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The Exchange Rate: Economic policy tool or market price?

Discussion paper by Heiner Flassbeck, UNCTAD, 2001

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There has been broad consensus among economists for decades that changes in the value of money over time cannot be used as an economic policy tool because people would quickly learn to adapt to any attempt to exploit the money illusion by inflationary policy. Paradoxically, the majority of economic analyses have never questioned the ability of policy makers to exploit money illusion over prolonged periods of time if the subject is the change in the value of money in space, i.e. exchange rate changes. The paper argues that the latter have to be treated in the same way as the former if economic theory is to be consistent. As a consequence, exchange rate changes can only be used to compensate for inflation differentials between countries, and nothing else. The paper draws on the European experience up to monetary union, as well as on experience in developing countries with different exchange rate regimes.




Heiner Flassbeck

No. 157
November 2001


Heiner Flassbeck

No. 157

November 2001

I am grateful to Yilmaz Akyüz, Wolfgang Filc and Jörg Mayer for their helpful comments on the first draft.


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The opinions expressed in this paper are those of the author and do not necessarily reflect the views
of UNCTAD. The designations and terminology employed are also those of the author.

UNCTAD Discussion Papers are read anonymously by at least one referee, whose comments are
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Comments on this paper are invited and may be addressed to the author, c/o the Editorial Assistant*,
Macroeconomic and Development Policies, GDS, United Nations Conference on Trade and Development
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JEL classification: F310, F410 and F420.

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Preface 1

Abstract 1







• Appendix: The roots of inertial inflation in Europe 26






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Heiner Flassbeck

United Nations Conference on Trade and Development, Geneva


In November 1999 Barry Eichengreen and Ricardo Hausmann wrote: “Curiously, early
contributions to post-Asia literature … said little about the choice of exchange rate regime, focusing
instead on transparency, prudential supervision, policy toward capital flows, and IMF reform. The
emphasis in recent writings is different; there, the exchange rate has taken centre stage” (Eichengreen and
Hausmann, 1999: 1). This shift in emphasis, called by the authors a “maturation” of the debate, is indeed
remarkable. In the post-Asian and ante-Brazilian crisis prevention debate, my attempts in the autumn of
1998, in my capacity as German G-7 Deputy Finance Minister, to shift the focus of attention to the
exchange rate regime failed ruefully. Lacking the support of eminent economists such as Barry
Eichengreen, I was denounced a priori as a “pure macroeconomist” trying to avoid the hard and complex
“structural” questions. In the next round my pleas to make the exchange rate regime in developing
countries more flexible without returning to the outdated regime of pure floating earned me the name of
“Mr. Target Zone”. At that time the new paradigm of corner solutions – choosing either absolutely fixed
rates or free floating – had quickly been adopted by the United States administration and the International
Monetary Fund, without waiting for the results of the commencing scientific debate.

In the new millennium the academic debate on an appropriate exchange rate regime for emerging
economies seems to be reaching a new stage. The painful experiences with hard pegs, such as the once
famous currency boards on the one hand and the “fear of floating” (G. Calvo) on the other hand have
forced the debate back to solutions between the corners. However, many officials as well as the
international financial institutions still adhere to extreme solutions. This is not surprising, given that the
corners seem to offer a strictly unilateral approach. If emerging economies could just have the choice of
fixing their rates permanently by dollarizing or floating them, countries with reserve currencies could
avoid international commitment. Furthermore, if the exchange rates of the Group of Three (G-7) are to
be set by market forces, the efficient allocation of international resources would appear to be guaranteed.
Political initiatives by other G-7 countries are rare (France and Japan, 2001) and barely successful, as long
as the majority of economists shares the view that only the corners of the continuum of possibilities can
prevent crises and provide unilateral solutions to a problem which is multilateral by definition.


The paper reconsiders the failure of mainstream economics to come up with a consistent and valid
exchange rate theory. There has been broad consensus among economists for decades that changes in
the value of money over time cannot be used as an economic policy tool because people would be quick
to learn to adapt to any attempt to exploit the money illusion by inflationary policy. Paradoxically, the
majority of economic analyses have never questioned the ability of policy makers to exploit money
illusion over prolonged periods of time if the subject is the change in the value of money in space, i.e.
exchange rate changes. The paper argues that the latter have to be treated in the same way as the former
if economic theory is to be consistent. As a consequence, exchange rate changes can only be used to
compensate for inflation differentials between countries, and nothing else. The paper draws on the
European experience up to monetary union, as well as on experience in developing countries with
different exchange rate regimes. It strongly rejects the idea of offering unilateral corner solutions for
the exchange rate regimes of developing countries in a multilateral world.

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1 Friedman (1962) and Sohmen (1967).

2 Keynes argued against the return of Britain to the gold standard at the pre-war parity. The optimum
currency area criteria of Robert Mundell and others were based on the idea of avoiding huge real costs by
depreciating a currency which, due to a negative demand side shock, is overvalued.


For economists brought up in the 1970s the controversy of fixed versus flexible exchange rates

was every-day bread and butter. The collapse of the Bretton Woods soft peg system of fixed but

adjustable rates required a quick political solution. The countries of the industrialized world were split

into two groups: the large, closed ones opted for floating, while most of the smaller ones opted for a new

peg with different anchors. Europe, with Germany as the anchor, formed the largest of these new soft peg

groups. In economic theory, fixed versus flexible rates were part of the general fight of fading

Keynesianism versus upcoming monetarism. Monetarism fought for a clear market solution and expected

“stabilizing speculation”, whereas most Keynesians mistrusted the “animal spirits” of the market and

feared herd instincts and bandwagon effects.

Nevertheless, the different schools were united regarding one important aspect of the international

monetary order: all admitted that any monetary system would have to assure sufficient flexibility of

prices, expressed in an international currency, to avoid fundamental external disequilibria in trade.

Although the monetarist school of thought expected domestic prices and wages to be flexible enough to

adjust to real and monetary policy shocks, they advocated an additional exchange rate flexibility as a

substitute for the lack of international price and wage flexibility.1 The Keynesian approach was based on

stickiness of wages and prices. With insufficient flexibility of wages and prices in general, the Keynesian

approach asked for a buffer to smooth international shocks or to avoid domestic misalignments leading

to external imbalances. Thus, in a Keynesian approach too, exchange rates should be flexible: flexible

enough, if not floating freely, to avoid real cost inhibited by adjustment to unforeseen external events.2

The aspects of flexible versus fixed prices – an essential ingredient of the former remarks – have

virtually disappeared in the modern debate on exchange rate regimes. The current approach centres

around the capital account, with the current account being an appendix or result of capital transactions.

The main topic of the former debate – how to avoid high and rising current account deficits and thus

unsustainable capital inflows – has been replaced by the question of how to sustain high and even rising

capital inflows. As Summers (2000) recently put it: “When well capitalized and supervised banks,

effective corporate governance and bankruptcy codes, and credible means of contract enforcement, along

with other elements of a strong financial system are present, signif icant amounts of debt will be

sustainable”. Given this “first” element of an effective national strategy for minimizing the risk of a

capital account crisis, the second one follows:

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3 See also Calvo and Reinhardt (2000b) and Fischer (2001) for similar views. The Meltzer Commission said
in its Report (2000: 8): “Maintenance of stabilizing budget and credit policies is far more important than the choice
of exchange rate regime”, and recommends the corners “as neither fixed nor fluctuating rates are appropriate for all
countries and all times”. The fact that in the recent literature the “lender of last resort” is addressed as one of the
most important problems is also based on pure capital account logic. In a broader view, the critical question is how
to solve economic problems in emerging markets without net lending from abroad.

… the choice of appropriate exchange rate regime, which, for economies with access to
international capital markets, increasingly means to move away from the middle ground of
pegged but adjustable fixed exchange rates towards the two corner regimes of either flexible
exchange rates or a fixed exchange rate, supported, if necessary, by a commitment to give up
altogether an independent monetary policy”. (Summers, 2000: 8)3

As a consequence, Summers concludes that the choice between the poles “has less to do with Robert

Mundell’s traditional optimum-currency-area considerations than with the country’s capacity to operate

a discretionary monetary policy in a way that will reduce rather than increase variance in economic

output”. Eichengreen and Hausmann (1999) attempt to solve the exchange rate question along the same

lines by investigating the relationship between financial fragility and the exchange rate, rather than

between the latter and prices and wages as well as interest rates.

The focus on the capital account in the recent debate explains the results. If the main target of

economic policy in emerging economies is to sustain debt and stable capital inflows, instead of preserving

competitiveness or high employment and living standards, the therapy may indeed be sought in the

corners. Absolutely fixed as well as fully flexible rates may reduce the risk of destabilizing speculation

and of moral hazard (“the time bomb waiting to explode”) (Eichengreen and Hausmann, 1999: 2). The

crucial question, however, is how to achieve simultaneously both internal and external equilibrium, as

Eichengreen and Hausmann call it, remains unsolved. Even worse, with the corner solution hypothesis

in place, and countries choosing the proper exchange rate regime by mainly considering the short-term

capital account logic, economies may err in terms of effective adjustment to fundamental current account

disequilibria or their domestic economic policy targets. For example, if a country with rather rigid wages

and prices chooses a currency board, it may achieve in the short run the capital account results promised

by the corner solution hypothesis. However, it is in deep trouble if prices and unit labour costs in the

anchor country and its competitors rise less in terms of an international currency, and it is faced with

competitive shocks and unable to restore competitiveness by means short of a full-fledged deflation. Its

inability to respond to these shocks will sooner or later trigger a loss of confidence in the capital markets,

and it will have to pay with high and rising interest rate spreads, thereby aggravating the fundamental

imbalance. On the other hand, countries with relatively flexible prices and wages choosing floating may

end up with too much flexibility if both flexible prices and flexible exchange rates move in the same


Hence, as the recommendations of the different schools are contradictory, we are left to decide

who was right: i.e. the economists of the old or those of the new generation. If the dominant problem in

the international trade of goods, services and capital is still the inflexibility of wages and prices as well

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as the need to preserve competitiveness, the corner solution theory can hardly make sense. In this case

a country choosing an exchange rate regime without taking into account its own degree of wage and price

flexibility, together with that of its competitors, will not escape crisis, even if the financial system as such

is strong and transparent. It is only if this still important but outdated problem can be solved somehow

or other that the corners may be feasible. But, as will be shown below, the modern view does not prove

the irrelevance of the old problem. In its obsession with the capital account, it does not address the

pressing questions posed by the existence of different national labour market arrangements or different

growth rates in countries with open trade and capital accounts. Even more astounding, the capital account

approach leaves aside the obvious inconsistencies arising if trading partners choose the opposite corner,

as was the case between Brazil and Argentina following Brazil’s switch to a flexible rate in the aftermath

of its crisis.

This paper follows some very simple considerations concerning the role of exchange rate changes

in the globalized economy. After a brief discussion of the root causes of the modern corner solution view

(section I) and of the different types of crises in different exchange rate regimes (section II), the various

functions attributed to exchange rate changes are examined. The main questions provoked by the corner

solution view are obvious: is the exchange rate a normal price like any other price on goods or the capital

market? If yes, absolute fixing must be difficult to reconcile with a market economy (section III). Is the

exchange rate a substitute for flexible prices and wages? If yes, can a priori recommendations for a corner

solution be justified without a thorough investigation into the differences in wages and the price inertia

of countries involved in international trade and free exchange of capital (section IV)? Is the exchange rate,

as some observers believe, a normal tool of economic policy? If yes, is it sensible to leave it to the market

or forsake its service by permanently fixing it? Do exchange rate changes efficiently buffer real shocks?

If yes, should this adjustment mechanism be sacrificed for the sake of stable capital flows and reduced

risk in international capital transactions (section V)? The last question was posed by critics from the

United States before the European Monetary Union (EMU) had entered its final stage. Is this objection

obsolete now, along with the indisputable benefits the anchor approach in the European Monetary System

(EMS) brought about as a device to fight inflation (section VI)? What have been the causes of inertial

inflation in Europe, and how might they eventually be overcome (section VII)?

Is anchoring a lasting solution or rather for transitional stages of disinflation and, if not, what are

the implications for currency boards or for outright adoption of a foreign currency, such as dollarization

(section VIII)? Is there a need for emerging economies to draw on foreign or domestic savings to finance

investment, thereby creating the “original sin”, as referred to by Eichengreen and Hausmann (see

section IX)? The final section explicitly deals with the notion of an “impossible trinity” (an exchange rate

peg, an open capital account and a monetary policy dealing with domestic affairs are incompatible).

I shall now replace the impossible trinity by an “impossible duality” (an open capital account and national

monetary policy are incompatible), arguing that no monetary regime can effectively isolate a country with

an open capital account, and I shall draw some global policy conclusions.

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This paper will not explicitly replicate the former controversy of fixed versus flexible exchange

rates. But in questioning the new corner solution paradigm I will not be able to escape the final question:

are variations in exchange rates necessary under all circumstances in a market economy? The answer,

again, is trivial: no, they are not necessary at all, as prices, wages and interest rates can do the job of

market clearing under most circumstances. Changes in the exchange rate can be a remedy in the event of

catastrophes and big shocks, when the burden of adjustment can no longer be borne by the nation state

alone. Beyond this, adjustments in the external value of money are indispensable only for the transition

stage from high to low inflation. Regarding the adjustment of real income to changing real circumstances,

if people can no longer be fooled by changes in the domestic value of money (usually called inflation),

changes in the external value of money also become useless, as the exchange rate illusion will

simultaneously be lost.


Recent literature on the crises in international finance in the 1990s lays the blame on soft pegs for

being the most important source of vulnerability. In Brazil, East Asia and the Russian Federation, pegged

exchange rates and the depletion of reserves are found to be a “very serious” cause of crisis (Summers,

2000, table 2: 8), whereas fiscal and current account deficits, total indebtedness or the lack of general

governance are not considered to be general features of a crisis-prone economy. This is true. The

definition of crisis in these analyses, however, is restricted to capital account developments, thereby

excluding the main targets of economic policy. The inclusion of growth, jobs and domestic inflation

yields ambivalent results. A soft peg, which has served quite well many purposes – at least better than any

other exchange rate system – should not easily be condemned in the end for causing a certain kind of

crisis. Obviously, the analysis of different exchange rate arrangements in the circumstances prevailing

in the country under consideration, and taking into consideration all the relevant policy goals, can do

justice to the role of the exchange rate regime.

