FLOATING CURRENCIES, CAPITAL CONTROLS, OR CURRENCY BOARDS: WHAT'S THE BEST REMEDY FOR THE CURRENCY CRISES?

Abstract

A number of different solutions have been proposed to deal with the Asian currency crisis. One proposal championed by the International Monetary Fund (IMF) is to allow the currencies to float while seeking to maintain their value through tight monetary policy. A second proposal calls for restrictions on capital flows. A third is establishment of currency boards, which seek to stabilize a currency's value by “pegging” it to the value of another currency. In examining each of these three alternatives, this article concludes that none offers a perfect solution. Capital controls are almost always bad, creating serious distortions throughout the economy and destroying investor confidence. Currency boards, as past experience suggests, can be effective in certain circumstances. Nevertheless, there are concerns that currency boards deprive countries of all policy flexibility (some of which could be helpful in coping with crises), are difficult to set up so as to maintain credibility, and may lack adequate reserves to instill confidence. Such concerns have stood in the way of using of currency boards in the cases of Russia and Indonesia. Having expressed reservations about these two “more radical” solutions, this article closes by noting the main problem with the IMF's prescription of floating currencies: its insistence on high interest rates and tight monetary policy. Because high interest rates tend to be ruinous for the local economy—and their effectiveness in limiting currency depreciation in times of crisis is far from clear—the author argues that interest rates should be raised only to compensate for inflation. Consistent with the recent experience of Brazil, the best solution may be just to allow currencies to float with a relatively loose monetary policy.