shall not exceed 3% of GDP in any one year. But there are some loopholes and complications, so perhaps it need not be taken too seriously. Many economists have

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rightly been critical of this German-inspired pact. It certainly goes against the argument advanced in chapter 7 that a fixed exchange rate regime (including monetary union) increases the need for functional finance. If the monetary policy instrument is taken away from individual governments they have all the more need for the fiscal policy instrument. The motive for the Stability Pact was a concern with moral hazard, namely that the European Central Bank might be compelled to bail out directly or indirectly governments that accumulate too much debt. In any case, the limitations set by the pact suggest that, if there is to be an adequate increase in fiscal impulse in a potential recession year, a large budget surplus will have to be run in the previous year. In chapter 7 I noted the need for surpluses in boom years so that deficits in slump years do not lead to excessive increases in public debt over the longer term. The consideration just discussed provides an additional reason for such earlier surpluses. The Outsider: Britain The United Kingdom, like Sweden, has not joined EMU so far for political reasons. Both countries now have managed floating regimes with inflation targeting. Indeed The United Kingdom (Britain, for short) is one of the pioneers of formal inflation targeting as the nominal anchor. When Britain left the ERM after the 1992 crisis and allowed the exchange rate to float, sterling depreciated by about 15% in nominal and real terms. Surprisingly, inflation did not increase. Not surprisingly, there were complaints from France about unfair competition from Britain. Later, especially since 1999, when the Euro depreciated itself relative to the dollar and other currencies, sterling appreciated in real terms on a tradeweighted basis.

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In spite of some problems of real appreciation, one cannot say that real exchange rate fluctuations of sterling so far have been serious enough to discredit Britain’s floating rate regime. In addition, inflation targeting (introduced in 1992) has been a success, helped by the increased independence of the Bank of England. The average British growth rate from 1993 to 1999 has been somewhat higher than the growth rates of the major countries that were on the way to EMU. The growth rates of these countries were probably held back by the tight monetary and fiscal policies required by the Maastricht Treaty. On the basis of experience so far the lesson of the British experience is that a floating exchange rate regime with formal inflation targeting has worked for a major economy. One reason, I believe, is that the economic policies under the Labour government have been stable and cautious, particularly because monetary policy has been depoliticized by the central bank (the Bank of England) having been made independent in the determination of monetary policy. Thus, from the point of view of the Nominal Anchor Approach there is no urgent need for Britain to join the EMU. Let me now raise an interesting analytical issue. What has Britain to gain from an economic point of view from joining EMU? Consider a three-country model with Germany, France, and the United Kingdom. Germany and France form a monetary union. Should Britain join, having previously decided not to form a union with either Germany or France separately? In other words, does the creation of a large monetary union by two major trading partners of Britain strengthen the case for Britain giving up its monetary independence? I leave aside the nominal anchor issue, since that is not a problem for Britain. I also leave aside the much-discussed issue of the likelihood of asymmetric shocks, which

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probably provides an economic argument against Britain joining. The aspect I want to discuss follows from the Exchange Rate Stability Approach. It provides an argument in favor of Britain joining the EMU. I shall call this the “customs union effect of monetary union.” I apply the concepts of the theory of customs unions here. Assurance of exchange rate stability has an effect similar to the removal of tariffs or the reduction of transport costs in the case of trade. Similarly, the elimination of exchange rate risk is essentially like a reduction of impediments to capital movements. When Germany and France form a monetary union both trade and capital movements between Germany and France will increase, there being both a trade creation and a trade diversion effect. If Britain joined the union there would be a further trade creation effect. For Britain these trade creation and trade diversion effects have two implications. First, if Britain is not a member of the union it will suffer from trade diversion away from Britain, which is clearly an adverse effect. Hence a loss will be imposed on Britain, reflected in worse terms of trade. Second, when Germany and France form the union, the potential gains to Britain from joining (compared with forming a union with Germany or France alone) will increase. The gains from trade creation to Britain are likely to be larger, the larger is the economy with which it is integrating. When two economies integrate, the gains from trade creation (relative to GDP) are likely to be greater for the smaller economy than for the larger one, and the bigger the larger economy, the greater the gains for the smaller economy. We have thus an argument in favor of Britain joining the union, both to avoid a loss owing to trade diversion against it and to reap a gain from potential trade creation. But it must be borne in mind that this line of argument assumes that

