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The developing world should abandon parochial currencies

Author: Benn Steil, Senior Fellow and Director of International Economics
January 16, 2006
Financial Times

Of all the objections that have been raised against globalisation—including its alleged damage to income equality, workers’ rights, democracy and the environment—none is even remotely as compelling as the devastating periodic havoc wreaked by currency crises in developing countries.

Economists with the most impeccable pro-globalisation credentials, such as the Financial Times’ Martin Wolf and my colleague, Jagdish Bhagwati, acknowledge capital flows as theAchilles heel of globalisation. Mr Wolf has argued that, thus far, the gains of integrating emerging markets into world capital markets “have been questionable, and the costs of crises enormous”. Mr Bhagwati has criticised “hasty and imprudent financial liberalisation”. I would like to say they are wrong, given that any justification for capital controls can appear to be a concession to otherwise misguided anti-globalisers. But they are right.

It is nonetheless critical to recognise that what we think of as globalisation is not the same thing as classical economic liberalism writ global, and that modern globalisation may be flawed without liberalism as a framework being similarly flawed. The best evidence comes from a much older era of globalisation, from the late 1870s until 1914. Not only was the world then comparably integrated on the basis of trade metrics, but by a number of financial metrics much better integrated. Purchasing power parity and real interest rate equalisation held internationally to a degree not seen before or since. Mean current account deficits and surpluses as a percentage of gross domestic product were twice as large. And studies have shown that capital flows did a better job of matching available capital to investment needs.

Perhaps most surprising is that short-term capital flows actually played a highly stabilising role: trade deficits could be reliably financed through short-term inflows stimulated by a modest rise in short-term interest rates. Furthermore, although financial crises did occur, recovery tended to be considerably more rapid. Why?

The monetary system that evolved during the globalisation of the late 19th and early 20th centuries was very different from today’s. Known widely as the gold standard, it comprised countries voluntarily backing their money with gold at a fixed rate of exchange. The Bank of England played a critical role, as its credible commitment to convertibility gave investors confidence to move funds globally rather than scramble for gold. Furthermore, countries facing financial crises found gold flowing in rather than out. As domestic assets became cheaper after a crisis, the expectation that exchange rates and asset prices would eventually revert to pre-crisis levels because of governments’ commitment to the gold standard boosted gold imports.

The post-1971 international monetary “system” comprises nearly 200 currencies, all circulating in the form of irredeemable IOUs. During gold-backed globalisation, commodity prices were aligned internationally about as well as they were across regions within countries. Today, we are so used to a world of autarkic national currencies that we consider it normal not for commodity prices to align internationally, but for the entire structure of prices in each country to shift up and down against the entire structure of other countries’ prices. Thus a fall in the global (dollar) price of a commodity such as coffee tends not to produce necessary diversification away from inefficient types of production, but an engineered economy-wide inflation and devaluation in countries in which coffee exporters are politically powerful. The central bank distorts all other prices in the economy to prevent adaptation to falling world coffee prices. This is at the root of development stagnation for many poorer countries.

The textbook case for floating a national currency is founded on the stabilising effects of using the exchange rate to protect domestic interest rates from movements in foreign rates and the ability to lower interest rates to counteract recessions. Yet the evidence is that the opposite happens: under floating rate regimes, developing country interest rates are more sensitive to foreign rates and, perversely, are more likely to have to go up rather than down during a recession to prevent capital flight.

Currency crises are now a big worry, particularly for countries with fixed or pegged exchange-rate regimes. Over the past two decades, severe crises have hit developing countries across Latin America and Asia, as well as those just beyond the borders of western Europe—in particular Russia and Turkey. The problem in each case emerged when they sought to take advantage of the opportunities afforded by a dollar-dominated international marketplace for capital. For developing countries that carries a fatal risk: creditors precipitate crises when they fear devaluation and in consequence default on dollar debts.

In short, developing countries do not actually see economic benefits from operating an independent monetary policy. Their interest rates are in effect tethered to US rates and their dollar capital imports expose them to currency crises—crises that would have been obviated by the gold backing that underpinned 19th-century globalisation and that deliberately disallowed independent policy.

Today, the best option for developing countries intent on globalising safely is simply to replace their currencies with internationally accepted ones, namely the dollar or the euro. Latin America’s star economic performer in 2004 was politically volatile Ecuador, which grew at 6.6 per cent with 2.7 per cent inflation, the lowest in 30 years. Ecuador dollarised in 2000. If the European Union were wise, it would change its policy on extending the euro entirely and offer to assist Turkey and others in adopting it immediately.

Anti-globalisers will be aghast at such a blow to “monetary sovereignty”. But that concept is among the most damaging sovereignty fetishes to have emerged in the 20th century. Spanish and later higher-quality Mexican silver coins circulated freely throughout the US until the late 19th century. Medieval popes actually condemned rulers for debasing currencies, which is today’s fatal state solution to every economic toothache.

One need only look at Argentina, generating double-digit inflation once again, to see the anti-globalisation backlash that inevitably emerges from the wreckage of failed experiments with national monies that no one wants to hold. Globalisation’s earlier golden age has taught us that capital flows need not be the Achilles heel of today’s reincarnation. The key is to refound globalisation on monies that people will hold without compulsion.

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