Everyone wants economic stability, and many are reluctant to abandon today what gave them stability yesterday. But trying to obtain stability from rigidity is illusory. The stability of the international financial system today depends on the willingness of countries with rigid exchange rates to allow greater flexibility.
In the aftermath of the international financial crisis of 1997-1998, many emerging markets found themselves – through currency depreciation, rapid productivity gains, or both – highly competitive. Countries that ran significant current-account surpluses, built up large reserves, and fixed (or heavily managed) their exchange rates in order to support the first two objectives appeared to secure external stability.
The irony is that the crisis of 1997-1998 was one in which a particular system of exchange-rate pegs failed when capital flowed out. Yet, in many ways, accumulating reserves worked better than anyone could have imagined – countries found that they could withstand considerable shocks and growth was impressive both domestically and globally. So, within a few years, many countries concluded that their pegs could work fine if supported by large enough war chests of official reserves. A new type of order emerged in the world’s exchange rate system.
There were, of course, some less desirable spillover effects on others. If a considerable fraction of the world economy wants to run a current-account surplus (by 2006, this included much of emerging Asia, most oil exporters, and Japan), an equal share of the world economy must run a deficit. In the period after 1998, the United States provided almost the entire required deficit.