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Should There be Five Currencies or One Hundred
and Five?
By Ricardo Hausmann*
Recent financial crises have shattered the consensus among bankers, policy makers, academics, and ideologues about appropriate economic policy in emerging markets. As economic professionals now return to the drawing board, one question is generating particularly fierce debate: Should emerging-market countries allow their currencies to float freely, or should they abandon them altogether in favor of strong international or supranational currencies such as the U.S. dollar or the euro?
The debate between “floaters” and “dollarizers” reflects the broader debate over the precise causes of the recent financial turmoil. Two opposing explanations have emerged: a dominant view based on what economists call “moral hazard” and an alternative theory based on what might be called “original sin.”
Just about anyone who has read about the financial crises in Asia, Latin America, and Russia has become familiar with the concept of moral hazard—the increase in recklessness that takes place when people are somehow protected against the consequences of their risky behavior. The readiness of governments and international institutions to provide bailouts in times of emerging-market (and other) financial crises may make investors less vigilant about weighing all the risks involved.
The alternative theory, which I call “original sin,” seeks to explain why many emerging markets are volatile and prone to crisis by focusing on three characteristics that such countries often share: good economic prospects, a certain degree of openness to international capital flows, and a national currency that cannot be used by local firms or the government to borrow abroad, and cannot be used, even at home, for long-term borrowing-a weakness, or “sin,” shared by the currencies of almost all emerging-market economies. Since these currencies cannot be used for either foreign or long-term borrowing, would-be investors must choose between borrowing in a foreign currency such as dollars or borrowing short-term.
This combination of characteristics is a recipe for financial fragility. It makes countries extremely vulnerable to sudden declines in the amount of liquidity in the banking system and to sudden currency depreciations. In fact, as the domestic currency starts to decline, companies fearful of further depreciation will attempt to buy foreign currency in order to cover their exposures. For its part, the government will seek to defend the currency by using international reserves. But using those reserves will dry up the amount of money in the domestic banking system, and as liquidity declines, banks will be forced to call in their loans, precipitating a banking crisis caused by the maturity mismatches.
The competing theories of moral hazard and original sin suggest two very different sets of options for countries with respect to monetary systems. The moral hazard explanation suggests that letting exchange rates float will limit volatility by making investors bear the full risk of moving capital in and out of a country. But if the problem is rooted in original sin rather than moral hazard, allowing the currency to float will not have much of an impact: As long as the national currency, whether fixed or floating, is one that cannot be used for foreign or long-term borrowing, financial stability will remain elusive.
Brazil, Indonesia, Mexico, Papua New Guinea, South Korea, and Thailand have recently opted for purely floating regimes. But floating regimes have not delivered much in the areas they were supposed to help: They have not provided more autonomy in the determination of interest rates, they have not facilitated more stabilizing monetary policies, and they have not led to an increased ability to absorb shocks.
The experiences of Chile, Mexico, Peru, or Venezuela—after the Asian Crisis of 1997 and the collapse in commodity prices in 1998—suggest that emerging-market countries with formal floating regimes do not allow their currencies to move much, even after huge external shocks. Floating rates in Latin America have therefore failed to deliver on the speed control and shock absorption qualities they promised.
An alternative to floating, strongly implied by the theory of original sin, would be for emerging markets to abandon national currencies altogether in favor of an international currency such as the dollar or a supranational currency such as the euro.
A world of international or supranational currencies would be financially stabler and safer for capital mobility. Long-term interest rates would decline and become less volatile, as we have seen in Europe, making it easier to cut budget deficits and promote growth.
Adopting an international or supranational currency would not be a panacea: Countries would still undergo shocks, and they would be unable to devalue or lower interest rates in response. Yet, they might not be any worse off than at present.Moreover, many of the shocks that emerging markets suffer are a consequence of the financial fragility that comes from having a domestic currency. In a world of fewer national currencies, this financial turbulence would presumably be smaller.
A world of more than 100 floating currencies is a relatively new phenomenon that is unlikely to be stable or compatible with globalization. In Europe, 11 countries have opted out of such a regime, instead going for a supranational currency. Emerging markets will follow a similar course.
A Guide to Exchange Rate Regimes
References
Barry Eichengreen’s Toward a New International Financial Architecture: A Practical Post-Asia Agenda (Washington: Institute for International Economics, 1999)
Paul Krugman’s “Monomoney Mania” (Slate, April 15, 1999)
Endnotes
*: Ricardo Hausmann is chief economist of the Inter-American Development Bank. Back.