NCPA - National Center for Policy Analysis

NBER Studies Show Fixed Exchange Rates Don't Work

May 16, 1997

In the wake of Mexico's 1994 peso crisis, some economists are revising their view of why people stage a run on a country's currency, forceing it to abandon a fixed rate of exchange with stronger currencies, such as U.S. dollars.

Previously economists thought that if a country pursued bad economic policies, people would pull their funds out and rush to greener pastures elsewhere. But Mexico had been making great strides in reforming its economy at the time of the monetary crisis.

Two new studies from the National Bureau of Economic Research (NBER) suggest alternative explanations.

A study by Michael Bordo and Anna Schwartz reviewed 19 historical currency crises, starting in the early 18th Century.

  • They argue that all were driven by a mismatch between domestic economic policy and a pegged exchange rate.
  • Governments fix their exchange rates in order to make their currencies more stable.
  • But over time, governments can't change their currency's value against others unless they change their underlying economic policies -- but few governments understand that.

In another NBER study, Robert Flood and Nancy Marion focus on Mexico. They believe that when economists review a country's "fundamentals" they err by not including politics.

  • The attack on the peso was caused by political woes -- a revolt in Chiapas and the assassination of a presidential candidate -- which caused the government to print more money.
  • Faced with a looming bank crisis and an election, Mexico failed to tighten monetary policy, even though the peso was overvalued.
  • With no change in policy -- and no privatizations to bolster reserves -- speculators attacked, surmising that Mexico's commitment to a fixed exchange rate was not strong.

Indeed, it was finally forced to abandon its fixed exchange rate after depleting its currency reserves in a vain effort to prop up the peso.

Source: Perspective, "How Money Gets Hot," Investor's Business Daily, May 16, 1997.

 

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