5 Conclusions

Fixed exchange rates exhibit no signs of disappearing. Despite all their potential benefits, however, history shows another persistent feature—the recurrent crises that mark the collapse of fixed regimes.

In this chapter, we studied two kinds of crises. Adverse fiscal conditions can send the money supply out of control. And changes in the real economy can weaken the commitment to a peg. Expectations matter in each case—shifts in investor sentiment can make the crises occur “sooner” (i.e., when economic fundamentals are better), leading to worries that some crises are an unnecessary and undeserved punishment.

Can We Prevent Crises?

With these insights, we can now confront the major policy problem: How can these crises be prevented? A number of solutions have been proposed that merit mention:

After what happened in 1997, some Asian countries may not turn to the IMF again—and with their reserve accumulation, they may not need to.

AP Photo/Hun Jai-hyaung

• The case for capital controls. Crises occur in the forex market when investors see an arbitrage opportunity in shifting from one currency to another. If a nation could shut down its forex market, the risk of a crisis occurring would be lower. However, experience shows that capital controls, which are used to limit or prevent cross-border arbitrage by investors, are hard to implement and never watertight. Empirically, there seems to be no consistent evidence that capital controls work to decrease crisis frequency or enhance growth. In addition, countries tend to want to maintain financial openness as a way to obtain some of the economic gains described in the chapter on financial globalization. Controls could be instituted as a temporary policy, but, given the speed with which crises can unfold, the controls often end up taking effect after the reserves have disappeared. In a few countries (Malaysia after 1997, Spain after 1992), capital controls may have improved a crisis situation, but in many cases controls had only weak or negative effects.27
• The case against intermediate regimes. One lesson of the models presented in this chapter is that a change in market expectations today can trigger “unnecessary” crises, with no deterioration today in economic fundamentals (e.g., GDP, inflation, etc.). After the experience of the 1990s, many leading economists began to see that intermediate regimes (such as dirty floats and soft pegs) are very risky when fluid market expectations are taken into account. Under such regimes, the extent of the authorities’ commitment to the exchange rate target would be seen as questionable, meaning that departures from the target to monetize deficits or pursue monetary autonomy might be suspected, leading to potentially self-fulfilling crises. How can a nation avoid this outcome? In the trilemma diagram, countries should get out of the middle and move to the corners. This view came to be known as the corners hypothesis or the missing middle. Given the prevailing view that controls are not a viable option, this reduces the trilemma to a dilemma: in this “bipolar” view, only the two extremes of a hard peg or a true float can be recommended (an idea dating back to Milton Friedman, quoted at the start of this chapter). Evidence has mounted that intermediate regimes have been more crisis-prone in the past (up to five times as likely to have a crisis than a hard peg, according to one study), but the move away from such regimes appears to be very slow.28
• The case for floating. In a crisis, a peg breaks. If there isn’t a peg, there is nothing to break. It might be desirable for all countries to float from that perspective. However, in the chapter on fixed and floating regimes, we saw that there are powerful reasons to peg, especially in emerging markets and developing countries with fear of floating. And empirically, there is no overwhelming trend toward floating regimes in recent years. Thus, the floating corner has not attracted all that many countries in practice.
• The case for hard pegs. If floating is out, then the “bipolar view” suggests that (short of dollarizing) countries should go the other way and adopt a really hard peg like a currency board. Only a few countries have ever taken this route, including such examples as Hong Kong (still operative), Estonia (now in the euro), and Argentina (until its 2001–2002 crisis). Not all of these regimes were strict currency boards, but they could all be considered hard pegs, with high reserve ratios and some rules to try to limit domestic credit. Did they work? Some worked very well. Although the Hong Kong Monetary Authority wasn’t following the strict rules, the system has worked, and the massive reserves have kept the peg alive even in times of financial market turmoil. But hard pegs can also break like any other kind of government commitment, if the authorities deem it necessary, as they did in Argentina. Lesson: all fixed exchange rates can be broken, no matter how strong they appear to be.29
• The case for improving the institutions of macroeconomic policy and financial markets. If hard pegs are not a panacea, then risks to pegged regimes might be minimized if the rest of the macroeconomic and financial structure in a country could be endowed with greater strength, increased stability, and enhanced transparency. Admittedly, these goals are always desirable no matter what the exchange rate regime, but they take on added importance when a country is pegging because fiscal and banking problems have emerged as the root cause of so many crises. The steps involved may be slow, incremental, bureaucratic, and unglamorous. But their defenders would claim that, although they lack the “quick-fix” appearance of currency boards and other schemes, these improvements are the foundations on which any successful fixed exchange rate regime must be built.
• The case for an international lender of last resort. We have seen that the adequate level of reserves to avert a crisis can depend on market sentiment. Why not borrow more reserves? This solution is not possible if lenders worry about an imminent crisis and you face a sudden stop. This is where the International Monetary Fund (IMF) can help. The IMF may lend to countries in difficulty if it thinks they can restore stability in a timely fashion with the help of a loan. But making the right judgments is far from easy. The IMF may impose unwelcome loan conditions that require policy change, including, for example, stricter control of budget deficits. If the conditions are ignored, the IMF may suspend the loan program. The IMF has also been criticized on occasion for being too hard (Korea in 1997) or too soft (Argentina in 2001). Moreover, its capacity to lend is limited and is increasingly dwarfed by private capital flows, causing concerns that future attacks may be too large for any IMF program to contain. Not that larger rescue capacity is necessarily good—at a basic level, many worry that the prospect of IMF bailouts, like any kind of insurance, may encourage lax behavior (moral hazard), which could worsen the crisis problem. Not surprisingly, the role of the IMF has been constantly questioned in the current era of globalization.30
• The case for self-insurance. What if a country wants to peg, but none of the above ideas offers much comfort? What if capital controls are unattractive or porous, floating too risky, and currency boards too much of a straightjacket? What if a country knows that its domestic macroeconomic and financial architecture is still in a state of remodeling? What if the country looks back at the 1990s and worries that IMF programs will be too small, too late, too full of conditions, or not available when they are most needed? In some ways, this describes many of the Asian countries, and other emerging markets, in the 2000s. The vast reserve buildup of recent years seen in these countries may be an exercise in saving for a rainy day to protect themselves against unpredictable shifts in global financial market conditions.