Why Should Emerging Economies Give Up National Currencies? A Case for Institutions Substitution

Abstract

This chapter argues that abandoning national currencies to adopt a hard currency can be an effective policy for emerging economies to deal simultaneously with the lack of credibility of domestic financial policies and the imperfections of globalized capital markets, and is organized as follows. Section 5.2 documents key features of emerging-markets crises that point to the central role of noncredible policy and imperfect capital markets in causing the crises. Section 5.3 reviews some analytical results which suggest that the globalization of (imperfect) financial markets had endogenous mechanisms which increased the vulnerability of emerging economies to sudden stops. Section 5.4 summarizes an analytical framework for studying economic fluctuations in a small open economy that features a transmission mechanism linking imperfections in world capital markets with lack of credibility, or uncertain duration, of domestic economic policy. Section 5.5 draws policy conclusions.