Crisis in general has been a common aspect of international economic relations in the past

200 years, irrespective of monetary arrangements. The gold standard, one of the corners, became famous

for producing frequent crises, with countries being unable to return to their parities without forcing undue

strain on the creation of employment and the growth of real incomes. This corner solution collapsed as

many countries, for different reasons, were unable to live up to the degree of monetary convergence that

the system required to replace successfully national policy-making by the golden anchor. Other kinds of

hard pegs have time and again produced economic crises. China and Hong Kong (China) went through

an extremely difficult adjustment process during the Asian crisis, as they refused to depreciate their

exchange rates. Argentina (with a currency board since the beginning of the 1990s) is still in 2001 in a

severe economic crisis, after the longest recession of all the crisis-stricken countries. Of course, Argentina

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4 There are many reasons to argue that the revaluation has actually been the main reason of the Japanese
slump Flassbeck (2000).

has not been in a capital account crisis for long as money has still been flowing in. But the country has

had to be rescued several times by the international community, has to pay prohibitive interest rates, and

is heavily indebted in a currency it cannot print.

The most impressive case of crisis in a corner, however, is East Germany (the former GDR) being

in a monetary union with West Germany since 1990. In terms of capital flows, transparency and credible

monetary policy, the region is in the best position of all small open economies in the world. Its overall

economic position, however, is disastrous. After its jump to the corner of irrevocably fixed rates, it has

almost lost its ability to export owing to a dramatic decline in international competitiveness (Flassbeck,

1999a). Even today, 10 years after the transition and huge fiscal transfers from the West, it is still in

danger of falling permanently behind comparable economic entities.

But floating too has not been free of crisis phenomena. Far beyond the capital account reasons for

the “fear of floating” (Calvo, 1999), floating has put its mark on the real economy of many countries, thus

explaining the fear of unchecked exchange rate flexibility. The US export sector and its job perspectives

were in crisis in 1984/5, following a huge and unjustified real effective appreciation. Germany, benefiting

most from the strength of the US dollar in the first half of the 1980s, experienced the opposite effect in

the second half of the decade when the deutsche mark bounced back. The Japanese economy went into

a deep deflationary crisis in the first half of the 1990s, when, in addition to a restrictive monetary policy,

its real exchange rate appreciated by some 70 per cent.4 The same was true for Switzerland in the late

1970s. The country had to stop a sharp real appreciation of its currency and the resulting real shock by

announcing unlimited intervention in case of a further inflow of capital. In the 1990s the devaluation of

the euro caused crisis in many parts of the US and British economies, as well as in parts of Eastern

Europe. On the other side, overshooting depreciation has very often provoked jumps in inflation or huge

losses in real income due to a deterioration in the terms of trade. The economic history of France, Italy

and the United Kingdom following the first two oil price explosions contains useful lessons in this

respect. Quite recently, the burden of external debt was dramatically increased by overshooting

devaluation in Asia. This put enormous strains on many countries lacking a credible exit strategy from

the soft peg, with their currencies left to float freely after the outbreak of the crisis.

Hence, to limit economic analysis to capital account crisis may be a justified exercise for the

restricted purposes of research. It cannot yield reliable economic policy recommendations as it covers too

little of the ground relevant to overall policy objectives. The fact that crises, forcing the spectacular rescue

operations of G-7 governments or IMF, do happen very often in middle-ground regimes, like a soft peg,

does not prove the case against these regimes. Soft pegs are the policy generally chosen by countries

aiming at disinflation by means of an external anchor. As the IMF admits, the performance of these

approaches in terms of successful disinflation have been impressive (Fischer, 2001: 9; Mussa et. al.,

2000). Given the institutional framework in these countries, if other exchange rate regimes do not offer

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the same assistance to disinflation, it is hardly viable for economists to argue that high and unstable

conditions surrounding the internal and the external value of money are superior to the opposite, even if

capital account crises occur frequently on the soft peg way to low inflation.

Furthermore, many economies choosing soft pegs explicitly do so in an attempt to reach the corner

of sustainable fixed rates and to avoid floating at all. This is pertinent for the small open economies in

Europe, but the Brazilian “Plano Real” may be similarly interpreted. In such cases, the soft peg period

with the incorporated disinflation and overvaluation is the transition period towards a more stable

arrangement, or even a monetary union. Under these circumstances the “impossible trinity” (of a fixed

exchange rate, capital mobility and a monetary policy dedicated to domestic goals) (Fischer, 2001: 4) –

is not responsible for the vulnerability of the soft peg, but for the explicit attempt to converge towards the

anchor and to finally replace a non-credible domestic central bank by a more credible external one. Given

the difficulties of any transition under realistic conditions, it is hard to argue that the jump from high

inflation and floating to low inflation and irrevocably fixed rates is easier than the way through a

transitional phase with a soft peg and an anchor. Putting countries too quickly in one regime or another

cannot answer the pressing questions related to the monetary integration of emerging market economies.

The widespread dislike of the middle-ground regimes in contemporary economics must have other

reasons than those usually cited. The most important one seems to be only implicit in the debate. Is it not

surprising that the advice to go to the corner of absolutely fixed rates or even to the outright adoption of

a foreign currency (dollarization or euroization) usually stops short of recommending the establishment

of a couple of monetary unions, following the European example? Even more astounding, many of the

advocates of the corner solution have criticized the EMU harshly for giving up the most important

instrument to fight the so-called asymmetric shocks, and have referred explicitly to the optimum currency

debate. In the corner solution debate, however, this line of thought is denounced or ignored. I will try to

show that the only reasonable way to fix rates permanently is by forming a monetary union. If there is

any truth in my argument, the corner solution advocates are either blind or base their case on other

arguments than those mentioned openly.

Both corners – floating on the one hand, currency boards or dollarization on the other hand –

represent unilateral approaches. The emerging small open economy decides and executes both approaches

without any assistance or cooperation from a reserve currency country. Is the leading motive behind the

“corner solution” the reluctance to support any kind of international cooperation? Can the famous

globalization of markets continue without global institutions and a much more global economic policy

approach? Can emerging economies be fully integrated into the world market without offering them some

effective influence over such crucial questions as the international level of interest rates? Can trade

liberalization and the liberalization of capital flows be recommended without establishing global rules

to avoid exchange rate changes distorting the optimal allocation of resources? All these questions are left

unanswered and not even put on the table at official international organizations and fora. Instead, the

unsound and inconsistent idea of the superiority of unilaterally executed corner solutions in the most

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5 In a recent paper Obstfeld (2001: 14) argues that the observation that real exchange rate variability is
closely correlated to nominal exchange rate variability provides overwhelming evidence “that domestic price levels
are quite sticky”. It is just the reverse: rather, this evidence proves overshooting of the nominal exchange rate over
fundamentals and misallocation by exchange rate variability. How else could one explain that the vast majority of
all transactions in the real world takes place, successfully, without an exchange rate and with much lower variability
in prices.

6 This, obviously, is a Schumpeterian, not a Walrasian,view of the economy.

7 In the latter case, however, it will be only captured empirically if the measurement of the real exchange rate
is based on unit labour costs, and not on prices.

important areas of international financial relations is put forward as a purely national solution in an

internationalized world.


A certain branch of the neoclassical school in economics rests upon the idea that exchange rate

changes are a necessary ingredient of a market economy, as only the existence of a flexible real exchange

rate to complement the other two important “real prices”, the real interest rate and the real wage, can bring

about equilibrium in national and international markets. In this view, the corner of absolutely fixed rates

cannot be sustainable per se, as price flexibility for market clearing is eliminated by the fixing of the

nominal exchange rate. However, this hypothesis can be easily refuted by just looking at the concept of

the “real exchange rate”. Paradoxically, the “real exchange rate” has neither a real dimension nor is it an

exchange rate. The real exchange rate measures change in the relative (nominal) competitiveness of

countries, regions or companies by comparing the price (or unit labour cost) changes occurring in the

entity under consideration within a certain period with price changes in competing entities. If there is a

nominal exchange rate between these entities, the change in the exchange rate is taken into account by

calculating in terms of one currency only. But if there is no exchange rate at all, the concept of the “real

exchange rate” does not loose its validity.5

This observation bears some importance for the adjustment to shocks inside monetary unions and

for hard pegs like a currency board. It also sheds some light on the polar positions of the above discussion

of fix versus flexible. If a company is able to increase productivity by means of the implementation of

a technological innovation, it may be able to reduce its cost level. With given nominal wages, the normal

feature for a single company, unit labour costs fall, and the company may use this to cut prices and

increase its market shares or to improve the level of its profits by unchanged prices.6 In both cases the

“real exchange rate” of the company has depreciated.7 The adjustment process of regional economic

entities is not different from that of companies. Seen from the perspective of competitiveness, regional

entities consist only of companies.

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8 The concept of flexibility of wages and prices discussed here should not be confused with the neoclassical
flexibility of real wages needed for clearing on the labour market. I firmly refuse the neoclassical notion (see
Flassbeck and Spiecker, 2000), but I see no way to avoid the adjustments to preserve international competitiveness
in an open economy, as explained above.

The assumption of given wages, however, has to be dropped if labour is not perfectly mobile

between regions and states. If regional or national wages adjust to regional or national productivity, the

sum of productivity gains of companies in the region do not accumulate to reach a competitive advantage

vis-à-vis other regions. Unit labour costs do not fall completely, and not even relatively if the productivity

advance of one region is much bigger than that of another. In this case the real exchange rates of the

regional entities remain constant, without depriving any company in any region of gaining market shares

beyond the borders of its home region in more or less the same way as within borders. If the individual

productivity of a company outpaces that of its competitors in or outside the region, it will gain with given

wages in both regions. Obviously, there is no need for a nominal exchange rate if the real one between

regions and nations is kept constant in this way by the flexibility of wages.

If the increase in nominal wages in one country, however, permanently exceeds the pace of

productivity progress, while it does not in the other, the real exchange rate of the former will appreciate,

and, given normal elasticities, lead to a loss in market shares for the region as a whole, thereby creating

external disequilibrium. Without a depreciation of the nominal exchange rate of the appreciating region,

the fundamental disequilibrium will prevail until either the latter region adjusts with an increase in wages

or the former with a fall in the growth rate of nominal wages. In these cases the flexibility of the exchange

rate acts as a substitute for the relative inflexibility of nominal wages. Countries or regions lacking this

wage flexibility have no other choice than to rely on exchange rate changes as the permanent loss of

market shares becomes unsustainable. Favourable short-term conditions on the capital market may allow

temporarily increasing capital inflows; the medium-term real adjustment, nevertheless, is unavoidable.

Hence, the flexible rate hypothesis of former writers grounded on inflexible prices and wages was sound.8

It cannot be rejected by a priori arguments based on capital account considerations. Only empirical

analysis proving that wages and prices are much more flexible today than in former times could save the

case for “fixing for your life” (Calvo and Reinhard, 2000b).

The logic of flexible prices with fixed exchange rates, pertinent as it is for hard pegs like currency

boards or dollarizations, is often misunderstood. Whoever deviates upward from the anchor is bound to

take brutal adjustment measures to catch up again if the once fixed exchange rate vis-à-vis the anchor is

to be kept constant. It is by far not enough for the high-inflation country to revert to the growth rates of

unit labour costs in low-inflation countries. Restoring the original competitive position – that held at the

time the exchange rate was fixed – means deviating downwards by exactly the same extent. To reduce

the growth rates of unit labour costs after a shock and adjust to the anchor growth rates means to stop the

loss of additional market shares vis-à-vis low-inflation countries, as the competitive position will no

longer be deteriorating. To regain the former position, it is necessary to “dive” below the anchor. If – as

was the case in the United States and Germany in the 1990s – the anchor is still performing very well in

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9 This, however, is true only in the case of a certain kind of money illusion (section V).

10 Diverging inflation trends in open economies are much more important than the “asymmetric shock”, which
was first discussed by Mundell (1961) in his optimum currency area paper. With diverging inflation trends grounded
in different labour market regimes (see appendix to section VI), the arguments in favour of hard pegs or dollarization
in this case do not hold (see, for example, Calvo, 1999), as long-lasting remedies, rather than one-off measures, to
preserve competitiveness are called for here.

terms of inflation (i.e. it can keep the growth rates of unit labour costs and prices very low), adjustment

for the high-inflation countries with no exchange rate changes usually implies entering a deflationary

circle of absolutely falling unit labour costs and prices, as happened in Argentina (see section VI).


As mentioned above, the advocates of fully flexible exchange rates in the past usually based their

argument on one strong pillar: if prices are not fully flexible, changes in the exchange rate in general are

needed to equilibrate diverging “fundamentals” between countries. In such cases the adjustment of the

exchange rate is, as a rule, superior to the quick adjustment of the fundamentals because it can help to

avoid large real income losses resulting from deflationary adjustments.9 That can be easily admitted. But

while this constitutes an argument against fixing rates irrevocably in all circumstances, an argument in

favour of fully flexible rates cannot be deduced from it. The experiences of the 1920s and 1970s as well

as that of the Group of Three show that market-determined rates, as a rule, do not lead to more

convergence, but systematically tend to increase divergence by overshooting their (equilibrium) ranges

– defined by the divergence of the fundamentals. The corner solution of a fully flexible rate brings about

precisely what it should have avoided.

The stylized facts of diverging fundamentals between two countries have been described above.

Without prejudice to other factors obviously playing a role, by far the most important case is a temporary

diverging inflation trend between countries.10 Even this very simple constellation of the relevant data may

lead to an insurmountable policy dilemma. Diverging inflation trends usually mean diverging nominal

interest rates. The high-inflation country offers higher interest rates than the low-inflation one. This is to

be expected, even if both countries have similar growth trends and exactly the same monetary policy

stance. To bring domestic real interest rates in line with real growth rates nominal rates have to be higher

in the high-inflation country.

Short-term capital flows are driven mainly by nominal interest rates and expected exchange rate

changes. Exchange rate expectations in reality, however, do not incorporate permanently the “rational”

solution which economic theory offers as “purchasing power theory”. A country fighting successfully

domestic inflation by means of restrictive monetary policy may, for the time being, gain credibility and

an appreciating currency, as the markets do not anticipate the negative impact that the strong currency

- 11 -

11 For an impressive description of the forces driving currencies beyond the fundamentals in emerging markets
– in this case Poland – see NZZ (2001)

12 This does not exclude the appreciation of currencies with relative and absolutely low interest rates, as the
example of the Japanese yen in 1999 and 2000 amply demonstrated. There is no coherent theory of flexible exchange
rates. The cases of high- and low-inflation countries demonstrate, however, that even in the most favourable
circumstances – i.e. the absence of mere speculation – the market forces cannot find a sustainable exchange rate.