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absolute exchange rate stability has significant effects on trade and on capital movements. One can also develop an argument of this kind about foreign direct investment coming from a fourth country (the United States) if the intended investment is to provide a base for sales in the three countries. Britain has a greater chance of getting such investment (and the tax revenues and higher employment or wages that go with it) if it is part of a larger trading and monetary area. Firms from the United States and Japan have indeed been aware of this last aspect, and it may explain why Ireland has attracted an exceptionally high proportion of such outside investment relative to Britain. A Few Words on the Transition Countries There are three larger formerly socialist (transition) countries that might eventually join the EMU, namely Hungary, Poland, and the Czech Republic. I have not analyzed their experiences in any detail, nor have I analyzed the implications of these countries having gradually to stabilize their exchange rates relative to the Euro so that they can then join the EMU. This would be a large and most interesting topic on its own. At the time of writing, Hungary had a BBC (band, basket, and crawling peg) regime, the band being 2.25% each way. The basket consisted of 70% Euro (earlier DM) and 30% dollar. Until 1999 Poland had a similar regime, but with a wider band (7% each way), and it switched to managed floating with inflation targeting that year. This replicates the Chilean story. The Czech Republic had an FBAR regime that ended in a typical FBAR crisis in 1997, when it also switched to managed floating with inflation targeting. This replicates the Mexican and Brazilian stories.

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German Monetary Union: The Choice of Initial Parity Finally, let me turn to German monetary union, which was established nine years before EMU. The decision to bring about a monetary union between the former East Germany and the Federal Republic of Germany was made at the end of 1989, not long after the fall of the Berlin Wall. The union was actually established in July 1990. Thus, there was no lengthy “convergence” process. As common sense might suggest, the key locking-in of exchange rates can be done very quickly if there is a genuine will to achieve monetary union. Chancellor Kohl had the will. That is the first lesson. The question now is whether a further lesson is to be derived from the choice of initial exchange rate parity. The parity he decided upon (against the advice of the Bundesbank) was one ostmark to one deutschmark. In terms of initial purchasing power parity this represented a big appreciation of the ostmark. The implications of a country entering a union with such an appreciated exchange rate are worth looking at carefully, and are also relevant for countries choosing to dollarize (or Euro-ize). First, the real value of assets originally denominated in ostmarks went up steeply. This was a big bonus for the citizens of Eastern Germany who held cash and bank deposits in ostmarks. No doubt there was also a political bonus in terms of votes in the East for Kohl’s party. On the other hand, public enterprises that had debts denominated in ostmarks were losers, which added to their later burdens of transition. The second aspect is more interesting. It has often been said that the prolonged high unemployment in East Germany after reunification was caused by the choice of initial exchange rate parity. One would naturally expect the transition process to cause high structural unemployment in

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the short run, as it has in most or all transition countries, but the argument has been that the choice of initial parity added to the problem. I believe that, in the particular case of German Monetary Union, this view is not correct. The argument assumes that nominal wages are rigid (or sluggish) both downward and upward, so that real wages rose—and so unemployment increased—as a result of the initial nominal appreciation. In my view, the effects of the choice of nominal exchange rate parity were overridden by trade union integration—the expansion of the authority of the west German trade unions over the whole of the area of the new German monetary union. Germany has a centralized wage determination system and centralized trade unions. After reunification the unions quickly spread their tentacles into East Germany and managed to raise eastern wages closer to western ones. Hence real wages in the east rose further. This wage adjustment can be attributed both to political union—so that East and West were now one nation with inevitably one labor market system—and to monetary union itself, which made East-West wage comparisons easier. If the initial nominal parity had been different, the final outcome would not have differed. Finally, real wages determined by the forces of trade union integration would have been the same. With an initial parity of, say, two ostmarks to one deutschmark, nominal wages after reunification would simply have risen much more. Centralized wage determination, whether through legislation or through the operation of nation-wide trade unions, is a well-accepted explanation for excessive unemployment in low-productivity or depressed regions of countries, for example, the Italian mezzogiorno. To an extent, the provinces of the former East Germany became the mezzogiorno of the new united Germany. The lesson is that, whatever the other

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benefits of monetary union, and irrespective of the choice of initial parity, when monetary union gives rise to trade union integration or legislated centralized wage determination (for example, through the imposition of a uniform minimum wage), it may lead to increased unemployment. References The literature on the European Monetary System and European Monetary Union is vast. For basic facts, a survey of the issues, and further references, see de Grauwe 2000 and chapter 3 of Solomon 1999. Extensive empirical analysis of the extent to which Euroland (the EMU area) is an optimal currency area, or close to it, is in Eichengreen 1997. The papers in that book are particularly interesting in comparing Euroland with the United States. On the crisis of the Exchange Rate Mechanism of the European Monetary System specifically, see Eichengreen 1997, chapter 7. Masson (2000) discusses possible exchange rate regimes for the more advanced European ex-socialist (transition) economies during their transition to EMU. On Ireland, see OECD 1999 and Walsh 2000, both of which discuss thoroughly the causes of the Irish productivity boom.

