by Paul Krugman
The key lesson from that conventional model is that abrupt runs on a currency, which move billions of dollars in a very short time, are not necessarily the result either of irrational investor stampedes or of evil financial manipulation. On the contrary, they are the normal result when rational investors contemplate the implications of unsustainable policies.
Some economists, however—notably Berkeley’s Maurice Obstfeld and Barry Eichengreen—argue that the standard model is too mechanical in its representation of government policy; and that the more complex motives of actual governments make speculation a more uncertain and perhaps more pernicious affair. Self-fulfilling crises, in which a currency that could have survived is nonetheless brought down, are a hot topic these days. But everyone agrees that a sufficiently credible currency will never be attacked, and a sufficiently incredible one will always come under fire.
Making the World Safe for George Soros
The very first real paper I ever wrote in economics was a piece entitled “A Model of Balance of Payments Crises,” written in 1977. It was a theoretical analysis of the reasons why attempts to maintain a fixed exchange rate typically end in abrupt speculative attacks, with billions of dollars of foreign exchange reserves lost in a matter of days or even hours. What I had in mind at the time were the attacks that brought down the Bretton Woods system in 1971 and its short-lived successor, the Smithsonian agreement, a year and a half later. It seemed to me then that the main interest of the paper would be historical; I did not expect to see attacks of that scale and drama again.
Based on a talk at the Group of 30, London, April 1997.
Luckily, I was wrong. I say “luckily,” because as the founding father of what has long since become the academic industry of speculative attack theory, my citation index goes up every time another currency crisis materializes, trailing its tail of economic analyses and rationalizations. And the decade of the 1990s has so far produced a bumper crop of crises, which is fun for me if not for the ministers involved.
But why are there so many crises? Why haven’t finance ministers, central bank governors, and so on learned to avoid them? To understand the durability of the speculative attack problem, you need to be aware of an underlying dilemma in exchange rate policy. To describe this dilemma, I find it helpful to think in terms of a little matrix of opinion, defined by the different answers to two questions.
The first question is whether flexibility on the exchange rate is useful. A country that fixes its exchange rate, in a world in which investors are free to move their money wherever they like, essentially gives up the opportunity to have its own monetary policy: Interest rates must be set at whatever level makes foreign exchange traders willing to keep the currency close to the target rate. A country that allows its exchange rate to float, on the other hand, can reduce interest rates to fight recessions, raise them to fight inflation. Is this extra freedom of policy useful, or is it merely illusory?
The second question is whether, having decided to float the currency, you can trust the foreign exchange market not to do anything crazy. Will the market set the currency at a value more or less consistent with the economy’s fundamental strength and the soundness of the government’s policies? Or will the market be subject to alternating bouts of irrational exuberance (to borrow Alan Greenspan’s famous phrase) and unjustified pessimism?
The answers one might give to these questions define four boxes, all of which have their adherents. Here is the matrix:
Is exchange rate flexibility useful?
No
Yes
Can the forex market be trusted?
Yes
Relaxed guy
Serene floater
No
Determined fixer
Nervous wreck
Suppose that you believe that the policy freedom a country gains from a floating exchange rate is actually worth very little, but you also trust the foreign exchange market not to do anything silly. Then you will be a very relaxed guy: You will not much care what regime is chosen for the exchange rate. You may have a small preference for a fixed rate or better yet a common currency, on the grounds that stable exchange rates reduce the costs of doing business; but you will not lose sleep over the choice. This is, I believe, the position of so-called “real business cycle” theorists, who believe as a matter of faith in the efficiency of private markets, and don’t believe that monetary policies of any kind make much difference to how those markets function.
Suppose, on the other hand, that you believe that the freedom gained by floating is very valuable, but that financial markets can be trusted. Then you will be a serene floater: You will believe that freeing your currency from the shackles of a specific exchange rate target, so that you can get on with the business of pursuing full employment, is unambiguously a good thing. This was the view held by many economists in the late 1960s and early 1970s; indeed, I remember as an undergraduate picking up from my teachers a definite sense that they regarded the whole Bretton Woods system as a barbarous relic, a needless straitjacket on macroeconomic policy.
You will be equally sure of yourself if you believe the opposite: that foreign exchange markets are deeply unreliable, dominated by irrational bouts of optimism and pessimism, while the monetary freedom that comes with floating is of little value. You will then be a determined fixer, seeking to lash your currency immovably to the mast—best of all, by creating a common currency shared by as many countries as possible. This is, as I understand it, the position of most of the central bankers of continental Europe.
But what if you believe both that the freedom that comes from floating is valuable and that the markets that will determine your currency’s value under floating are unreliable? Then you will be a nervous wreck, subject to stress-related disorders. You will regard any choice of currency regime as a choice between evils, and will always worry that you have chosen wrong.