13 A striking example was the recent switch in Hungary from a crawling peg to a flexible rate with inflation-
targeting. Immediately after the move the Hungarian currency appreciated sharply, although the country still has an
inflation rate of around 10 per cent (compared with 2 per cent in Germany, its main trading partner), as it offered
much higher nominal interest rates than Germany.

and still high inflation rates will exert on the international competitiveness of the country in the medium

or long run.

Investors in short-term deposits in other countries do not systematically take into account the

inflation rate in the high-inflation country. They do not buy goods in that country or retain the currency

for a number of years; they put their money in for just a day, a week, or three months. If, during that

period, the inflation divergences between a high-inflation and a low-inflation country do not bring about

the general expectation of depreciation of the high-inflation country’s currency, investment there is more

attractive than in the low-inflation country.11 Nearly all financial crises in the post-Bretton Woods period

(UNCTAD, 1998: 55) have been accompanied by large nominal interest rate differentials. The funds

flowing into the high-inflation country will increase the attractiveness of its currency, as they tend to

appreciate rather than depreciate it. Even if governments try to limit the extent of appreciation of the

domestic currency by buying foreign currencies, they will usually add to the confidence of international

investors as international reserves increase.

Without excluding other possible cases, the basic logic of short-term capital flows with flexible

exchange rates is a simple one: higher interest rates attract short-term capital. Inflation differentials

explain most of the interest rate differentials.12 Thus, the currencies of high-inflation countries tend to be

appreciated in the short term.13 But this undermines further the fundamental external equilibrium between

high-inflation and low-inflation countries, as the real exchange rate of the country with the higher

inflation rate is revalued – i.e. the loss in international competitiveness is aggravated. In theoretical terms,

as the uncovered interest rate parity doctrine dominates the explanation of short-term flows, the role of

the purchasing power parity (PPP) doctrine comes into play only at a later stage. When, owing to the

visible deterioration of its international competitive position, the high-inflation country’s currency loses

the “confidence” of international investors, the overvaluation may have to be corrected. But by then it is

usually too late to avoid a crisis.

The tendency of floating rates to overshoot was clearly recognized by early writers. Hayek

(1937: 62) wrote:

It is because with “mixed” national monetary systems the movements of short term funds are frequently
due, not to changes in the demand for capital for investment, but to changes in the demand for cash as
liquidity reserves, that short term international capital movements have such a bad reputation as causes
of monetary disturbances. And this reputation is not altogether undeserved …

- 12 -

14 Laursen and Metzler (1973) summarize the experience of the 1930s more or less in the same way:
“Exchange rates at that time underwent frequent and substantial fluctuations … the fluctuations that occurred
nevertheless created serious doubts concerning the effectiveness of a flexible exchange system in equalizing a
country’s international payments and receipts”. They conclude “that a regime of flexible exchange rates would not
be successful unless capital movements were subject to some kind of control” (pp. 277/8). Some modern writers
wonder where the flexibility of flexible rates come from (Dornbusch, 1999: 325) and argue that the variability lost
by “signing away an exchange rate” may show up elsewhere in the economic system. This is a strange argument
given the fact that more or less all economists subscribe, rightly or wrongly, to the idea that the price level should
by all means be prevented from fluctuating as otherwise the allocation of resources would be disturbed. Moreover,
the exchange rate variability is only the byproduct of the pertinent inability to stabilize the price level in all countries
in the same way. If the attempt to stabilize the price level fails, it is hardly a solution to introduce a price level
substitute which is extremely volatile, and any attempt to stabilize the price level is bound to fail because the
flexibility lost there will show up somewhere else.

15 For the first description of this effect see Flassbeck (1998).

16 For domestic investors it is always the reverse, i.e. attractive investment in a high-inflation country for
foreigners means attractive indebtedness for domestic creditors in the low-inflation countries.

and asked whether “national monetary authorities [are] in a position to prevent capital movements which

they regard as undesirable…”? His answer is clear-cut:

I am altogether unable to see why under a regime of variable exchanges the volume of short term capital
movements should be anything but greater. Every suspicion that exchange rates were likely to change
in the near future would create an additional powerful motive for shifting funds from the country whose
currency was likely to fall or to the country whose currency was likely to rise. I should have thought that
the experience of the whole post-war period and particularly of the last few years had so amply
confirmed what one might have expected a priori that there could be no reasonable doubt about this.
(Hayek, 1937: 63–64)

Hayek concluded that under a regime of fixed rates, like the gold standard, short-term capital movements

would “on the whole” have a stabilizing effect on balance-of-payments disequilibria, whereas flexible

rates do the opposite. “This means that if the original cause is already a short-term capital movement, the

variability of exchanges will tend to multiply its magnitude and may turn what originally might have been

a minor inconvenience into a major disturbance” (Hayek, 1937: 64).14

Even excluding irrational movements of exchange rates as the dominating force on the currency

market yields no simple and lasting solution to equilibrate the fundamentals of countries with diverging

inflation rates and interest rates. If, for example, inflation differentials between countries are deeply

rooted in the institutional arrangements of the labour market, as very often seems to be the case (see

section VII), there is no easy choice for the high-inflation country and definitively no corner solution

available. Monetary policy is in a dilemma. There is no interest rate at which internal and external

equilibrium can be achieved simultaneously.15

If, with a fully liberalized capital account, a high-inflation country chooses to fight inflation by

means of high interest rates or by keeping the real interest rate as high as in the low-inflation countries,

its currency will be attractive with both flexible as well as fixed rates for international investors in short-

term assets.16 In a fixed rate or semi-fixed rate environment, the high-inflation country’s international

reserves will rise in the short term despite the real revaluation and the loss of competitiveness. In a

- 13 -

17 The term is Schumpeter’s (1939: 30).

18 As shown below (section VII), inflation can and should be replaced in most cases by unit labour costs.

flexible rate world its currency will in nominal terms appreciate in the short run, despite of the even

stronger real revaluation and the bigger loss of competitiveness. If the high-inflation country chooses to

keep its nominal interest rates as low as those in the low-inflation country, it will be able to avoid

destabilizing capital flows, but it will not be able to fight inflation by means of monetary policy.

Thus, both flexible rates as well as soft pegs between high- and low-inflation countries destabilize

short-term international capital flows and directly undermine sound banking principles, even if standards

and codes of sound banking are applied by the high-inflation country. Domestic stabilization in the high-

inflation country can only be achieved if it offers consistently higher interest rates than those in the low-

inflation countries. Thus, the inflation-rate differentials between weak-currency and hard-currency

countries are matched by corresponding interest-rate differentials. But if, in the short run inflation

differentials are not matched by a corresponding risk of depreciation of the high-inflation country’s

currency, a fundamental disequilibrium is inevitable.

Free capital flows between countries with differing inflation performances usually break the link

between interest rate differentials and the risk of depreciation, as exchange rates do not follow PPP.

Introducing PPP as a “theoretical norm”17 is the only way out. With exchange rate expectations being

“rational” in terms of PPP exchange rate expectation, (e*) always equals the interest rate differential (i*)

and the price level differential (p*)18:

e* = i* = p*

But in reality this solution does not apply. Expectations are not rational along the lines of PPP,

as unhedged borrowing offers short-term profit in both corners as long as the general expectation has not

reversed. Let us take a simple example. Some of the countries in transition in Eastern Europe heading for

accession to the EU and EMU choose a linear adjustment path from 10 per cent inflation today (2001)

to 2 per cent inflation in 2005. If their real interest rates are as high as in Western Europe, an anchor

approach (fixing vis-à-vis the deutsche mark) will offer arbitrage opportunities with an open capital

account in the transition period, as their nominal rates are some 20 per cent (8+6+4+2 – the accumulated

inflation differential) higher than in the anchor country for the entire period. At the same time, the real

appreciation of their currencies will amount to 20 per cent if the nominal rate has not changed. At the end

of the adjustment period they will have achieved convergence of the inflation rate, but their currencies

will be overvalued. They will suffer from huge current account deficits due to loss in competitiveness and

the service on foreign debt. One way or another, therefore, a financial crisis will be inevitable.

Choosing the corner of floating with restrictive domestic monetary policy to bring down inflation

will destabilize the external account even more. Speculation on uncovered interest rate parities will yield

- 14 -

19 Given the very often unreliable data, a simple but straightforward rule to identify a coming exchange rate
crisis or a collapse of the real economy in an “emerging market” is the following: if nominal short-term interest rates
in a developing or transition economy are higher than in industrialized countries by more than the growth differential
and the nominal exchange rate of the former does not fall at an annual rate that equals the difference in (annual)
interest rates, the constellation of data is not sustainable as either the interest rates or the exchange rates are too high
in the “emerging market”.

high returns as nominal and real interest rates in the transition economies will be higher than in the first

case. Additionally, the currencies of the high-inflation countries will tend to appreciate, thereby increasing

the incentive for foreign investors to buy domestic assets and the incentive for domestic borrowers to lend

abroad. Hence, the speculative bubble will, as a rule, be larger with floating than with a soft peg, and its

ultimate burst will be more painful than in the case of an anchor approach. The theoretical solution

introducing rational expectations based on PPP as a built-in stabilizer of the adjustment process is the

least probable case. If a country chooses to adopt a strategy of disinflationary monetary policy, its assets

become extremely attractive in both corners during the period of disinflation. Speculative capital starts

to flow into the country, and domestic banks and companies borrow much more abroad than they would

if the risk of a depreciation were present from the beginning. At the same time, as in any period of

disinflation, the conditions for domestic investment deteriorate. Real interest rates are high and their effect

is exaggerated by the real appreciation. Floating is worse than fixing as it adds to the persistent

uncertainty, given non-rational expectations.

Thus, international investors may earn very high rates of return in countries where real income,

domestic profits and the number of jobs are falling. Moreover, the developing or the transforming country

is usually unable to cut interest rates because this would endanger the credibility of monetary policy at

home. In the short term, at least, the political will to achieve economic stability is reflected in the decision

to keep nominal interest rates high. How long an external economic imbalance following the exchange

rate peg or an appreciation can be sustained is an open question. With growing visible external imbalances

the market’s willingness to believe in the emerging country’s exchange-rate policy will fade. As soon as

investors are convinced that the anchoring country will not manage to slow down the growth of its

external debt smoothly, confidence deteriorates, thus leading to a reduction in reserves or a fall in the

country’s exchange rate.

Real-world examples of these constellations were provided by the Baltic Republics in 1992 and

1993, Mexico in 1994, the Russian Federation, Ukraine and Kazakhstan in 1995, and by some Asian

countries in the big crisis in 1997/98.19 The same pattern can be found in many developing and

transforming countries which have not been at the centre of a crisis. Poland, the Czech Republic and

Hungary (as high-inflation countries), in comparison with Germany (as a low-inflation country), had been

in such a situation. With much higher inflation than Germany but with very similar real interest rates,

these countries offered very attractive short-term assets for a couple of years after they had opened their

capital market to the Western world. With or without pegs, their overall competitiveness deteriorated at

the same time and their current accounts moved into deficit. Without correction of their overvaluation in

- 15 -

20 Rodrik (2000: 7) seems to share Dornbusch’s view about the exchange rate being an “important policy
tool”, but qualifies the argument regarding the deflationary dangers of price and wage adjustment in a low inflation
environment. Later, however, he praises real exchange rate changes as “an important contributor to growth spurts”
and notes that countries without these depreciations would have been worse off. There can be no doubt about that.
But who was better off then? Real exchange rate changes are a zero sum game. A true global approach has to address
both sides and cannot stop short by pointing to the advantages of one side and ignoring the disadvantages of the

the course of the Asian crisis in 1997 and 1998, the situation would have been unsustainable in Poland

and the Czech Republic. Only Hungary managed to avoid a permanent real appreciation by means of a

consistent crawling peg for a couple of years.

The high-inflation/low-inflation case is rather easy to handle compared with a case where the

interest rate differential is due to a real growth differential of the countries involved rather the inflation

differential. The Republic of Korea prior to the Asian crisis approximated vis-à-vis the United States such

a constellation. If in both countries the Taylor rule explains the short-term interest rate, the high-growth

country will have a persistently higher short rate than the low-growth country. Arbitrage by international

investors and domestic borrowers will again be the result. As in the high-inflation case, flexible exchange

rates do not stop the net inflow of capital as long as there are no strong indications of depreciation of the

high-growth country’s currency. This time, however, the rational expectations hypothesis based on PPP

does not even apply. The high-growth country may have rather low inflation. Appreciation increases the

incentives for portfolio investment as it adds to the favourable interest rate differential without even the

long-term threat of depreciation. A sharp and pronounced overvaluation will be the normal outcome in

a floating regime. Although this may help to turn around the net capital flows, it will distort trade flows

as well as investment incentives inside the country. The overvaluation will eventually provoke

undervaluation without ever removing the source of the trouble, the diverging nominal interest rates.

The result of the preceding analysis is simple. Exchange rate changes are necessary to equilibrate

the ever emerging gap between the price and cost level of high-inflation and of low-inflation countries.

But, given the unavoidable shortsightedness of the market, the PPP rule has to be enforced by

governments and/or central banks and cannot be left to the market. Diverging fundamentals other than

the inflation rate divergences cannot be equilibrated by changes in the exchange rate.


Dornbusch (1999: 323) called the peg of a currency the “loss of a key adjustment instrument” for

economic policy and asked whether this could be really made up by wage and price flexibility. This

assertion is worth considering as it meets the presumption of many economists that flexibility of the

exchange rate is needed in open economies, as it is much more easily available than the flexibility of

prices and wages.20 In this view hard pegs or monetary unions are outdated supertankers launched by

politicians for “political” reasons only, reducing the flexibility of the economy, and in particular the

- 16 -

21 Even more confusing are the consequences of the layer upon layer of supply and demand shocks after the
German unification, which is often taken as an example of inadequate adjustment inside Europe due to a too rigid
monetary system. The majority of economists took and continues to take it virtually for granted that Germany should
have appreciated its currency after unification, even in relation to the European core countries. But why should the


labour market in the participating countries. Modern economies, the advocates of this theory contend, are

too inflexible to be managed without the much more flexible exchange rate as a “shock absorber”. Only

a flexible exchange rate, for example, could help to overcome the consequences of a so-called

asymmetrical shock, such as an earthquake, in a country with open borders and intense trade relations

with the rest of the world.