14

The Exchange Rate Regime: Too Sensational, Hollowed Out, Unimportant

Too Sensational? Recent history seems to justify the conclusion that the FBAR in an environment of high capital mobility should be completely ruled out. There have been too many FBAR crises in the 1990s, beginning with the crisis of the Exchange Rate Mechanism in 1992. When I refer to the FBAR here I include its inflationfighting version, namely the active crawling peg, a key ingredient in exchange-rate-based stabilization programs. This conclusion—which is now fashionable—will have to be qualified, but let me summarize what the costs of crises consist of. First there are the costs of the losing battles that central banks fight against speculators by trying to sustain an eventually unsustainable exchange rate through foreign exchange intervention. A central bank sells foreign currency when it is cheap and later buys it back when it is dear. When the speculators eventually win, losses will have been incurred by central banks, sometimes very high ones. This is a redistribution from the public to the private sector. I have sometimes told my students that when the philanthropist-financier George Soros made large profits at the expense of the Bank of England as a result of the ERM crisis it happened to be a

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favorable redistribution of income. Mr. Soros used his wealth in very valuable ways (mainly to foster “open societies” in Eastern Europe and the former Soviet Union), while the British government would probably use its tax revenues less fruitfully. But that was an unusual case. Second, there are the costs imposed by the temporary increase in domestic interest rates that is another line of defense against speculators. These interest rate increases hurt the financial system, the public finances, and aggregate demand. Third, there are the costs imposed on the private sector by unexpected or jerky devaluations. They are the costs incurred by the losers, notably wage earners in nontradable-producing sectors, and industries using imported inputs. Notably, they include the costs of UFB (unhedged foreign-currencydenominated borrowing). Since such devaluations should not be completely unexpected, in the latter case these are really the costs of gambling when the gamble turns out to yield a bad outcome. Finally, and most important, there is the damage done to the political system and, more specifically, to the government and especially the finance minister, when the official authorities dramatically fail to achieve something—the maintenance of an exchange rate or a crawling peg tablita—that they have promised to achieve. There is a serious loss of credibility. A vivid impression of this effect can be obtained from the memoirs of John Major, prime minister of Britain at the time of the ERM crisis (Major 1999, chapter 14). In his view, his government never recovered from that crisis. That can be said about many governments. Not long after the ERM crisis I wrote: “The nominal anchor policy (I referred to the FBAR here) cannot be recommended to a finance minister who is riskaverse.” (Corden 1994, p. 84) These crises are too sensational.

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Frankel (1999) has put the view that there are always trade-offs and hence “interior solutions.” It is not normal in economics to argue that one must go to extremes. Hence why should the FBAR regime be completely ruled out? The question is a good one. The costs of crises that I have just outlined have to be very high to outweigh the undoubted benefits of the FBAR. The FBAR has some of the advantages of the absolutely-fixed exchange rate regime (following from the Nominal Anchor Approach and the Exchange Rate Stability Approach), and some of the advantages of the flexible exchange rate regime (following from the Real Targets Approach). Thus the low-speculation FBAR can be a nice compromise. With a high-speculation FBAR, one must balance the benefits from a regime that may serve for several years as an effective nominal anchor and as an exchange rate stabilizer against the high costs of occasional crises. If adjustments with an FBAR are very rare, as during the Bretton Woods regime, the outcome approaches the absolutely-fixed end, and if they are fairly frequent, as during the early ERM regime, it approaches the flexible rate end. In fact, it may actually be a flexible peg regime. Crises will be rare when adjustments are frequent. One might then conclude that an FBAR with frequent adjustments should not be ruled out. This is another way of saying that a flexible peg regime is acceptable while a “true” FBAR, where the exchange rate commitment is strong because the exchange rate is meant to serve as genuine nominal anchor, is not acceptable. What do the case studies in the preceding chapters tell us on this matter? My case studies mostly consist of countries that have had FBAR regimes and (excepting China and India) have experienced crises. Thus there may be selection bias here. In the case of several of the Asian crisis countries,

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notably Indonesia and Malaysia, and possibly also Korea, I have argued that the explicit or implicit FBAR regime was not a significant cause of their crises. This is contrary to a common view. The importance of the exchange rate regime in causing a crisis has often been overrated. But it is also true that all the crisis countries inevitably had to give up their FBAR regimes, and allow their exchange rates to float, as a result of their crises. Thus the FBAR regime may not have been the primary cause, or even any cause at all, of the crisis, but the regime was not sustainable. In addition, the initial FBAR regimes in Thailand and especially Indonesia contributed to the UFB problem when the crises came, and so made the crises worse. The attempt in some cases (notably Mexico, Thailand, and Korea) to sustain the fixed exchange rate too long imposed temporary but significant costs of the type I outlined above. This might also be said of the 1992 ERM crisis. Finally, it is worth bearing in mind that the ERM experience up to 1987 suggests that it is possible to sustain an FBAR regime provided adjustments are frequent. I discussed exchange-rate-based stabilization programs in chapter 10. A key ingredient in these programs was the use of an active crawling peg regime with a tablita that inevitably led to real appreciation. Such a regime is essentially a special case of an FBAR. In all the cases I have discussed, these programs ended in crisis. On the other hand, they did achieve their inflation-reducing objective. This has also been true of the Argentine case. The question then arises whether timely exits—in time to avoid crises—would have been possible. It is a theme of this book that there are always trade-offs involved. I share this view with Frankel (1999). But, on balance, it seems to me that “true” FBARs (as distinct from flexible peg regimes) involving a strong exchange rate commitment, and thus involving reluctant adjustment, are discredited by

