Managing Currency Pegs

When confronted with the current crisis in peripheral Europe, many specialists in emerging-market macroeconomics feel that it is déjà vu all over again. An implication of this feeling is that in order to understand the current situation in southern Europe, one should dust off the theories of exchange-rate crises that were motivated by the economic experience under fixed exchange rates in Latin America in the 1980s and 1990s. We quarrel with this view. The models of the 1980s and 1990s were built around the premise that the fixed exchange-rate regime was unsustainable in the long run, primarily because of structural fiscal deficits. Celebrated examples of this body of work are the model of balanceof-payments crises in Krugman (1979) and the temporariness hypothesis in Calvo (1986). In both of these models, the emphasis is on the macroeconomic dynamics during the initial and terminal stages of finite-lived exchange-rate pegs. In our view, the world is currently witnessing an entirely new breed of currency pegs. Unlike in the Latin American experience, in the European one countries joined a currency union as part of a much larger political and economic integration program with a group of countries that includes two of the largest and most developed economies in the globe, namely, Germany and France. As a consequence, for many of the emerging countries that are part of the eurozone, and for reasons that may exceed economic considerations, breaking away from the currency union may not be a viable option. The policy challenges arising for this new generation of peggers call for at least three pieces of new theory. One piece is concerned Managing Currency Pegs