However, this theory raises serious doubts. Is it indeed true that exchange rate flexibility is an

efficient instrument of economic policy, as a significant number of economists of all theoretical views

would still have us believe? Let us examine the following possibility: the follow-up costs of an earthquake

devastating a considerable part of the capital stock of a country. The real income of this country would

inevitably drop unless there were external help. Apparently it is possible to adjust reasonably smoothly

to such a shock if all parts of the population simply accepted the inevitable loss of real income. That

would be the case, for example, if the work force were to accept the price hikes following the shock

without demanding an increase in nominal wages from the state and the private sector.

An adjustment problem would occur, however, if the work force demanded compensation for the

price hikes caused by the earthquake and could push through its demand. In this case, either profits would

go down, with additional negative consequences on investment and the job market, or – if monetary

policy remained accommodative – firms managed to reflect the excessive wage demands on higher prices,

thereby turning the one-time price hike into a lasting inflation. Obviously, economists speaking of

inflexible and encrusted labour markets and the consequent need for an exchange rate buffer are referring

to such an eventuality. But would devaluation have the desired effect in the aftermath of an earthquake

under the auspices of this kind of real wage rigidity? The work force in the fictitious country would not

be willing to accept the inevitable loss of real income caused by the earthquake to society as a whole.

However, according to the prevalent thesis regarding the buffer function of the exchange rate, they would

accept a devaluation, which, because of worsening terms of trade, would in fact represent an additional

loss of real income.

If this thesis were wrong, however, because the economic actors did not distinguish between price

hikes induced by the earthquake and those induced by devaluation and if monetary policy remained

accommodative, devaluation would result in an even more pronounced hike in the inflation rate than in

the pure earthquake scenario. The need to tighten monetary policy would then be even greater. The

consequence is simple: the currency of the earthquake-devastated country would devalue sooner or later

if real wages were inflexible. Devaluation, at any rate, would not be a buffer for the real shock, but would

at best compensate for the negative secondary effects of the shock in the form of higher inflation and a

deterioration in the stricken country’s international competitive position.21

- 17 -

deutsche mark have been appreciated? In its immediate aftermath, the shock of reunification was for Germany no
doubt what is described in literature as a negative supply shock. The state reacted to it with a positive demand shock.
As a result, Pan-Germany’s real per capita income dropped; the previously high positive balance of payments slipped
deep into the red; wages and inflation, as well as the public budget deficit, climbed much more steeply than before
and than in other countries. Why should the currency of a country in that situation appreciate instead of depreciating?
With the deutsche mark depreciating in real terms, the problem of countries like France would have been aggravated
rather than solved. If, for example, the underlying cause of the European problems at that time was not to be found
in misaligned exchange rates but rather in a misguided monetary policy approach in Germany, no exchange rate
variation inside Europe could have contributed to dissolving the crisis. The undeniable fact that an appreciation of
the deutsche mark would have helped France does not prove the case for an appreciation as the appropriate remedy
for Europe as a whole (see section VI).

22 The famous example Milton Friedman chose to demonstrate the superiority of exchange rate changes
compared with price changes was “daylight saving time”. He argued that changing the external value of money
would be as efficient as a “daylight saving time” regulation, as all relevant prices would be changed at one stroke
by an appreciation or a depreciation. Generations of economists seem to have accepted this example uncritically,
although it is erroneous in nearly every respect. Daylight saving time is a convention to which the majority of people
seem to agree as they consider it to be an efficient adjustment to changing daylight times. It is not, however, a
substitute for a real adjustment which people are unwilling to perform, as in the case of exchange rate changes. In
daylight saving time every individual moves the short hand of his watch and thus acts voluntarily to adjust. Exchange
rate changes, like inflation or deflation, are felt indirectly by individuals in terms of falling or rising real income,
but these cannot be imputed to the root cause. Even more, if people explicitly reject adjustment to a real shock but
accept the effects of exchange rate changes, obviously they do not understand what’s going on. Wicksell (1958: 247)
rightly states: “As currency is primarily a measure of value, it ought to be possible, even in the most unfavourable
circumstances, for a country to maintain that standard just as constant as, for instance, its standards of length,
capacity or weight”.

With the thesis of the exchange rate as a buffer for real shocks, economic theory has built a

strange inconsistency into its system of tenets. On the one hand, it states that economic policy in the long

run cannot operate with change in the value of money over time – that is, with inflation – without causing

the economic actors to lose “money illusion” and adjust their nominal demands to the climbing inflation

rate. On the other hand, many economists consider changes in the exchange rate as a readily available

instrument of economic policy. They do not point out that, in the long run, economic actors may, of

course, also see through this specific form of money illusion, and may therefore rob it completely of its

effect. The vicious circles of inflation, depreciation and resulting higher inflation that some of the

European countries struggled with in the 1970s and the 1980s provide ample evidence of this.22

The reduction in the external value of money (that is, devaluation) is just as unsuitable and

unusable in the long run as an instrument of economic policy as is the reduction in the internal value of

money (that is, inflation). In a consistent theoretical framework (or with rational expectations) exchange

rate changes provide just as little buffer against real shocks as do changes in the rate of inflation. Earlier

economists were quite aware of this fact. Knut Wicksell, one of the great innovators, wrote at the

beginning of the twentieth century that “a stable value of money in time as well as in space” is the central

precondition for a functioning market economy. By the end of the century this insight seems to have been

lost. According to Wicksell’s logic, the only function to be attributed to fluctuations in the exchange rate

is the balance-of-inflation differentials, for example, the difference between changes in wages per unit

in comparison with countries which are not, or not yet, able to limit the internal devaluation of money

quite as well as, for example, Europe or the United States.

- 18 -

23 As shown above, Hayek (1937) consequently opposed flexible exchange rates and favoured an international

24 The case of the revaluation of the US dollar in the 1980s, or Japan’s dramatic misalignment in the 1990s,
has shown the degree of deviation from any equilibrium rate in the short and medium run. See the evidence of IMF
(1998) showing that PPP holds for periods beyond 20 years.

In such a framework fundamental trade imbalances are prevented, since all participating countries

maintain their competitiveness, and the real exchange rate remains constant. In the past, flexible exchange

rates did not offer good guarantee in the short run. In the long run, however, they performed passably

well. But long phases of over and undervaluation of the nominal exchange rate, and thus long phases of

misallocation of resources, were the price which had to be paid for the experiment with flexible exchange


Why is it that the currency market misaligns time and again, whereas we believe that all the other

markets – the markets for everyday consumer goods as well as those for extremely expensive investment

goods – work effectively? As a radical liberal thinker, Hayek has led the way towards a solution:

according to his theory of markets, the goods ones are efficient because in these markets millions of

participants collect trillions of individual information units, which determine the prices of a huge variety

of goods. A government can neither collect nor process this information reasonably, and thus cannot

produce prices which adequately reflect scarcity. The market for currency (or stocks) is organized quite

differently. In this market, information is collected which stems mostly from government sources, such

as statistical offices or central banks. Some traders interpret this information in a certain way, even on a

global scale, as they try to match the views which are seen as best representing those of the majority of

their colleagues.23

The aim of the game is not to buy the product because it is needed to produce or sell something

that forms part of an individual act of profit-making, but to make the highest profit with the best forecast

of the final outcome. The result must not be “rational” in the sense of the rational expectations theory,

as the market participants do not have to share the view that PPP is the only solution in any period of

time. Thus, the equilibrium rate is unknown and speculation is not stabilizing – as foreseen by the early

writers such as Friedman (1962), Sohmen (1967) or Johnson (1972) – but destabilizing in the short term.

In the long run, the “theoretical norm” of PPP is valid, as huge disequilibria will always turn rates in the

“right” direction. But short-term misalignments24 inhibit huge losses in real output in the short and long


The more general policy conclusions are obvious: the role of a large variety of factors as potential

determinants of the exchange rate or the degree of “credibility” a country can earn “in the markets”

c onfuses the analysis in the capital account approach and its policy recommendations. Fiscal policy, for

example, is given undue weight in “stabilization programmes”, although it is far from being clear how

an austerity programme including a reduction of public expenditure and all the other cruelties usually

prescribed can help to overcome “incredible” economic policy in a country under suspicion of the

- 19 -

“markets”. This objection applies to all other “structural” measures, such as privatization or deregulation,

usually enlisted as remedies to cure “fundamental weaknesses”. The question whether such measures are

needed or not may be an important one, but it cannot be answered by “evaluating” speculation in the

financial markets. The majority of economic policy adjustments in any economy of the world is not

related to the exchange rate question at all. It is only the capital account approach which gives undue

weight to the “judgement” or the “confidence” of the “markets” concerning the future development of

economies as a whole.


After the collapse of the Bretton Woods system, the most important of the smaller European

economies decided to “tie their own hands” in monetary affairs, as it was later on called in Austria. The

“snake” and the “snake in the tunnel” – i e. bands of fixed exchange rates around the fluctuating deutsche

mark – were the first systemic and regional answer to the unwinding of the global system of regulated

exchange rate relations in 1973. The search for a solution for the region as a whole incorporated many

advantages. All the countries sacrificed part of their economic policy power to the group as a whole or

to Germany as the anchor of the system. But, at the same time, they gained autonomy vis-à-vis market

power and the influence of such multilateral international organizations as IMF. The Central Bank of

Germany de facto acted as lender of last resort for the system, although this role had never been explicitly

assigned to it.

The decision to stabilize its nominal as well as its real exchange rate may be an autonomous

national issue for a country. But de facto it is in fact a bilateral question. The country pegging its currency

needs another country’s currency to peg to, thereby forming the “anchor” of the system. The natural

anchor for many European countries at the beginning of the 1970s was the deutsche mark. It had been the

most stable currency after the Second World War, and Germany’s economy as a market for the products

of neighbouring countries was large enough to give them the impression that their currencies could benefit

from stability vis-à-vis the deutsche mark. Given the political will of all the participating countries in

Europe to head towards further unification in many fields of economics and politics, from the beginning

Germany did not just follow the smaller countries in this move, but actively participated in the first steps

to form a new European currency system as soon as the turbulence of the collapsing old system had


An anchoring country in which the overall inflation performance is quite similar to that in the

anchor country is in an easy position from the beginning. Austria in its relation to Germany is a good

example. Nevertheless, the general inflationary performance in normal times is only one aspect. The real

test for a successfully anchoring country is its reaction to different kinds of shocks compared with the

anchor’s reaction. Chart 1 gives the different patterns of reaction in low- and in high-inflation countries

- 20 -









1972 1973 1974 1975 1976

G e r m a n y
F r a n c e
Aust r ia
Un i t ed K ingdom

Uni ted Sta tes

Unit labour costs after a negative
supply shock, 1972–1976









1979 1980 1981 1982 1983

G e r m a n y
F r a n c e
Aust r ia

Un i t ed K ingdom
Uni ted Sta tes

Unit labour costs after a negative supply
shock, 1979–1983








1987 1988 1989 1990 1991

G e r m a n y
F r a n c e
Aust r ia
Un i t ed K ingdom
Uni ted Sta tes

Unit labour costs after a positive
demand shock, 1987–1991








1997 1998 1999 2000 2001

G e r m a n y

F r a n c e
Aust r ia
Un i t ed K ingdom
Uni ted Sta tes

Unit labour costs after a positive demand and
a negative supply shock, 1997–2001

Chart 1

Unit labour costs and external shocks

Source: AMECO database, European Commission, Brussels, spring 2001.

- 21 -

in the course of supply, as well as of demand shocks in Europe from 1972 to today. It contains unit labour

costs as proxy for inflation in these countries, thereby hinting at the fact that conditions in the labour

market play a crucial role in defining a country’s role in the game. Chart 2 contains the rather similar

pattern of the respective inflation performances.

The group consists of Italy and the United Kingdom, the persistent high-inflation countries; the

performer in the middle range is France; and Germany and Austria are the prototypes of what we call low-

inflation countries. The United States is depicted as a reference line. Moving from the beginning of the

1970s to the present time yields a straightforward message: all the countries seem to have learned how

to deal with the different shocks in the course of time. Germany has clearly been since the beginning the

best performer as fas as the absorption of the inflationary consequences of shocks are concerned, and has

consequently assumed the role of anchor. Austria follows Germany very closely in all aspects and has

been able to keep its exchange rate stable throughout. The high-inflation countries have proved to be

inflexible compared to the low-inflation ones, as their unit labour costs and their inflation rates jumped

up following negative supply shocks and positive demand shocks and as a rule came down only slowly

– i.e. the downward movement of prices and nominal wages was much more rigid compared with those

in the anchor country. Consequently, anchoring economies which could not follow the anchor country

had to depreciate in order to restore the real value of their currencies and their competitive position.

The most outstanding and clear-cut example of an unsustainable peg was the attempt of Italy and

the United Kingdom to fix their currencies vis-à-vis the deutsche mark already in 1988, i.e. at a very early

stage in the development of the EMU. In the wake of the stock market crash in the autumn of 1987, the

central banks in the United States and Europe reduced their interest rates to historical lows, despite the

fairly limited effects of the crash on the real economy. Thus, the monetary stimulation at a rather late

stage of economic recovery gave new momentum to the global economy and world investment. Following

the shock, the growth performances of the economies under consideration were more or less identical (see

chart 3): all reached growth rates of 4 per cent or more, with the United Kingdom being the best performer

at the end of the 1980s, and West Germany outpacing the others at the beginning of the 1990s following

the unification boom.

The inflation performance during the crucial period 1987–1992, however, was quite different:

w hereas in the traditional low-inflation countries (including the United States) it remained below 4 per

cent in spite of upbeat growth, in Italy and the United Kingdom inflation rose to 8 per cent or more. Even

more pronounced were the differences in the growth rates of unit labour costs. Germany, Austria and

France experienced a very slow and moderate reaction of wages to falling unemployment and rising

growth; the increase in labour costs remained subdued and below the rise in prices. In Italy and the United

Kingdom, however, growth rates of unit labour costs jumped from 4 to close to 10 per cent, outpacing

the hard currency group. Thus, compared with the anchor country the two newcomers to the EMS, Italy

and the United Kingdom, lost ground in the direct external competition with Germany, Austria and

France. With fixed nominal exchange rates, accumulated over the four-year period 1987–1991, Italy’s

- 22 -








1972 1973 1974 1975 1976

G e r m a n y

F r a n c e
Aust r ia

Un i t ed K ingdom

Uni ted Sta tes

Inflation after a negative supply shock,








1979 1980 1981 1982 1983

G e r m a n y
F r a n c e
Aust r ia

Un i t ed K ingdom

Uni ted Sta tes

Inflation after a negative supply shock,











1987 1988 1989 1990 1991

G e r m a n y
F r a n c e
Aust r ia
Un i t ed K ingdom
Uni ted Sta tes

Inflation after a positive demand shock,











1997 1998 1999 2000 2001

G e r m a n y

F r a n c e
Aust r ia

Un i t ed K ingdom

Uni ted Sta tes

Inflation with positive demand and negative
supply shock, 1997–2001

Chart 2

Inflation and external shocks

Source: AMECO database, European Commission, Brussels, spring 2001.