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experience when there is high capital mobility. The costs, especially the “too sensational” political-credibility costs of crises, are just too high. India and China managed to sustain such regimes (formal in the case of China, informal in the case of India) because of effective capital controls. But the qualifications should be noted. The more their financial systems develop and open up, the more their trade is liberalized, and the more multinationals play a role in trade, the more difficult it will be for controls to sustain an FBAR regime. Hollowed Out? Suppose we grant that, in general, high-speculation FBARs should be ruled out. Is nothing then left other than the two extremes of absolutely-fixed or currency board regime on the one side and pure floating on the other? Obviously not. Those regimes that have a strong FBAR content would be ruled out. These include active crawling peg regimes that have been central elements in exchange-rate-based stabilization programs in Argentina, Brazil, Chile, Mexico, Turkey, and elsewhere. Narrow target zone regimes would also be ruled out. I mean here those regimes where the two limits to the band are meant to represent true commitments, where the central rate is an FBAR rate, and where the band is sufficiently narrow to represent a significant constraint on policy. One might even rule out currency boards, unless the exchange rate and associated monetary policy commitments are, in some sense, absolute. Otherwise a currency board regime turns out to be much like an FBAR. But other regimes remain, notably low-speculation FBARs, flexible peg regimes, and managed floating. With flexible pegs there is frequent adjustment of the exchange rate in response both to changing fundamentals

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and to market forces. Managed floating allows maximum flexibility to the authorities. It allows for sporadic intervention in the foreign exchange market, and also (like pure floating) for the opportunity to target monetary policy at times on the exchange rate, but without making an explicit exchange rate commitment. Managed floating is the pragmatic regime. Like pure floating it cannot fulfill the role of a nominal anchor. In that respect it must be supplemented by some kind of monetary policy commitment, the currently most acceptable one being inflation targeting. But the requirements of the Real Targets Approach must also be taken into account. Inflation targeting should only be the medium-term objective. All this follows naturally from discussion in earlier chapters and is hardly a dramatic conclusion. If one thought of the high-speculation FBAR as being the only possible regime in the middle, and of the absolutely-fixed (or currency board) regime as being at one end, while pure-floating is at the other end, with nothing else available, then one could reasonably agree with the rather extreme view. This view has been described as the “hollowing-out” of the middle, the “bipolar” view, or the “vanishing intermediate regime.” But, of course, there are other possible regimes, notably the low-speculation FBAR, the flexible peg, and managed floating. Does the Exchange Rate Regime Really Matter? Does the exchange rate regime really matter? The question or issue has appeared at various places in this book, notably in the discussion of fiscal policy and in several of the case studies. So, let me summarize the answer. A repeated theme of this book and of the lessons of the case studies is that the exchange rate regime matters very much when there is a negative shock. Provided the shock is

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not expected to be very temporary, real depreciation will be required to maintain or restore aggregate output and employment—that is, “internal balance.” Monetary policy, or automatic monetary mechanisms, can maintain or achieve external balance, but cannot necessarily maintain “internal balance” at the same time. The ending of a boom is an example of a negative shock, though not the only example. Thus, while the causes of a crisis may not be greatly influenced (and indeed may not be influenced at all) by the exchange rate regime prevailing during the boom, the depth and the duration of the crisis may be heavily influenced by the regime that prevails once the boom ends. A recession will be briefer if the nominal exchange rate can depreciate, bringing about real depreciation, and thus—after a lag—increasing exports and reducing imports. The importance of this effect depends upon the answer to an empirical question: To what extent do nominal devaluations or depreciations have real effects that are lasting for some years? The answer, in my view, is that they do have such effects for large and mediumsized economies, except, in the past, for some Latin American countries caught in a high-inflation trap. Leaving high inflation aside, the empirical evidence seems to be overwhelming. It is for this reason that I have put so much emphasis on the Real Targets Approach, an approach that is based on essentially Keynesian assumptions. Whether changes in the nominal exchange rate have significant real effects is in doubt, and hence important, only for relatively small or very open economies, including possible future members of EMU, where a switch to an absolutelyfixed (or currency board) regime is a serious option. To what extent do the assumptions of the Real Targets Approach apply to such countries? Here more empirical research examining past devaluation experiences is needed. In fact, I am

