Exchange Rate Arrangements in the Americas: Lessons from East Asia?

Abstract

Even before a consensus had developed about the lessons from the East Asian crises, events in Brazil and Russia added grist to the policy analysts' mill. In this welter of conflicting interpretations, it is difficult to settle on an appropriate set of responses, in part because there is no common view on what precipitated these events. In this paper, I set forth an integrated reading of the theory and empirical literature on financial crises and exchange rate regimes. These messages are then applied to the question of the optimal exchange rate and monetary arrangements for the emerging economies of the Americas. The key points that flow from this analysis are the following. First, recent financial crises not interpreted as the inevitable outcome of globalization, but rather the consequence of private agents exploiting either explicit or implicit government guarantees to insure private liabilities. These liabilities could take the form of officially guaranteed bank debt (as in the 1980s) or insolvent banks and dollar-denominated corporate debt (the 1990s). Second, while fixed exchange rate regimes do not cause all such financial crises, they may exacerbate them, to the extent that they make government guarantees more explicit. This is especially true because our knowledge of the equilibrium exchange rate - in real time - is very limited. Third, currency boards and dollarization might mitigate the likelihood of currency crises, but they cannot provide inoculation against financial crises, unless the Federal Reserve Board is willing to take on the role of regulator and lender of last resort. Furthermore, such fix regimes are likely to impose heavy costs upon the economies in question since the economies of the region do not constitute an optimal currency area. Thus, the lesson I take from recent experiences in the global capital is that, except for the most pathologically managed economies, freely floating exchange rates are often the best route to take. The caveat is not a trivial one. If, for instance, Brazil is unable to bring its budget deficit somewhat in line, then dollarization that imposes a hard constraint upon its fiscal system might be beneficial on net. Whether this option would be politically feasible is a question I leave to those better equipped to answer this question. The article is structured in the following manner. Section 2 contains a discussion of the major features of recent financial crises. Section 3 will address the issue of exchange rate overvaluation, while the subsequent section forwards some thoughts on the desirability of hardfixes of the exchange rate. Concluding remarks follow.