- 23 -








1972 1973 1974 1975 1976

G e r m a n y

F r a n c e
Aust r ia

Un i t ed K ingdom

Uni ted Sta tes

Growth after a negative supply and
a negative demand shock, 1972–1976








1979 1980 1981 1982 1983

G e r m a n y
F r a n c e
Aust r ia
Un i t ed K ingdom
Uni ted Sta tes

Growth after a negative supply and
a negative demand shock, 1979–1983








1987 1988 1989 1990 1991

G e r m a n y

F r a n c e
Aust r ia

Un i t ed K ingdom

Uni ted Sta tes

Growth after a positive demand shock,








1997 1998 1999 2000 2001

G e r m a n y
F r a n c e
Aust r ia
Un i t ed K ingdom
Uni ted Sta tes

Growth with positive demand and
a negative supply shock, 1997–2001

Chart 3

Growth and external shocks

Source: AMECO database, European Commission, Brussels, spring 2001.

- 24 -

25 Krugman’s description of the European crisis as “second-generation model” of financial crisis is
misleading. Krugman (1998) weighs heavily the fiscal situation of the countries in crisis, but does not take into
account how quickly they all turned around after depreciation of their currencies, despite high budget deficits. In
my opinion, there have not been several generations of models but only variations of one theme.

real exchange rate (calculated with unit labour costs) appreciated by 23 per cent, and the United

Kingdom’s by 28 per cent vis-à-vis Germany. The loss of competitive power in these two countries was

reflected in a huge swing in the current account from surplus to deficit.25

The United Kingdom and Italy, trapped by a deflationary threat on the one hand and the decision

to quit the EMS on the other hand, opted for depreciation. It is easy to see from the above charts why the

decision of France not to give in to the pressure coming from the “markets” in 1992 was justified. France

as well as Austria were able to preserve their competitive position in the aftermath of the positive demand

shock. France had been under pressure from the markets because the overall economic situation at that

time was rather gloomy, compared to Germany or Austria, so that a depreciation would have been an easy

way out of the recession. But the decision of the French government, with the assistance of most other

members of the EMS, to stick to the “unwritten” rules of the game – namely to use depreciation only in

case of an external disequilibrium – proved to be right. Putting it differently: the pressure of the markets

in the case of France was quite unjustified, whereas for the United Kingdom and Italy it was fully

justified. The bold move of the French authorities to challenge the wisdom of the market proved to be


This case of a currency crisis in Europe highlights the role that controls and interventions in the

market for short-term capital can play and, at the same time, what role they cannot play. In the case of the

pound and the franc in 1992, a massive and uncontrolled flight was by no means justified in either case.

A thorough analysis by the authorities in both countries would have shown what the chart proves, namely

that there was a limited need to adjust the pound but none at all to adjust the franc. There was no reason

to panic or fear a total collapse of the EMS; but controls could have helped to avoid big and unjustified

market instability. But with or without controls the British and Italian problem had to be solved.

The most important lesson to be learned from this event in Europe concerns the macroeconomic

steering of the system. A better “early warning system” within the EMS could have prevented the systemic

crisis. If the authorities of the EMS as well as of all countries involved had realized at a much earlier stage

that the situation of the lira and the pound was becoming unsustainable, they could have reacted much

sooner and depreciated the currencies of the two high-inflation countries already in 1989 or 1990, thereby

averting the worst of the crisis and saving France from the contagion effects of a general speculation

against currencies with fixed exchange rates.

The crisis phenomena and the waves of speculation frequently occurring in systems of fixed and

semi-fixed exchange rates could give rise to the impression that an anchor approach to stabilize the

external and the internal value of money is counterproductive in most cases. But things are not always so

simple. Anchoring a small and very open country’s currency has in several cases proved to be a very

effective method of stabilization of the domestic price level. The main economic policy target many

- 25 -

26 The question of whether the stability game has been overall successful in terms of growth and employment,
the intrinsic targets of economic policy, is a different one. Monetary restriction normally goes with rising
unemployment in the short term. However, if countries opt for long-term monetary stability – i.e. a stable domestic
inflation rate – there are only a few valid arguments to defeat such an approach. The simplified Phillips curve
analysis’ record concerning the explanation of inertial inflation is hardly convincing.

anchoring countries had in mind was not the external but the internal value of money. This approach has

proven its merit time and again.

This is true for small anchoring countries in Europe such as Austria, the Netherlands and Belgium.

In these economies inflation has been subdued for decades in the same way as in their anchor country

Germany, and they have been able to adjust to shocks as effectively. The anchor approach has also been

successful in some larger countries like France and Italy. Although France fixed its exchange rate later

than the smaller countries (in 1987) and the adjustment was not always as smooth, it did manage to catch

up fully with Germany’s inflation performance. But even Italy, which was the subject of many speculative

attacks and backlashes in its adjustment process, finally converged in terms of growth rates of unit labour

costs and flexibility in case of shocks to the anchor. The growth rates of unit labour costs over time

demonstrate the enormous convergence of performance of the European countries in the phase that could

be called the third oil price explosion of 1999–2000. Wage growth in a formerly high-inflation country

such as Italy does not exceed productivity much more than in low-inflation ones like France, Germany

and Austria. Unit labour costs in the whole region have not risen at all in response to the oil price hike.

Obviously the critical question is whether this success should be attributed to the anchor approach

or to other factors, with evidence for the United Kingdom and the United States showing that countries

with flexible exchange rates can be as successful concerning the speed and sustainability of adjustment

to shocks as anchoring countries. Of course, the Western industrialized countries have developed quite

different institutional arrangements in the labour and goods markets to stabilize the internal value of

money – arrangements that have proven successful. However, for some open economies pressure from

outside and through the import and export channels has been stronger than domestic economic policy

pressure alone. Italy is the most prominent example of a fairly large economy in which the domestic

institutional framework has hardly been sufficient to successfully stabilize monetary conditions. But with

the pressure from cheap imports and an ambitious target for the exchange rate vis-à-vis the deutsche mark,

economic policy authorities could always force the economic agents to stick much more strictly to the

rules of the stability game.26

- 26 -

27 This section was first published as part of Bofinger (2000).

28 In Europe direct government intervention or even the determination of nominal wages by government
decree played an important role during the convergence process.

Appendix: The roots of inertial inflation in Europe27

Why was the inflation performance of European countries so different in the 1980s? Why did it

take more than a decade in Italy but only two years in Germany to bring inflation back to tolerable levels

after the second oil price explosion? What explains the average performance of France in this respect and

the excellent one of the Netherlands? The impact of monetary policy cannot explain the inflation outcome.

While monetary policy was restrictive all over Europe after the oil price explosion of 1979–1980, on the

demand side economic policy was much more expansive in Germany in the 1980s than in France or Italy.

Obviously there must have been factors on the supply side of the economy responsible for the long-lasting

stickiness of prices and for the inertial inflation in these countries. These factors must have forced

monetary policy makers to tighten the monetary screws much more and much longer in the high-inflation

countries to bring about the degree of monetary (nominal) convergence needed for a successful pegging

of nominal exchange rates in the 1990s.

The supply side, obviously, represents the cost level of the economies under consideration. If

overall costs are higher and more sticky in one country, a stronger impact of monetary policy is required

to achieve the same result regarding inflation. In modern, vertically integrated, economies there is only

one intermediary good which is not produced at a certain stage of the production process: that is labour

as a whole. Thus, for large, relatively closed, economies nominal unit labour costs are by far the most

important cost component. Unit labour costs for these regions (e.g. the United States and EMU) are highly

correlated with the rate of inflation (chart 4). In log-linear terms: the growth rate of inflation (p) is

determined by the growth rates of nominal wages (w) and the growth rate of the mark-up over costs (u)

on the one hand and the growth rate of labour productivity (:) on the other hand:

p = (w + u) – :

If the mark-up is constant over time – i.e. if there are no changes in income distribution between

labour and capital – prices are determined by unit labour costs alone (w – :).

In this analysis either more or less exogenous nominal wages determine inflation directly or

inflation inertia resulting from institutional arrangements fixing nominal wages in relation to past inflation,

the degree of the exogenous role of wages depending on the centralization of wage settlements or direct

government interference.28 Given the undeniable success of corporatist approaches to determine wages

and prices as well as the overwhelming empirical evidence of the dominant role of inflation inertia, it is

- 27 -

European Union













1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001



t y

Unit labour costs


United States








1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001



t y


Unit labour costs

Chart 4

Unit labour costs and inflation

Source: AMECO database, European Commission, Brussels, spring 2001.

- 28 -

29 IMF (2001: 117). Although the IMF study points to the fact that “inflation inertia and money supply have
to be found to be key determinants of inflation”, it quickly turns to the “widespread view that fiscal policy is closely
connected with the inflationary experience of many emerging market economies” (p. 123). The general obsession
of IMF with fiscal policy is totally misleading. The graphs presented to show the correlation between fiscal deficits
and inflation in emerging markets are unconvincing (pp. 128/9). But by consequently ignoring the riddles posed to
its theory by Japan (exploding budget deficits and deflation) or the United States (huge budget surpluses and
moderate inflation) in the 1990s, the analysis lacks credibility.

30 See IMF (1999) and Flassbeck and Spiecker (2000) for an empirical refutation of the IMF view.

31 Flexible nominal wages are superior to sticky ones only under conditions of negative demand shocks and
“rational expectations” concerning future anti-inflationary measures of monetary policy. In this case a quick reaction
of nominal wages and prices can help to avoid rising real interest rates and restrictive monetary effects on output
and employment. But a symmetric reaction of nominal wages in case of an expansionary monetary policy would
lead to the same result, namely a small reaction of output and employment. This time, however, the result is inferior
to sticky nominal wages. Thus, monetary policy should rely on itself and not on the replacement of monetary policy
by “monetary management by the trade unions” by means of falling prices and wages, as Keynes once had called it.

rather surprising that IMF in its latest World Economic Outlook sticks to a fiscal deficit cum seigniorage

hypothesis of inflation.29 This inconsistency, obviously, is attributable to the underlying neoclassical

employment theory IMF subscribes to.30 If real wages determine employment by inducing companies to

produce with more labour or more capital, nominal wages cannot be at the same time an important

determinant of the price level. If, however, (exogenous) nominal wages determine unit labour costs, with

labour productivity determined by investment and technology, and unit labour costs determine the price

level, there must be another (exogenous) factor determining investment and the growth rate of production

as a whole. This can only be the interest rate. Hence, monetary policy has to assume responsibility for the

real development of the economy as soon as wages help to keep inflation down, a consequence that

independent central bankers all over the world would like to avoid.

Negative supply side shocks have often been the trigger for inflation and resulting inflation inertia.

Nominal wages play the crucial role. They may be rigid or flexible regarding the overall price level in the

case of a supply side shock, like an oil price hike. If nominal wages are rigid, real wages are flexible if

the price level moves as a result of a supply shock. Thus, the “rigidity of wages” proves to be an

ambivalent term. Inflexibility or rigidity of wages is often blamed for being one of the main hindrances

to a flexible response by labour markets in Europe. But the case of a supply side shock questions

traditional concepts of rigidity as a pathological phenomenon. Neoclassical theory expects real, not

nominal, wages to be flexible. But for real wages to be flexible, nominal wages have to be inflexible, if

prices are flexible.31 Thus, sticky nominal wages are clearly desirable in cases of supply side shocks. If

commodity prices rise as a result of falling supply (“oil”) and (rigid) money wages do not react, the shock

is absorbed without inducing an inflationary spiral. However, if nominal wages are flexible (vary with

prices), the effects of a supply shock will either increase inflation or will reduce demand and investment

as soon as monetary policy tries to avoid an acceleration of inflation.

There is a second important aspect. For demand side policies, like monetary policy, to succeed in

stimulating growth, rigid nominal wages relative to employment are the most important ingredient, as the

experience of the United States in the 1990s showed very clearly. If money wages do not rise at an early

- 29 -

32 To be clear concerning the explanation of unemployment in France and Italy: it was not “neoclassical”
unemployment caused by too high real wages, but rather “Keynesian” unemployment owing to too high real interest
rates. The reaction of real wages relative to unemployment (the wage share) was, in the course of the 1980s, as
flexible in France and Italy as in Germany and much more flexible than in the United States, where real wages hardly
ever lagged behind productivity (Flassbeck and Spiecker, 2000).

stage of the recovery, monetary policy can be accommodative for a very long time and unemployment can

fall accordingly. There is only one exception: the degree of monetary restriction to achieve a certain fall

in the inflation rate depends on the flexibility of nominal wages downwards, and not on real wages. If

nominal wages are rigid downwards – meaning that they are slow to react to rising interest rates and rising

unemployment – monetary policy has to tighten more than in the case of a quick and strong reaction of

nominal wages, given a rather stable trend of productivity growth. Thus, as a rule, the nominal rigidity

of wages is the preferable regime in a world bombarded by positive and negative real shocks from both

sides of the market.

Flexible nominal wages in response to prices, and thus real wage rigidity, was the regime used by

some of the large European economies to handle the two oil price explosions – with disastrous results.

France and Italy, for example, had to fight since the mid-1970s with backward-looking indexation

schemes; moreover, in those countries nominal wages were inflexible in response to unemployment.

Consequently, flexible nominal wages (a function of past prices) led to inflexible real wages, and

restrictive monetary shocks had grave consequences on the real economy, as prices reacted with a huge

lag to the fall in demand. The important exception in continental Europe at the beginning of the 1980s was

Germany: like the United States, it was successful in bringing unit labour costs and inflation rates down

almost immediately after the end of the oil price hike. Some other European countries – a group consisting

of the Netherlands, Belgium, Denmark and Austria – managed to keep pace with Germany, even in the

first half of the 1980s.