Well, the last decade or so has given us a lot of evidence that bears on the two questions. True, the world rarely gives us clean natural experiments—although in some cases it comes pretty close. (For example, when Ireland decided in 1987 to stop pegging the punt to the pound sterling and start pegging it to the Deutsche mark, the prices of Irish goods abruptly stopped tracking the U.K. price level and starting following the German index instead—a fairly dramatic demonstration that money matters and therefore that monetary policy can matter, too, even in a small country.) I believe, however, that there is enough evidence to make a clear pronouncement: The nervous wrecks have it. Yes, the monetary freedom of a floating rate is valuable; no, the foreign exchange market cannot be trusted.
Let me start with the value of a floating rate. The classic case against there being any such value is that any attempt to make use of monetary autonomy will quickly backfire. Imagine, in particular, a country that drops its commitment to a fixed exchange rate, and uses that freedom to cut interest rates (which of course leads to a decline in the value of its currency). Ardent defenders of fixed rates insist that instead of an increase in employment, the result will very soon be a surge in inflation, wiping out both any gain in competiveness vis-à-vis foreign producers and any stimulus to real domestic demand. This was a position that seemed to be supported by a reading of the evidence in such cases as the repeated depreciations of the pound in the 1970s, or the devaluation of the Swedish krona in 1982.
To be honest, I never accepted that interpretation even of those events. But in any case a succession of more recent events has made it harder and harder to sustain this view of the way the world works. In the mid 1980s the U.S. dollar quickly dropped from 240 to 140 yen, from 3 marks to 1.8; there was not a hint of the surge in inflation that some had predicted. Many Europeans discounted this experience—after all, America, with its huge economy and relatively small reliance on international trade, is a special case; matters would be different if a European country tried the same thing. Then came the crises of 1992. I was assured by many French economists that Britain’s depa
rture from the Exchange Rate Mechanism would swiftly be punished; and Sweden’s finance minister personally assured me that a depreciation of the krona would be an inflation disaster. Yet Britain got off scot-free—and even Sweden, when it depreciated a few weeks after my conversation with Ms. Wibble, suffered none of the predicted pain.
Nobody would claim that devaluing your currency is always and everywhere a good thing. What we can say, based on experience, is that the freedom to pursue an independent monetary policy that comes with a flexible exchange rate is indeed valuable as long as you start from a position of low inflation, and as long as domestic price increases are restrained by the presence of a lot of excess capacity. These may sound like restrictive conditions, but they aren’t: They are exactly the conditions under which you would want the freedom to cut interest rates in the first place.
So far so good—but then there is the problem of the foreign exchange market.
Economists are, for understandable reasons, attached to the “efficient markets” theory of financial markets—a theory that attributes all fluctuations in financial prices to news about current or expected future fundamentals. As a sort of benchmark, an explanation of first resort for how asset prices behave, this theory has been enormously useful and productive—not to say lucrative, since much of the modern risk-management industry is based on that theory. But in many markets, very much including the foreign exchange market, the theory has become more or less impossible to believe as a literal description. Part of the argument involves technical tests—the anomalies just keep piling up, and the efforts to rationalize those anomalies within an efficient market framework have become an ever more desperate matter of adding epicycles.
But beyond these technical assessments, there is the simple question of plausibility—what it sometimes known as the “smell test.” Can anyone come up with a good reason—which is to say real changes in what the markets knew about fundamentals—that justified a shift of the yen/dollar exchange rate from 120 plus in 1993, to 80 in 1995, then back to 120 plus in 1997? Isn’t it far more reasonable to view the whole thing as a case of exchange traders following a trend they themselves had created? And of course these were not small swings: For Japanese industry the absurdly strong yen was a body blow.
So we are, as I said, firmly placed in the “nervous wreck” box of my little matrix. And that is the reason why the speculative attack industry—or perhaps I should say industries, since it comprises both those like me who write about such attacks, and, far more important, those like George Soros, who actually engage in them—continues to thrive.
After all, if ministers were serene floaters, they would simply treat the foreign exchange market with benign neglect; and they would therefore offer no target for speculative attack. If they were utterly determined fixers, they would do whatever was necessary to beat back speculative attacks—and the speculators, knowing this, would rarely attack in the first place. What creates an environment in which Soros can make money and I can write papers is the prevalence of finance ministers who decide to fix their currencies, but are suspected of being less than total in their commitment to that policy.
Let me say a bit more about the kind of speculative attacks that flourish in this environment; for there have been some major developments in the theory since I and a few other people started it twenty years ago.