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surprised that more has not been done. In terms of the analysis of chapter 9, how small is small? Are any generalizations possible? The exchange rate regime also matters in so far as an FBAR creates an unhedged foreign-currency-denominated borrowing (UFB) problem. This was evident in the Asian crisis. An FBAR regime existing during the boom may create a UFB problem when the boom ends and the exchange rate depreciates. The UFB problem does not cause the crisis but, once the exchange rate depreciates, it makes the recession worse. The exchange rate regime matters only a little during a boom in capital inflow, the period that lays the foundations for a later crisis. This contrasts with the importance of the regime when there is a negative shock. I refer here to my counterfactual stories in the cases of Mexico and Thailand, and to the discussion of the Irish boom. Inevitably, when there is a boom, there will be real appreciation irrespective of whether the exchange rate is fixed or flexible. I have elaborated on this at length in my exposition of counterfactuals. There is little reason why a boom that is based on, or at least ends, in euphoria should not go on its merry way under a currency board or a floating rate regime, as much as under an FBAR. For avoiding the adverse effects of a boom, exchange controls or taxes that discourage excessive short-term borrowing matter. Adequate supervision of banks matters, corporate governance, the degree of connected lending by domestic banks, and the efficiency of the use of available information (or caution if information is not available) by foreign lenders all matter. In addition, the accumulation of foreign exchange reserves is helpful. The exchange rate regime matters less. To say that the exchange rate matters only a little during a boom does not mean that it does not matter at all. In the case

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of a boom in capital inflow, a floating exchange rate regime is likely to lead to rapid nominal and real appreciation, with the usual Dutch Disease effects. By contrast, under an FBAR or an absolutely-fixed exchange rate regime, where domestic prices rise gradually as the money supply expands, real appreciation will be slower to develop. With a managed floating regime or an FBAR real appreciation can be moderated when the central bank intervenes in the foreign exchange market, and at the same time sterilizes, at least partially, the domestic monetary effects of such intervention by the sale of domestic bonds. This is the policy package many developing countries pursued during the emerging markets capital inflow boom of the 1990s. The limits are set by the costs of sterilization. The exchange rate regime also matters only a little when fiscal policy is out of control. There will be trouble under any exchange rate regime. With a floating or a flexible regime, when the deficits are monetized out-of-control fiscal policy will manifest itself in inflation. Under an FBAR (including an active crawling peg regime) it will manifest itself as periodic currency crises, as has been shown by many episodes in Latin America and, most recently (2001), in Turkey. Under a currency board regime it will show itself as a debt (default risk) crisis, as recently occurred in Argentina. In all cases, it is no good blaming the exchange rate regime, whether floating, FBAR, or fixed, when the source of the trouble is to be found in excessive fiscal deficits. A closely related issue is whether one exchange rate regime would be more successful than another in turning out-of-control fiscal policy into under-control fiscal policy. Some might argue that only crises lead to the necessary reforms. If this view were correct, the FBAR, the currency board regime, or the absolutely-fixed exchange rate regime

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should all be preferred to the floating rate inflationary regime. I have reservations about this. Fiscal reforms must be faced up to directly. Fiscal policy must be straightened out first, before the exchange rate is fixed (whether FBAR-style with an active crawling peg, or absolutely). The Unhedged Foreign Borrowing Problem Once Again I have paid much attention to the unhedged foreigncurrency-denominated borrowing (UFB) problem. It intensified the crises in all the Asian crisis countries, except Malaysia, but especially in Indonesia, as well as in Mexico. It made depreciations contractionary. It was directly caused by the invitation to gamble that FBARs generate. One might conclude that if FBARs were to go out of fashion this problem would also disappear. Indeed, it might disappear even if an FBAR were restored, since borrowers would have learned some lessons from the Asian crisis experiences; in the future they would hedge their borrowing. It obviously will disappear if a country joins the EMU or moves to a lasting currency board regime. It will not disappear if a currency board regime eventually breaks down. If a country moves to a flexible or a floating exchange rate regime, the need to hedge will become apparent quickly. Insofar as borrowers in developing countries are unable to hedge internationally because the market either regards the scale of possible trades as too low (so that the market is “thin”) or regards the risks as too great, borrowing will become more risky and will be discouraged. Alternatively, hedging services may be available but, for the same reason, may be very expensive. Again, borrowing will be discouraged. If the capital market attaches a high price to a particular service, either because of a lack of scale and liquidity or