Given the German and US examples, other countries quickly learned that inflation was not the

solution to the emerging labour market problems in the aftermath of a supply shock. But the institutional

arrangements on the labour market, which had been created to shelter employees from the negative

repercussions of loss in real income, could not be dissolved quickly for political reasons. In consequence,

instead of a quick dissolution of inflexible labour market regimes (i.e. the dissolution of nominal

flexibility and reinstallation of nominal rigidity), the answer was harsh monetary restriction resulting in

an extremely long period of disinflation, with the final conversion to the German and US level of unit

labour costs and inflation only at the beginning of the 1990s. The price to be paid was much higher

unemployment in France and Italy than in West Germany and in the United States before the recession

of 1991/2.32

Pertinent to the understanding of the process are the cases of the Netherlands and France in

comparison with West Germany. For both members of the EMS the development of unit labour costs in

Germany was obviously the reference line, the “anchor” for all those countries aiming at membership of

the EMS and later on of the EMU. German unit labour costs rose, by and large, by 2 per cent annually

- 30 -

33 Similar undervaluations occurred in Finland and Ireland. The EU Commission ignores these cases, thereby
violating its role as the guardian of the smooth functioning of the currency union.

34 See Flassbeck and Spiecker (2000) for a closer look at the facts.

throughout the 1980s. France did not manage to get its wage policy to follow this line until the second half

of the 1980s, and fixed its exchange rate irrevocably to the deutsche mark only in 1987. The Netherlands

adopted a quite different approach: after a huge inflationary bubble during the 1970s and an

unemployment rate which doubled Germany’s in 1982, the Dutch government adopted a new regime of

labour relations. Under the supervision of the government, wage policy agreed to a moderation of nominal

wage increases, even below the Germany rates, given the different national productivity trends. The real

exchange rate of the Netherlands was devalued as the nominal rate was fixed to the deutsche mark. By this

“beggar-thy-neighbour” approach the Netherlands economy gained overall competitiveness and won

market shares all over Europe, whereas the high-inflation countries struggled with domestic as well as

foreign demand.33

It is important to note that the successful non-monetary moderation of inflation was achieved in

European countries with highly centralized processes of wage-bargaining, such as in Germany and the

Netherlands. But, in stark contrast, a country with a highly decentralized labour market, like the United

States, was able to compete with the most successful European approaches regarding adjustment to supply

shocks, i.e. nominal wage rigidity and real wage flexibility, given more or less the same monetary policy

stance, in the course of the 1980s. Thus, the United States could have fixed their rate vis-à-vis Germany

at the same time as the Netherlands and much earlier than France. The fact that Germany and France were

much less successful regarding their labour market performance throughout the 1990s seems to be a

different story, as the Netherlands decoupled from Germany only after 1992 in terms of overall

unemployment. Surprisingly enough this was not the result of an ongoing moderating of wages vis-à-vis

Germany but rather the opposite, namely higher growth rates of unit labour costs and an acceleration of

domestic demand.34

The lesson to be learned from the European labour market developments since the adoption of the

plan for a common currency is rather simple: countries with very different labour market regimes can join

a system of fixed or quasi-fixed exchange rates if they are able to adjust their unit labour cost

developments to that in the majority of other countries. Any system is free to choose a growth path of unit

labour costs, which will then determine the inflation rate, or to fix the inflation rate and let nominal wages

adjust to this inflation target, given a stable trend of productivity growth. The transition to such a low

inflation performance, backed by a sufficient degree of nominal wage rigidity and real wage flexibility,

can be very costly, however. Any country joining a system which includes already successful countries

should check on the possibilities to alter its labour market regime in time to avoid major blows to its

economic targets and the stability of the whole system. If Italy, for example, had been able to abandon

- 31 -

35 The problem of backward-looking indexation of wages and pensions is generally virulent in countries
fighting with inertial inflation. Recent examples include Turkey and most of the transition economies in Eastern
Europe. In these cases the traditional approach of IMF to fight budget deficits to restrain the expansion of the
monetary base is extremely costly compared to income policy tackling expectations of inflation directly (Hoffmann
et al., 2000).

36 The crucial question concerning dollarization is not the volatility of national monetary policy but the labour
market institutions keeping inflation low despite an expansionary monetary policy. Thus, even in the face of volatile
interest rates in emerging markets, it is unjustified to state “not to have a central bank may actually be a benefit
rather than a cost” (Joint Economic Committee, 2000: 13).

much earlier on the “scala mobile”, its scheme of backward-looking indexation, the adjustment costs for

everybody in Europe could have been considerably diminished.35

Convergence of monetary conditions, including wages and unit labour costs, has been the main

feature of Europe’s path to monetary union. To be successful, dollarized countries or currency boards have

to achieve the same degree of convergence with no assistance from the anchor country. However, as in

Europe, convergence of wages and unit labour costs in recession periods of high or even rising

unemployment is not sufficient. The real test is a high degree of convergence in the face of falling

unemployment and high growth rates. For the EMU this test still lies ahead. Have the roots of inertial

inflation been eliminated, or have the price rigidities of some countries just been hidden temporarily under

the pressure of the supply surplus on the labour market?36


Outside Europe there are other prominent examples of successful monetary stabilization by means

of an external anchor. Brazil has proven this in spite of the heavy weather faced by the economy.

Following the introduction of the Plano Real in July 1994 and fixing of the real vis-à-vis the US dollar,

the Brazilian inflation rate came down from a four-digit figure in 1993 to a one-digit figure after 1997.

In terms of the pure reduction in the inflation rate this is an extraordinary performance. It is difficult to

argue that the Brazilian authorities could have achieved this without pressure through the import channel

mentioned above. But even with the inflation rate coming down quickly during the disinflation process,

the external competitive situation deteriorated. Despite several depreciations of the nominal value of the

currency, there was an actual appreciation of the Brazilian real, which had reached – according to the

calculations of the national authorities and international organizations – an overvaluation of 20–30 per

cent by the end of the disinflation process.

Certainly, an overvaluation of the currency is a necessary outcome if the anchor approach is to be

rational. It is precisely the pressure stemming from overvaluation – i.e. from low import prices and tough

competition in the export markets – that acts as a sanction against unjustified claims of workers and other

sectors of society. With an overvalued exchange rate, the adjustment pressure of the world market (i.e. of

“globalization”) is artificially but voluntarily increased. Again, this kind of strategy is reasonable if

- 32 -

37 It is more than surprising that Stanley Fischer, Deputy Director of IMF, admits frankly how difficult the
political economy of an overvalued anchoring country is. Had this been understood from the beginning, the question
of a credible exit strategy would have received much more attention (Fischer, 2001: 9).

countries cannot do better than the anchor country, but they will suffer from money illusion. Without an

anchor approach (i.e. with a constant real exchange rate) there is no help from outside for the domestic

target of getting rid of certain kinds of money illusion. The whole burden falls on domestic institutions.

Unfortunately, from the very beginning of the implementation of the anchor approach, many

international institutions and advisors did not pay sufficient attention to the necessary overvaluation of

the anchoring country’s currency and did not prepare the policy makers for the inevitable depreciation,

i.e. they did not prepare a reliable exit strategy. The remedy for overvaluation is simply a nominal

depreciation in the anchoring country when domestic stability is achieved. The depreciation should take

care of the accumulated overvaluation of the disinflation phase. In the case of Brazil, for example, during

the crisis it was rather obvious that the real had to be depreciated by something like 20–30 per cent to help

the country out of the balance-of-payments trap.

Although the pure economics of the restoration of international competitiveness are simple, the

political economy of this technical operation is a protracted one, and the pace of the progress towards a

political solution has been generally underestimated.37 Governments have put all their political credibility

on the playing field and have succeeded in convincing people that the fix rate has brought more good than

harm. Moreover, they fear a revival of inflationary pressures and the return of inflation-feeding

institutions, such as the famous backward-looking indexation schemes for wages and pensions, as soon

as the door is opened by an inflationary impulse coming from a depreciation. Additionally, in the phase

of disinflation governments have been proud of gaining the “confidence” of international markets in the

form of an inflow of short-term capital and an increase in international reserves. There is a risk of

endangering these achievements by loosening the external grip on inflation.

However, many of the fears in the anchoring country seem to be exaggerated. Depreciation will

cause only a small new inflationary shock (depending on the weight of imports on total value added),

compared with the disinflation the country has managed to fight. But even this is only a one-off effect if

strong second-round effects on inflation can be avoided. Crucial for the success of the operation to restore

international competitiveness is to contain the depreciation to the absolute necessary minimum. At this

stage only is the active assistance of the anchor country needed. It may help the anchoring country to

retain the confidence of the markets it has gained so painfully by figuring out the necessary degree of

devaluation and by direct intervention in the currency market in the case of heavy speculation against the

anchoring country.

To float the currency of a country in an overvaluation crisis is quite wrong. The jump from semi-

fixed to fully flexible rates that IMF had been advocating in the winding up of the Asian crisis and in

Brazil is dangerous and unnecessary, as this policy usually leads to an overshooting of the devaluation,

with disastrous effects on the financial system of the countries concerned and on the competitive position

- 33 -

of countries not yet involved in the crisis. The European experience can serve as a role model in this

respect. In Europe the institutional arrangements of the EMS have often helped to figure out the necessary

rate of depreciation and to add credibility to the measures taken by the depreciating country. Whenever

market pressure forced a justified depreciation or authorities decided that a depreciation was inevitable,

it has been possible to process the depreciation without the danger of overshooting by the markets.

“Orderly depreciations” of the overvalued currencies of high-inflation countries have been the trademark

of the EMS for many years.


External and internal stability of the price level is just a tool to better accomplish the relevant

targets of economic policy, namely more employment and higher growth rates in real income. An

anchoring country explicitly gives away important tools to achieve these targets. Thus, its overall

economic policy success depends directly on the anchor country’s own success. The latter’s policy,

however, may be ideal under the circumstances prevailing within the country itself, but that does not imply

that it is the right policy for the group formed by the anchor country together with its surrounding satellite


This was one of the main problems of the Bretton Woods system in the first two decades after the

Second World War. US monetary policy may have been adequate for the United States. The Federal

Reserve Bank was forced by law to take into account the economic environment in the United States to

underpin its decisions – although the US dollar was the hegemonial currency of the global exchange rate

system. The same is true for Germany as the anchor of the EMS. For the country with the hegemonial

currency this policy can go on indefinitely, but for the system as a whole such a policy approach,

obviously, is not adequate, as monetary conditions may require a quite different approach in other


Apparently, other policy options have to be considered. The move to a multilateral monetary

system, with all countries participating in the decision-making process, is the only consistent way out.

Nothing short of a monetary union can help to avoid permanent mismanagement of global monetary

policy. Hence, in Europe, the step to create the EMU was not just the result of the attempt of the French

government to avoid continued political domination by Germany, as many have argued. From an

economic point of view, it was also a fully justified step, given the fact that for systemic reasons Germany

could not concur with Europe’s needs in an overall non-inflationary environment.

For very small, extremely open economies, forming just satellites of the anchor country, the anchor

approach may be adopted for a rather long period if, by and large, the anchor country’s economic policy

follows reasonable principles and accepts the existence of the satellites with benign neglect. But for any

larger group and for countries of equal size or economic power, the anchor approach can only be a

- 34 -

38 Such a gap has definitively emerged in Bulgaria and most probably also in the Baltic countries with a
currency board.

39 Even Argentine officials admit that there was, at the beginning of 2001, an overvaluation of at least 20 per
cent. But any attempt to restore competitiveness by domestic cost-cutting measures or government subsidies are bound
to fail if they do not – as does a change in the exchange rate – discriminate between production for domestic purposes
and exports. But if they do, they will necessarily violate international trade rules, which proves that these rules are more
or less useless if they do not include unjustified exchange rate changes as one of the most important distortions to trade.

transitional stage on the way to monetary union. A consistent monetary policy is only possible for the

group as a whole and thus can only perceived by a united central bank. The transitional phase, however,

can last a very long time. From the first steps to the last it took Europe 30 years. But the formation of the

different steps towards monetary union and the political will to move further in the right direction may

give such country groupings an enormous degree of independence to act vis-à-vis the rest of the world,

and may minimize the interference of international financial organizations in domestic affairs. Thanks to

the economic strength as well as stability of the anchor and its will to solve the multilateral problems, even

small countries may be able to avoid the role of demandeur in Washington or to resort to IMF as lender

of last resort.

The situation is totally different with unilateral solutions such as currency boards or dollarization.

These systems explicitly lack the advantages of a monetary union, but have many disadvantages as they

are neither transitional stages towards a monetary union nor sufficiently isolated from the floating rate

regimes surrounding them. The future of the existing currency boards in developing or transforming

countries is uncertain, with Argentina being the most critical case. Some observers still believe that

Argentina has a chance to overcome the persistent economic slump by means of “structural adjustment”,

such as privatization or a further reduction in its public sector deficit. Hence, the country is still the object

of generous unilateral assistance, as donors believe in its ability and willingness to adjust. Already in

recent years the Argentine government has taken draconian measures to cut down public spending, e.g. by

sharply reducing in absolute terms the salaries of public officials. The share of public spending in GDP

is lower now in Argentina than in any other South American country.

Nevertheless, there is a fundamental misconception about the potential role of “structural

adjustment” and fiscal policy in the case of a “trapped currency board”, as seems to be the case in

Argentina. This misconception is owed to the dominance of a neoclassical theory, which is based on the

fiction of a smooth adjustment of “flexible prices” in a market economy. Giving up this fiction yields

bitter results. Once a currency board regime is faced with an overvaluation of its currency in a world of

rather stable price levels, it has virtually no chance to escape this trap by means other than a depreciation

and the abandoning of the whole currency board. The overvaluation of the peso is quite obvious.

Argentina may have avoided the emergence of a huge gap in its competitive position vis-à-vis the Western

world after the introduction of the currency board owing to a rather successful anti-inflationary policy.38

However, after the devaluations in Brazil and other South American trading partners vis-à-vis the

US dollar, Argentina’s position deteriorated sharply.39

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40 It is more than surprising that many people still believe that currency boards tend to create a monetary
regime where foreign currency generation is automatically guaranteed through monetary inflows. At the same time
it is admitted that countries with currency boards can have the problem of lack of competitiveness and of very high
interest rates. Obviously, money may be flowing into the country, but only at rates which kill its economy
(Argentina’s short rate was as high as 18 per cent in the spring of 2001, with zero inflation). But even at
astronomically high rates, money will not be available if overall competitiveness is not improved quickly, as
everyday experience with bank lending shows.