The original models of such attacks imagined a country that was known to be following policies ultimately inconsistent with keeping its exchange rate fixed—for example, printing money to cover the budget deficit. That is, the eventual doom of the fixed rate was not in question to an informed observer. The speculative element came from the incentive of investors to anticipate the inevitable. Knowing that eventually the currency would drop in value, investors would try to get out of it in advance—but their very effort to get out of a weak currency would itself precipitate the collapse of the fixed rate. Understanding this, sophisticated investors would try to get out still earlier…the result was that a massive run on a currency could be expected at a time when it might still seem to have enough reserves to go on for many months or even years.
This analysis is still the canonical one, but recent discussion has emphasized three further concerns.
First, some economists have argued for the importance of self-fulfilling currency crises. They imagine a country whose government is prepared to pay the cost of sticking to an exchange rate indefinitely under ordinary circmstances, but which is not willing and/or able to put up with the pain of keeping interest rates high enough to support the currency in the face of speculators guessing that it might be devalued. In that case the fixed rate will survive if investors think it will; but it will also collapse if they think it will.
Second, there is the obvious point that if markets are subject to irrational shifts in opinion, to running with the herd, this applies as much to speculative attacks on fixed exchange rates as to gyrations in the value of flexible exchange rates. One remarkable fact is that there is not a sign in the markets that the great currency crises of the nineties were anticipated—that is, until only a few weeks before Black Wednesday in Britain, or the Mexican crisis of 1994, investors were cheerfully putting their money into pounds or pesos without demanding any exceptional risk premium. (This in spite of the fact that quite a few economists were actually warning in each case that a crisis might be in prospect). Then quite suddenly everyone wanted out. Was this because of some real news—other than the observation that everyone else suddenly wanted out?
Finally, there is the return of the gnomes of Zurich. Finance ministers whose currencies are under attack invariably blame their problems on the nefarious schemes of foreign market manipulators. Economists usually treat such claims with derision—after all, the British politician who coined the phrase was so ignorant that he didn’t even know that the gnomes actually live in Basel. But nobody who has read a business magazine in the last few years can be unaware that these days there really are investors who not only move money in anticipation of a currency crisis, but actually do their best to trigger that crisis for fun and profit. These new actors on the scene do not yet have a standard name; my proposed term is “Soroi.”
There are, of course, two ways to defeat all of these speculative pressures. One is to be basically indifferent to the exchange rate, depriving the Soroi of their “one-way option.” The other is to lock in the exchange rate beyond all question—something best done by simply creating a common currency, leaving nothing to speculate in.
Which of these is the better solution? That is a peculiarly difficult question to answer. We have a theory of “optimum currency areas,” which gives us a checklist of the things that ought to matter; but it is famously hard to turn that checklist into an operational set of criteria. What recent theorizing—backed by recent experience—does seem to indicate is that you should make a choice one way or the other. That is, in a world in which hot money can move as easily as it now does, an imperfectly credible fixed exchange rate combines the worst of both worlds: You forsake the policy freedom that comes with a flexible rate, yet you remain open to devastating speculative attacks.
If a group of countries decide that they should, in fact, adopt a common currency, everything we know about the economics says that they should follow what Barry Eichengreen calls the Nike strategy: Just do it. A prolonged transition period simply creates a target-rich environment for speculative attack, as markets have time to wonder, “Will they or won’t they?”
One can only imagine the prospects for speculative havoc if the project to create a single currency involves a transition period of many years; sets rules for that transition period that impose severe economic hardship on the countries involved, hardship that undermines popular support for the project without in any real way preparing the ground for the unified currency; and last but not least, creates a basic uncertainty about whether any individual country, no matter how much it is committed to the idea of monetary union, will be allowed to join—bec
ause admission to the club is, in the end, contingent on criteria that are very hard to meet and in any case ambiguous in their interpretation.
Is it possible that the framers of the Maastricht Treaty—Europe’s plan to create economic and monetary union—were secretly on the payroll of the Soroi? Or that they enjoyed the idea of playing a massive practical joke on their fellow Europeans? Or did they simply fail to think it through?
Part 6
Beyond the Market
Money makes the economic world go round, but it is a means, not an end. The essays in this part of the collection are all, one way or another, about the difference between prices and values—and the light that economic analysis can shed on that difference.
The first, “Earth in the Balance Sheet,” uses environmental politics to offer a new riff on an old theme in economics: the idea that markets go wrong when important scarce resources are not priced. The next pursues the same idea, this time focusing on traffic congestion. In both cases, the failures of markets offer a strong rationale for government intervention. Unfortunately, democratic politics itself is afflicted by some of the same “market failures” that the political process must try to cure; I address that problem in the third essay here, “Rat Democracy.”
The remaining essays are less conventional in their themes. “A Medical Dilemma” argues that improvements in medical technology pose a deep moral and political issue: How much are we willing to let money buy? “The CPI and the Rat Race,” taking off from some disputes about (of all things) the measurement of inflation, tries to get a grip on the implications of the indisputable fact that people care not only about how well they live in absolute terms, but about their relative status.