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because of a perception of high risk, it is quite appropriate that use of that service be reduced. It is a simple demandand-supply story. With regard to short-term borrowing, at least, such discouragement of borrowing should be welcomed, since we have seen how volatile and troublesome it can be. Even here, though, one must exempt trade-related short-term flows. What Regime Choice for Different Countries? I shall now sum up by considering the regime choices for five categories of countries. These categories are the Big Three, the potential candidates for absolutely-fixed or currency board regimes, the high-inflation countries, the candidates for low-speculation FBARs, and the rest. Let me begin with the Big Three, namely the United States, Euroland, and Japan. They have floating exchange rates with a limited degree of intervention, sometimes coordinated, and with monetary policy not focused much, if at all, on exchange rate stability. As a result interest rates are much more stable than exchange rates. Monetary policy is determined by domestic considerations—maintaining low inflation and, if possible, avoiding deep recessions. This is not likely to change. I have written elsewhere, as have many others, that various schemes for establishing a coordinated monetary policy, or for agreeing explicitly on target zones, are highly unlikely to be adopted and are not necessarily desirable. So, let me move on. I come now to all those countries where the possibility of establishing a currency board, dollarizing (or Euro-izing), or of joining the EMU, has to be considered. This category includes potentially many small and some medium-size countries in the developing world. It includes, above all,

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small open economies and countries with records of very high inflation. It also includes all those countries, whether large or small, which are possible or likely new members of EMU —notably Britain, but also (among others) the Czech Republic, Denmark, Hungary, Norway, Poland, and Sweden. Here the possibility arises of making a fateful regime choice that is meant to be long term, or even permanent. If it were to become apparent that a currency board was not meant to be long term, then crucial credibility benefits would be forgone. Interest rates would not fall and nominal wage increases would not be moderated. In all these cases exiting the regime would be very painful. For these countries all the issues discussed in this book are very important. In all these cases the central question is: What is lost by permanently forgoing the exchange rate or monetary policy as a policy instrument? It is not sensible to make any general statements about the economic gains and losses. For each country a separate analysis must be made. But I hope that the theoretical chapters in this book can help to provide a framework. Next, there are the countries with very high inflation, usually attributable to out-of-control monetized fiscal deficits. Here there is a history of exchange-rate-based stabilization programs, notably in Argentina, Brazil, Chile, and Mexico. Some of these programs have failed because an active crawling peg regime (which makes a program “exchange-ratebased”) was not supported by appropriate fiscal reform. The outstanding example was the Argentine program of 1978–1980. Others have succeeded and reduced inflation rates drastically. This was true of the programs I have referred to in chapter 10. The Argentine Convertibility Plan was, of course, dramatically successful in this respect. The most recent Turkish program also succeeded in reducing the inflation rate. But all of them ended in crisis with the excep-

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tion of the Argentine regime, which at the time of this writing was indeed subject to a crisis but had not actually ended. Looking back, and assessing these programs, one must tradeoff the successful reduction of inflation against the costs of the eventual FBAR crisis. An immediate but naive conclusion might be that a country should not get into a high-inflation situation to begin with. I am sure that this is the advice the IMF readily gives. And it may be that for some years lessons will have been learned, so that few countries will enter this high-inflation category. Nevertheless, for this kind of case, two questions arise. First, why must an inflation-reducing stabilization program be based on the exchange rate? Why not go directly to fiscal policy reforms and to an inflation-targeting monetary policy? I have discussed the possible answer earlier: An active crawling peg (which is a version of an FBAR) provides some discipline and some credibility, more than inflation targeting is likely to. Nevertheless, the costs of crises are very high, especially in political terms, so that it should be considered whether the combination of an independent central bank and firm inflation targeting could not do the job. The second question is whether an early exit from the regime is possible—an exit that would take place once inflation had been significantly reduced and before anticipatory speculation forced it. I have discussed this at length in the Brazilian case study. The Turkish program, which crashed in 2001, actually contained an exit plan, but it is not surprising that speculators doubted that the associated fiscal and other reforms would take place, and anticipated the exit. Perhaps the Turkish program was the last exchange-rate-based stabilization program. Next I come to those countries that choose and are able to maintain strict, effective exchange controls, or that are not significantly integrated in the world capital market for other

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reasons. Thus they can still choose FBARs without great concern about a speculation problem. These are the lowspeculation FBAR cases. I assume here that they have rejected the currency board, dollarization, and EMU alternatives. China is currently the most important example here. Many developing countries may still come into this category, but the number is likely to decline. Normally such countries would fix to the dollar or the Euro, but in some cases, mainly in Asia, they might fix to a basket that also includes the yen. I now turn to the rest. This group consists of the emerging market countries and all the advanced economies other than the Big Three and the actual EMU members. My first reaction is simply to suggest “pragmatism” and to call it “managed floating.” That is actually the current situation. FBARs, with strong exchange rate commitments, should be avoided. A combination of direct intervention in the foreign exchange market and interest rate management may actually keep the exchange rate quite stable, though not absolutely rigid, for varying periods, and there may be implicit target zones, but there are not explicit exchange rate commitments. The absence of such a commitment is crucial. Monetary policy may be based on an explicit inflation-targeting framework, as in the case of a growing number of countries and as in the case of the EMU. Alternatively, it may involve an informal trade-off between avoiding recessions and avoiding longerrun increases in inflation, using all sorts of explicit or implicit criteria, as in the case of the United States. An alternative for some emerging market countries is to try flexible pegs, sliding into FBARs, backed up with some exchange and banking controls (preferably market-based), applied only intermittently, the aim being to avoid largescale short-term capital inflows of the kind that created the Asian crisis. In addition, outflow controls during major crises