As shown above, the only instrument left to a country with an absolutely fixed exchange rate is

wage cuts to adjust to such a revaluation of the real exchange rate. Unit labour costs have to fall in

absolute terms. Thus, the reduction in Argentina in the salaries of public officials is insufficient. Those

parts which are most exposed to international competition need to be cut, namely industry and agriculture

in the case of Argentina. But even if this can be brought about by political pressure on unions and

employers, there is no easy way out. An overall cut in wages may, as a rule, restore competitiveness but

it will not offer a solution for the overall economy. In the very short run a reduction in nominal wages will

not force the overall price level to fall, but will result in falling real wages. If real wages fall, the demand

of private households will fall too as, apart from economic text-book cases, employment will not react

immediately to the fall in real wages in a depressed economy. Faced with falling domestic demand and

falling profits, companies may cut prices step by step and thus restore the real income of their workers.

But the move towards deflation will not restore real demand, as workers – confronted with the fear of

further cuts in wages, and in an attempt to take advantage of the benefits of falling prices – postpone

consumption. In addition, the incentive to hold liquidity increases when prices fall.

This is especially important for a rather closed economy like Argentina. Wage cuts in such an

economy prove to be disastrous as they quickly translate into falling domestic demand in one way or

another. Even if the positive effects of an improvement in international competitiveness materializes, the

negative effects on domestic demand by far outweigh the positive ones. This is the classical case where

“the tail wags the dog”, to quote McKinnon (1963). If fiscal policy in this environment tries to solve the

crisis by further cutting domestic demand, the crisis can only be intensified. An overall reduction in

domestic demand helps to reduce the current account deficit, and thus seems to heal the lack of

competitiveness. In Argentina this “improvement” up to 1999 was regarded as a big success in the

government’s strong attempts to cope with the crisis. But the real test on competitiveness is a flourishing

economy with no growing deficits, and not a stalling, or even collapsing, one with falling deficits on the

current account. The mere reduction of absorption of internal and external resources is not sustainable.

At this stage it seems to be hard for policy makers to get a realistic picture of the state of the

economy.40 Capital is still flowing in to finance the current account deficit with no quantitative restriction.

But most of the currency board countries have to pay rather high interest rates despite domestic stability.

Argentina’s spread on United States Treasury bills has hardly ever been less than 500 basis points, but it

has been temporarily as high as 1,300 basis points. Bulgaria has a short-term interest rate of more than

10 per cent, as have also the Baltic states. However, 10 per cent is too high for domestic purposes if the

inflation rate is close to zero, as in Argentina (at a real rate of 10 per cent in a recessive period) or close

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41 Currency boards are inferior to the anchor approaches used in Western Europe in the run up to the EMU,
as they deprive national monetary policy of any means to provide sufficient liquidity to the banking system to allow
for a steady-hands policy regarding the short-term interest rate. While a country with “tied hands” in monetary
affairs has to follow the monetary policy of its anchor only, a currency board hinges on the willingness of the foreign
capital markets to supply capital at a certain interest rate. As the judgement of the markets concerning the ability
of the country to service debt fluctuates, both the short and the long rate may also fluctuate, thereby producing what
the currency board should have avoided: an extremely unstable monetary environment. The same is true for
dollarization if there is even the slightest risk of a sovereign default.

42 As IMF – one of the strongest proponents of the corner solution – is willing to act as lender of last resort
in currency board systems, the moral hazard for international investors is inevitable.

to the Western level, as in the Baltic countries. An interest rate of 10 per cent may not be high for domestic

reasons if the inflation rate is close to 10 per cent, as in Bulgaria. But then the competitive position has

deteriorated, with an absolute fixed exchange rate, and the crisis in overall competitiveness will show up


A currency board or dollarization can only function properly if the anchoring country has a much

higher growth rate of real income and can thus afford to pay higher interest rates in a hard currency or if

the interest rates remain stable, as in the anchor country.41 Otherwise the hard pegs will attract

international investors in short-term assets in these countries, as the necessary link between higher interest

rates and the risk of devaluation is abandoned and the chance of a bail-out is high.42 In this case the

economic fundamentals of the anchoring country are definitively in disequilibrium in one way or another,

and the currency board cannot be sustained in the long run. The need to adjust the exchange rate may be

obscured for a while by favourable external circumstances, but it will ultimately prove to be inevitable.


Larry Summers, formerly Secretary of the United States Treasury, in his analysis of the

international financial crises recommends avoiding “policy biases toward short-term capital”. This bias,

in his view, could be observed time and again in the recent crises. His position reveals the underlying

confusion of mainstream economics when he adds that “we saw it [the bias] in the Russian Federation,

in the government’s determined efforts to attract international investors to the market for rouble-

denominated GO’s” (Summers, 2000: 9). Summers’ description is not entirely wrong. Indeed, extremely

high nominal interest rates and the dollar peg of the rouble attracted short term flows. Nominal interest

rates amounted to something like 50 per cent, with overall price inflation at around 20 per cent.

Imagine the verdict of such an eminent economist as Larry Summers for the economic policy

makers (and their advisors) in an industrialized country going for a real interest rate of 30 per cent and a

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43 However, it is quite surprising how many economists ignored the role of interest rate differentials in the
Russian crisis. Instead, fiscal policy is discussed as if strict fiscal discipline could have healed the effects of an
overly restrictive monetary policy. See Desai (2000) and Eichengreen and Hausmann (1999). Williamson (2001)
is one of the few analysts with a clear vision of the role of interest rate differentials.

unilaterally pegged exchange rate with no exit strategy.43 But the core of the problem is the domestic

stance of monetary policy. No industrialized country could survive economically 30 per cent real interest

rates, whatever the exchange rate regime might be. At the time of the installation of the peg, the Russian

Federation was supervised by IMF. Under the guidance of an IMF programme its central bank gained

independence without knowing how to use its power effectively. With and without the overvaluation of

the rouble in real terms the country would have gone bust sooner or later. Hence, there is no point in

saying that you should avoid “policy biases towards short-term capital”. The point is, you should avoid

disastrous domestic economic policy by any means because it will kill you, whether or not your country

is attractive for international capital.

The crucial point is a simple one. There is no such thing as an autonomous or independent national

monetary policy for countries with open capital accounts. High-inflation countries – those with relatively

high growth rates or with misguided monetary policy, as in the case of the Russian Federation – cannot

expect to be insulated from the rest of the world if there are no obstacles to the mobility of capital. Any

deviation of interest rates from the fundamental equilibrium equation, and thus from PPP, will lead to

speculative flows, irrespective of the exchange rate regime. If a country aims at fighting double-digit

inflation (as the Russian Federation did in 1995), it has the choice to abandon capital account openness

or to search for membership in a monetary block offering a clearly defined exit strategy when unavoidable

real revaluation has to be corrected.

Some writers seem to presage this problem by creating dilemmas like the “original sin” of

Eichengreen and Hausmann. However, if countries are lacking a deep and stable financial market a

mismatch (either a currency or a maturity mismatch) will only be unavoidable if they are unable to

stabilize their exchange rates (unilaterally or as part of a system). If they cannot stabilize their exchange

rates permanently, their interest rates may be too high because of inflation also being too high. Then they

should opt for “BBC” (“basket, band and crawl”, as John Williamson, 2001, calls it), or an anchor

approach. There is no other way out. The “original sin” hypothesis seems to assume a financially insulated

economy with an open capital account, which, as we have seen above, is a contradiction in itself. The

Eichengreen and Hausmann thesis is significant, however, as it hinges onto the underlying theoretical

problem that the whole exchange rate discussion is implicitly burdened with. The “original sin” thesis

would make sense if countries could avoid the impossible duality and were forced to borrow abroad or

to draw on domestic savings to meet their development and investment needs. Neither option is realistic

or necessary.

Developing countries may have current account deficits and thus net capital inflows. There are,

however, close limits to both. Obviously, the formerly held view identifying more or less balanced current

accounts with external equilibrium was exaggerated. Nevertheless, there are sustainable and unsustainable

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44 This fact, which is, following the above reasoning, the normal outcome has, according to Horioka and
Feldstein (1980), been the basis of many misleading speculations concerning international capital mobility. Feldstein
and Horioka argue that the high-slope coefficient is evidence for a rather small mobility of capital or restrictions for
capital mobility, even in the group of industrial countries, as otherwise capital should be free to move and “to seek
out the most productive investment opportunities worldwide” (Obstfeld and Rogoff, 1996: 162). This is a
fundamental misunderstanding. It is just the reverse: the more similar in their structure and the more open the
countries under consideration are, the smaller will be the net movements of capital (the balances) between them.
Such a finding has no direct implications for gross movements. These can be extremely important and may lead,
without the “contradiction” seen by Obstfeld and Rogoff (1996: 162), to “the remarkable closeness of the interest
rates that comparable assets offer despite being located in different industrial countries”. The country is usually no
indication of category of importance in the markets or for economics, if we are not dealing with interferences in the
market by national governments.

45 Sometimes it seems to be forgotten in modern economics that the notion “saving in money terms” creates
a fallacy of composition. The overall economy does not save. Total savings in money terms (monetary wealth, net
financial assets) always exactly equal zero. If one group saves less, another group is “forced” to save more and vice
versa. With private households not saving at all, as in some developing countries, the savings of the company sector
will compensate for the lack of genuine saving. This is the only way to explain the catching up of earlier emerging
markets with current account surpluses (as in Japan or Germany in the 1950s), or the American experience of the
1990s. With falling savings of private households, the financial position of other sectors improved in the 1990s. The
government budget moved into surplus and companies increased their profits as a result of rising demand. This led
them to spend more money on investment in fixed capital.

current account deficits, and there is speculation about sustainability in the markets, even in the case of

the former. As a rule, current account deficits are unsustainable if they are closely related to a real

overvaluation, a loss of competitiveness. As current accounts on the macro level are just the aggregation

of accounts on the micro level, the same rules of sustainability apply as in the case of deficits of

households and companies. A country or region consisting in general of the same economic entities as any

other country a priori does not need foreign capital.44 Seen from this point of view, it is a strange idea to

believe that poor countries with little private households savings can simply “draw” on the existing

savings of industrialized regions to finance their investment.45

Hence, currency mismatches are not a central issue. Maturity mismatches are of importance only

if domestic savings determine domestic investment. If it is the other way round – i.e. the level of

investment determines the level of savings – the maturity mismatch can be neglected as an economic

policy problem. This is a crucial question, and probably the most important one. If the economic world

is dominated by the autonomous decision of private agents to spend or to save, the maturity mismatch as

well as the currency mismatch, and thus the capital account approach in general, have their merits. One

of the arguments IMF brought forward in developed and transition countries to defend the anchor

approach and/or high interest rates was indeed the “lack of capital” in these economies. According to this

orthodox view, an inflow of capital from outside or the mobilization of domestic savings by high interest

rates only could fill the “savings gap”, and thus allow for a sufficient amount of investment in fixed

capital. But if this is not the relevant theoretical model, the whole approach falls apart.

Saving out of real income is pivotal in theoretical models with given real income. If real income

is endogenous – i.e. if we are dealing with economic models bound to explain why and how real income

is or is not generated – the causal nexus of savings and investment is just the contrary. If savings do not

create investment but investment creates savings, then the “original sin” is pointless. In a non-neoclassical

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46 However, already at a very early stage of economics as a science this problem was addressed and a
preliminary solution found: the only way to finance additional investment and growth of the overall economy is by
the artificial creation of additional money. According to many early writers, including Schumpeter in 1912 and
Hayek in 1933, additional money would allow increasing investment without negative repercussions from the
capital market. This idea found its expression in the phrase of “forced saving” – a subject of concern to many
economists in the 1930s.

47 The importance of money at the beginning of the twentieth century was clearly recognized by Schumpeter
(1964) in his Theory of Economic Development of 1911. In Hayek’s (1933) view too, only abundant money allows
high growth rates and a quick development of nations. For Schumpeter it is explicitly a potentially inflationary
policy which spurs economic development. Monetary policy has to “prefinance” the process of development, without
any certainty that the additional money will be used for real growth. This explains why catching-up processes are
usually endangered by inflationary acceleration. The whole process is potentially inflationary without becoming
inflationary in the end. While a lot of studies deal with the microeconomics of Schumpeter’s theory, the no less
important subject of macroeconomics has been neglected.

48 As money savings in the economy as a whole are necessarily zero, the notion of “savings” needed to
“finance” investment is not useful at all. Investment is highly correlated with the dynamics of the overall economy;
this, however, is stimulated and not depressed by a fall in the savings rate of private households. With a fall in the
savings ratio of one group of the economy, at the end of all the adjustment processes – incorporated mainly in more
investment and more imports – the whole output will, as a rule, be higher, not lower, than it would have otherwise
been. The ratio of savings may be falling, with absolute savings (i.e. investment) rising. The savings of a single
group of the economy may be zero or negative; the economy under consideration as a whole may have invested more
in fixed capital in relation to output than ever before. The only form of meaningful “savings” for the overall
economy is, in the least analysis , fixed investment. To stimulate real investment, increasing net imports of
developing-country capital (increasing current account deficits or increased “saving” of other countries) is counter-
productive, as this will diminish profits if other sectors of the economy do not dissave by the same amount (see
Flassbeck, 1999b, for a further explanation).

(Schumpeterian) view, the existence of neoclassical savings does not foster the process of development,

as the reliance on savings out of given real income would decelerate, not accelerate, the creation of capital

through rising profits.46 In Schumpeter’s words, what is needed in these cases is not capital in the sense

of realized and unconsumed income, but just money to prefinance a process in which capital is created

by investment, and thus finally by the creation of real income.47 This is the main reason, in my opinion,

for the disastrous results of IMF’s attempt to stimulate the creation of capital in the transforming

economies by a policy of austerity and high real interest rates. It is exactly the opposite of the reasonable

in the Schumpeterian view.48


The exchange rate is neither a domestic economic policy tool nor a reliable market price. Exchange

rate changes should be the necessary concomitant of diverging inflation (or unit labour cost growth) rates.

