NEW HAVEN: Asia’s leaders have finished their meeting in Kuala Lumpur with all sorts of promises. It is to be hoped that all have concluded, in the wake of a year of crisis, that fixed but adjustable exchange rates are a bad idea.
The only viable regimes, indeed, in our globalized financial world are floating exchange rates and irretrievably fixed rates. Most developing, emerging, and transition economies should henceforth have currencies with floating rates.
East Asia’s victims of currency crises were, like most other nations, on fixed rates - pegged to the dollar, other major hard currencies, or baskets of currencies. The central bank promised to redeem its own currency on demand by any holders, foreign or domestic, in prescribed amounts of hard currencies. Often these pegs were ranges rather than precise values, and in many cases the midpoint of the bracket moved over time at a prescribed speed. These pegged rates were not immutable. Central banks could adjust them or abandon them at any time, violating their solemn promises.
Naturally, market participants speculate on these possibilities. Worse, they speculate on what other currency holders will think. This is the inherent source of the system’s instability. Although everyone seems surprised when currency crises occur, they are not surprising and happen at one time or another to almost all fixed-exchange-rate currencies. Recently, they have hit European countries (the United Kingdom, Italy, Spain, Sweden, Finland), Latin America (notably Mexico in 1994), Russia and other transition economies, as well as Asia’s tigers.