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should not be ruled out ideologically, though their general effectiveness and their applicability to many countries are, in my view, still open to question. References The locus classicus for the “hollowing out of the middle ground” is Eichengreen 1994. But a careful reading of this book shows that Eichengreen did not rule out managed floating. The ruled-out middle ground consisted of the FBAR and regimes close to it, notably active crawling pegs and narrow target zone regimes. Ostfeld and Rogoff 1995 is the other influential reference with the basic anti-FBAR message. A pragmatic approach is in the IMF staff review of the issues by Mussa et al. (2000). Stanley Fischer, Deputy Managing Director of the IMF at the time, seemed, in various speeches, to be subscribing to the extreme “bipolar” view, but in Fischer 2001 he writes that “proponents of what is now known as the bipolar view—myself included—probably have exaggerated their point for dramatic effect. . . . a wide variety of flexible rate arrangements are possible.” Edwards (2000) concludes that “the IMF should actively encourage countries to adopt either a floating system or a super fixed one,” but he probably defines “floating” in the broad flexible rate sense, much as Fischer does. Frankel (1999) argues strongly against the extreme view, writing that “The rejection of the middle ground is explained simply as a rejection of where most countries have been, with no reasonable expectation that the dreamed-of sanctuaries, monetary union or free floating, will be any better.” He does not rule out high-speculation (high-capitalmobility) FBARs.

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John Williamson—long an advocate of the crawling peg and the target zone—likes intermediate options for developing countries, and in Williamson 2000 has an extensive review of the implications of various intermediate regimes. For some developing countries he particularly favors a “BBC” regime, namely a very wide band (target zone), a basket (multi-currency central rate), and a rate of crawl for the pegged central rate.

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Index

Absolutely-fixed regime, 21–23, 28, 37, 57–58, 63, 106, 129, 169, 175 Adjustable peg regime, 41 Anchor currency, 4 Appreciation, real, 102–105, 118 Argentina, 2, 17, 23, 65–66, 108–111, 140–141, 147, 179–193, 256–257 Asia, 97, 98, 117, 122–131, 195, 219, 247–248, 252 Balance, external, 44, 251 Balassa-Samuelson effect, 235 Banks, central, 31, 48, 72, 183–185, 232, 238 Band, basket, crawling peg (BBC), 241 Barro-Ricardo complication, 100–101 Bimetallic standard, 11 Bonds, domestic, 56, 25 Borrowing foreign, 128, 130, 160 short-term, 222–223, 254 unhedged foreign-currencydenominated, 117, 122, 125–131, 163, 166, 192, 198–199, 254–257 Bretton Woods regime, 9, 12–15, 41, 43, 46, 51, 147, 227, 230

Calvo-Hausmann argument, 129–131 Canada, 25–26 Capital long-term flow of, 42 mobility of, 3, 15, 36–38, 42, 47, 55, 230 Chaebol, 211 Chile, 111, 155–161 China, 143, 219–220, 258 Communauté Financière Africaine zone, 65, 112 Consolidation, fiscal, 110–111 Crawling peg regimes, 24, 74–76, 111 active, 2, 64, 74–76, 109–110, 156–158, 162, 171, 245, 246, 248, 257 passive, 74–76, 110, 158, 173 Credit, short-term, 229 Currency areas feasible, 135–137, 141–143 optimum 92, 133–134, 227, 244 Currency board regimes, 2, 15, 23, 62–68, 112, 129, 134, 136, 168–171, 179, 190–193, 208–209, 212, 223–225, 249 Customs union, 240–241 Czech Republic, 241

272

Deficits budget, 110, 112, 156 current-account, 159, 162, 168, 172, 205, 222 fiscal, 106–112, 164, 166, 171–172, 180, 182, 184, 253 Deflation, 10–11 Depreciation, nominal, 136 Deutsche Mark, 15, 56, 61, 72, 157, 233 Devaluation, 44–45, 48, 107, 113, 117–131, 136, 146, 169 Developing countries, 3, 43–44 crises in, 18 liberalization and, 146, 148 regime choice in, 255–256 Diaz-Alejandro, Carlos, 118, 121 Dollar, 4, 24, 29, 78 Dollarization, 22, 62, 67, 117, 129, 169–170, 188–190, 212, 223 Dominance, fiscal, 109 Dutch disease, 97, 102–106, 159, 253 East Germany, 73, 243 Emerging markets, 18, 258 Euro, 4, 5, 24, 233, 238 European Monetary System, 9, 15–16, 51, 70, 148, 227–231, 245, 246 European Monetary Union, 4–5, 15–17, 34, 61, 135, 141, 144, 227, 231–233, 236–241, 244, 248, 256 European Union, 143–145 Exchange-Rate-Based Stabilization Program, 162, 172, 182, 256 Exchange rates floating, 15, 34, 110 nominal, 84, 251 real, 83 Exchange Rate Stability Approach, 1, 21, 29–32, 36–38, 70, 135–138, 147–152, 228, 229, 239–240 Federal Reserve Board, European, 31 Fiscal policy, 95–114, 184–185, 254