This is the only position on exchange rates consistent with the widespread conviction that inflation is

neither necessary nor permanently exploitable in modern economies. It is the extent to which countries

differ concerning their ability to avoid inflation – the change in the value of money over time – that they

need changes in the value of money in space. This is not to repeat the outdated naive version of the

purchasing power theory. It has never been true as a theory, that is, an explanation of floating exchange

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49 Cooper (2000) reaches a similar judgement. Hicks (1968) had already taken the same stance.

rate changes in any relevant period of time. Exchange rate changes along the lines of PPP should be an

economic policy target, just as low inflation rates are. If realized, this could bring about better allocation

of resources and a smooth adjustment of financial flows between countries which, for one reason or the

other, are not able to converge their inflation performances quickly.

Hence, floating the exchange rate should be a priori excluded from the economic policy agenda.

The widespread fear of floating in emerging economies is fully justified. But it is not only justified as the

result of the fear of financial fragility; fear of floating is justified by the fear of inflation, a notion nobody

would question seriously today. Changing the exchange rate, however, between countries of diverging

inflation trends without floating means economic policy cooperation. As the exchange rate of a country

with free trade and an open capital account is, by definition, a multilateral phenomenon, it cannot be left

to the unilateral decision of one country.

Fixing the exchange rate one way or the other does not create, but only reveals, the existing lack

of monetary autonomy in a system of free capital and goods flows. There is no “impossible trinity”, but

rather an “impossible duality”.49 To open the capital account and to loose national monetary autonomy

is not contingent on the exchange rate regime. Interest rate differentials not strictly covered and sterilized

by the dominance of PPP are bound to distort any attempt to achieve successfully national monetary

targets. This is true for small open economies as well as for large closed ones. The latter may only be large

and closed enough to ignore the outcome on its external accounts.

It is one of the great errors of economics in the twentieth century to have suggested to politicians

that there is such a thing as national sovereignty in economic policy, if a unilateral monetary system is

installed which is “flexible” enough to buffer external shocks. There can be no such thing. The existing

monetary systems are barely able to balance monetary disturbances without major friction, let alone real

shocks. The worldwide crisis of 1997/8, in combination with the current euro crisis and the erratic

movements of the dollar-yen rate, shows that national sovereignty in the sense of an effective insulation

from such events does not exist. Every nation in the world is affected in some way. The loss of national

sovereignty, the “impossible duality”, is an immediate result of the opening of the goods and capital

markets, not the result of an inappropriate monetary order. There is, therefore, no alternative to

international cooperation in exchange rate policy, if free trade and largely free movement of capital are

to be guaranteed.

The idea of a cooperative global monetary system is to preserve on a multilateral basis equal

conditions for all parties concerned, much as multilateral trade rules apply to all parties in the same

manner. That is why the main idea behind the foundation of the International Monetary Fund in the 1940s

was to avoid competitive depreciations in a world without a multilateral solution for the currency problem.

In a well-designed, global monetary system the need and the advantages of the depreciation of the

currency of one country has to be balanced out against the disadvantages of others. As changes in the

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50 In a recent paper Das (2000) argues that fixed rates “are difficult to sustain in a world of increasing capital
mobility”, as they may come under speculative attack. But, at the same time, he admits that a country with
“significant policy autonomy” under flexible rates may “have trouble gaining credibility in international financial
markets” (p. 19). Obviously, the same effects may apply in both systems. A fixed rate may not be credible, and
neither may a policy with flexible rates. Speculation may test a commitment to defend a rate or lead to overshooting,
and thereby harm the economic policy objectives of governments. This kind of argument leads nowhere if the
interaction of prices, wages, interest rates and exchange rates are not explicitly analysed. For a broader analysis, see
Flassbeck (1988).

exchange rate deviating from PPP affect international trade in exactly the same manner as changes in

tariffs and export bounties do, it has to be the subject of multilateral negotiations. The reasons for the real

depreciation and the necessary dimension have to be identified in multilateral negotiations. If such rules

are applied, the real exchange rates of all parties involved will remain more or less constant, as strong

arguments to create competitive advantages at the level of the nation state will hardly be found. Real

appreciations which may have happened in one country due to overshooting wages may at best be

compensated for by an adequate depreciation of the currency. Unjustified unilateral action will force

retaliatory action by trading partners.

To unilaterally fix rates permanently, as realized in different currency board regimes all over the

world, or in dollarization, may have its merits in providing a stable monetary framework for countries with

per se unstable institutions. But fixed rates vis-à-vis large and stable as well as flourishing economies are

a mixed blessing. To keep rates stable without destroying the production potential and job opportunities

in these countries is an extremely ambitious and in many cases insolvable task. In Western Europe only

the very highly developed countries have succeeded in fixing their exchange rates without major blows

to the deutsche mark as anchor.50 But even these countries could only succeed because they are part of a

much wider multilateral institutional arrangements (the EMS and the European Union) in which they can

seek orderly workouts in the event of a crisis, which is not the case for unilateral approaches like currency


The only way out for high-inflation or high-growth countries not members of a monetary union

is to resort to controls on short-term capital flows. If they are able to avoid destabilizing inflows and

outflows either by taxing them or by directly limiting their size, the hardest choices and misallocations

caused by erratic exchange rate changes can be avoided. But resort to controls does not replace the search

for an appropriate exchange rate system. If a high-inflation or high-growth country opts – despite capital

controls – for free trade of goods with its neighbours, it has to find ways to preserve its competitive

position, i.e. how to devalue, or not to revalue, its currency.

In all respects this means returning – as in the Bretton Woods system – to a mix of adaptable

exchange rates in combination with controls in the event of a crisis. Since the most problematic sector of

the financial market “casino” is by far the foreign-exchange market, a “monitoring” and “early warning

system” should be developed by the large industrial countries in cooperation with the emerging nations.

The prompt adjustment of nominal exchange rates should prevent large imbalances in foreign trade and

a cumulative build-up of foreign liabilities. Even in such a system, destabilizing capital movements cannot

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be entirely excluded, but they are less likely to occur, because the markets have been given clear

guidelines, and because untenable interest constellations and massive real under- or over-evaluation should

be avoided. In such a case the system can minimize, though not fully avoid, surveillance and interference

in the capital account.

Regional cooperation may be a temporary answer to the challenges coming up with globalization

and liberalization if global solutions are out of reach. But regional monetary systems too do not prevent

crisis and turmoil on the capital market. Given the insolvable conflicts in a world of different nation states

in any monetary system put to the test since the Second World War, the Bretton Woods system and then

the EMS in the 1980s and early 1990s, recurring crisis-like phenomena forcing governments and central

banks to intervene have been unavoidable. Only with the creation of the EMU, have the European

countries gone a step further than in the fixed exchange rate systems of the past, and have thereby finally

done away with the speculation surrounding relative exchange-rate relations. This is an achievement for

the global economy. But it cannot be copied easily by others as their political conditions may not be as

favourable as in Europe. Nevertheless, multilateral efforts to lead the developing countries towards

regional arrangements are inevitable as long as global progress seems to be out of reach.

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UNCTAD Discussion Papers

No. 94, January 1995 XIE Ping Financial services in China

No. 95, January 1995 William W.F. CHOA The derivation of trade matrices by commodity
groups in current and constant prices

No. 96, February 1995 Alexandre R. BARROS The role of wage stickiness in economic growth

No. 97, February 1995 Ajit SINGH How did East Asia grow so fast? Slow progress
towards an analytical consensus

No. 98, April 1995 Z. KOZUL-WRIGHT The role of the firm in the innovation process

No. 99, May 1995 Juan A. DE CASTRO Trade and labour standards: Using the wrong
instruments for the right cause

No. 100, August 1995 Roberto FRENKEL Macroeconomic sustainability and development
prospects: Latin American performance in the

No. 101, August 1995 R. KOZUL-WRIGHT Walking on two legs: Strengthening democracy
& Paul RAYMENT and productive entrepreneurship in the transition


No. 102, August 1995 J.C. DE SOUZA BRAGA Financing the public sector in Latin America
& Sulamis DAIN

No. 103, September 1995 Toni HANIOTIS & Should governments subsidize exports through
Sebastian SCHICH export credit insurance agencies?

No. 104, September 1995 Robert ROWTHORN A simulation model of North-South trade

No. 105, October 1995 Giovanni N. DE VITO Market distortions and competition: the particu-
lar case of Malaysia

No. 106, October 1995 John EATWELL Disguised unemployment: The G7 experience

No. 107, November 1995 Luisa E. SABATER Multilateral debt of least developed countries

No. 108, November 1995 David FELIX Financial globalization versus free trade: The
case for the Tobin tax

No. 109, December 1995 Urvashi ZUTSHI Aspects of the final outcome of the negotiations
on financial services of the Uruguay Round

No. 110, January 1996 H.A.C. PRASAD Bilateral terms of trade of selected countries from
the South with the North and the South

No. 111, January 1996 Charles GORE Methodological nationalism and the misunder-
standing of East Asian industrialization

No. 112, March 1996 Djidiack FAYE Aide publique au développement et dette
extérieure: Quelles mesures opportunes pour le
financement du secteur privé en Afrique?

No. 113, March 1996 Paul BAIROCH & Globalization myths: Some historical reflections
Richard KOZUL-WRIGHT on integration, industrialization and growth in the

world economy

No. 114, April 1996 Rameshwar TANDON Japanese financial deregulation since 1984

No. 115, April 1996 E.V.K. FITZGERALD Intervention versus regulation: The role of the
IMF in crisis prevention and management

No. 116, June 1996 Jussi LANKOSKI Controlling agricultural nonpoint source pollu-
tion: The case of mineral balances

No. 117, August 1996 José RIPOLL Domestic insurance markets in developing coun-
tries: Is there any life after GATS?

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No. 118, September 1996 Sunanda SEN Growth centres in South East Asia in the era of

No. 119, September 1996 Leena ALANEN The impact of environmental cost internalization
on sectoral competitiveness: A new conceptual

No. 120, October 1996 Sinan AL-SHABIBI Structural adjustment for the transition to dis-
armament: An assessment of the role of the

No. 121, October 1996 J.F. OUTREVILLE Reinsurance in developing countries: Market
structure and comparative advantage

No. 122, December 1996 Jörg MAYER Implications of new trade and endogenous
growth theories for diversification policies of
commodity-dependent countries

No. 123, December 1996 L. RUTTEN & Collateralized commodity financing with special
L. SANTANA-BOADO reference to the use of warehouse receipts

No. 124, March 1997 Jörg MAYER Is having a rich natural-resource endowment
detrimental to export diversification?

No. 125, April 1997 Brigitte BOCOUM The new mining legislation of Côte d’Ivoire:
Some comparative features

No. 126, April 1997 Jussi LANKOSKI Environmental effects of agricultural trade lib-
eralization and domestic agricultural policy

No. 127, May 1997 Raju Jan SINGH Banks, growth and geography

No. 128, September 1997 E. COSIO-PASCAL Debt sustainability and social and human devel-
opment: The net transfer approach and a com-
ment on the so-called “net” present value calcula-
tion for debt relief

No. 129, September 1997 Andrew J. CORNFORD Selected features of financial sectors in Asia and
their implications for services trade

No. 130, March 1998 Matti VAINIO The effect of unclear property rights on environ-
mental degradation and increase in poverty

No. 131, Feb./March 1998 Robert ROWTHORN & Globalization and economic convergence: An
Richard KOZUL-WRIGHT assessment

No. 132, March 1998 Martin BROWNBRIDGE The causes of financial distress in local banks in
Africa and implications for prudential policy

No. 133, March 1998 Rubens LOPES BRAGA Expanding developing countries’ exports in a
global economy: The need to emulate the stra-
tegies used by transnational corporations for
international business development

No. 134, April 1998 A.V. GANESAN Strategic options available to developing coun-
tries with regard to a Multilateral Agreement on

No. 135, May 1998 Jene K. KWON The East Asian model: An exploration of rapid
economic growth in the Republic of Korea and
Taiwan Province of China

No. 136, June 1998 JOMO K.S. & M. ROCK Economic diversification and primary commod-
ity processing in the second-tier South-East
Asian newly industrializing countries

No. 137, June 1998 Rajah RASIAH The export manufacturing experience of Indo-
nesia, Malaysia and Thailand: Lessons for Africa

No. 138, October 1998 Z. KOZUL-WRIGHT & Becoming a globally competitive player: The case
Lloyds STANBURY of the music industry in Jamaica

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No. 139, December 1998 Mehdi SHAFAEDDIN How did developed countries industrialize? The
history of trade and industrial policy: The cases
of Great Britain and the USA

No. 140, February 1999 M. BRANCHI, Traditional agricultural exports, external
G. GABRIELE & dependency and domestic prices policies: African
V. SPIEZIA coffee exports in a comparative perspective

No. 141, May 1999 Lorenza JACHIA & Free trade between South Africa and the European
Ethél TELJEUR Union – A quantitative analysis

No. 142, November 1999 J. François OUTREVILLE Financial development, human capital and poli-
tical stability

No. 143, November 1999 Yilmaz AKYÜZ & Capital flows to developing countries and the
Andrew CORNFORD reform of the international financial system

No. 144, December 1999 Wei GE The dynamics of export-processing zones

No. 145, January 2000 B. ANDERSEN, Copyrights, competition and development: The
Z. KOZUL-WRIGHT & case of the music industry

No. 146, February 2000 Manuel R. AGOSIN & Foreign investment in developing countries: Does
Ricardo MAYER it crowd in domestic investment?

No. 147, April 2000 Martin KHOR Globalization and the South: Some critical issues

No. 148, April 2000 Yilmaz AKYÜZ The debate on the international financial architec-
ture: Reforming the reformers

No. 149, July 2000 Mehdi SHAFAEDDIN What did Frederick List actually say? Some
clarifications on the infant industry argument

No. 150, August 2000 Jörg MAYER Globalization, technology transfer and skill
accumulation in low-income countries

No. 151, October 2000 Bernard SHULL Financial modernization legislation in the United
States – Background and implications

No. 152, December 2000 Dilip K. DAS Asian crisis: Distilling critical lessons

No. 153, December 2000 Mehdi SHAFAEDDIN Free trade or fair trade? Fallacies surrounding the
theories of trade liberalization and protection and
contradictions in international trade rules

No. 154, June 2001 Jörg MAYER Technology diffusion, human capital and eco-
nomic growth in developing countries

No. 155, August 2001 Alberto GABRIELE Science and technology policies, industrial
reform and technical progress in China: Can
socialist property rights be compatible with
technological catching up?

No. 156, August 2001 Andrew CORNFORD The Basel Committee’s proposals for revised
capital standards: Mark 2 and the state of play


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