Index

Fixed-but-adjustable regime (FBAR), 1–4, 41–58, 108–113, 129–131, 155–177, 195–238, 241, 245–249, 252–259 Fixed exchange rate regime, 98, 105, 133–134, 142, 144 Flexible exchange rate regime, 96, 104–105, 108, 133, 174 Flexible peg regime, 68–69, 249–250 Floating rate regimes, 15, 18, 29, 30, 33, 37, 61, 67, 105–106, 112, 129–131, 148, 157, 164, 239 Foreign direct investment, 212–215, 218, 222 Foreign exchange reserves, 23, 47–50, 113, 252 Franc fort policy, 229 Functional finance, 2–3, 97–106, 125, 158, 186–187 German Monetary Union, 242–244 Gold standard, 9–14, 65, 163 Hedging, endogenous, 130–131 Hong Kong, 2, 66, 223–225 In-between regimes, 22 India, 220–223 Indonesia, 29, 204–209, 248 Inflation, 10–11, 25–26, 32–34, 45, 157, 170, 173, 176, 191, 238–241, 257 Informal regime, 78 Instability, fiscal, 106–108 Integration, monetary, 16, 149–152, 251 Interest rates, 47, 54 International Monetary Fund, 6, 18, 26, 57, 164, 166, 211 Intervention foreign-exchange, 55 non-sterilized, 52–56 sterilized, 52–56, 163, 253

Index

Investment, 101 Ireland, 228, 232–238 Jamaica Agreement, 15 Japan, 4–5, 148, 197, 255 Keynes, John Maynard, 13 Korea, 124, 126, 209–212, 248 Labor, international mobility of, 92 Large economies, 139–143, 255–256 Lender of last resort, 184, 225 Maastricht Treaty, 17, 231, 239 Malaysia, 212–219, 248 Managed floating regime, 22, 61–63, 69–70, 78–80, 238, 250, 253 Menem, Carlos, 180 Mexico, 161–171 Misalignments, 72 Monetarism, 17–18 Monetary union, 22, 129, 139, 240 Money supply stabilization of, 54 sterilization of, 53 Netherlands, 143 New Zealand, 25–26 Nominal Anchor Approach, 1, 13, 21–26, 32–34, 67, 111, 134–135, 156–159, 229, 239 Nontradables, 102, 137 North American Free Trade Agreement, 162 Ostmark, 242 Pegged rate regime, 61–63, 76–79 Pegging, 76–77 Pegs, 63 Philippines, 195 Pinochet Ugarte, Carlos, 156

273

Polar exchange rate regimes, 56–57 Portfolio balance model, 3, 54 Pure floating regime, 1, 21, 23, 25, 27, 44, 56 Real Targets Approach, 1, 21, 26–28, 31–36, 57, 83–93, 135, 137, 159, 191, 227 Recession, 117, 118, 156, 225, 251 Regime choice, 9, 255–258 Russia, 109 Seigniorage, 67, 189 Shocks asymmetric, 133, 138–145, 170, 174, 179, 227–230 negative, 85–86, 92, 93, 97–101, 104, 117, 137, 186, 250–252 positive, 102–104 Silver standard, 10, 11 Small economies, 4, 133, 136, 141–143, 255–256 Soros, George, 245–246 Southern Cone, 17 Speculation, 37, 48–51 Stability, 48 Stabilization, 157, 171, 182, 257 Sterilization, 159, 224 Superior judgment hypothesis, 72 Surplus, fiscal, 99 Tablita, 64, 74, 76, 246, 248 Target zone (band) regime, 22, 62, 63, 70–74, 157, 159 Thailand, 124, 126, 196–208, 248 Tradable and nontradable sectors, 102 Trade, 144–152 Transition countries, 17–19 United Kingdom, 10–12, 25, 26, 34, 238–239, 246 United States, 4–5, 11, 255

274

Unremunerated Deposit Requirement, 160–163 Vanishing intermediate regime, 250 Wages, 27–28, 92, 225, 243 nominal, 28, 136 real, 28, 136, 171 Yen, 15, 29, 56, 72

Index