Free Currency Markets, Financial Crises and the Growth Debacle: Is There a Causal Relationship?

The paper develops an alternative hypothesis that attributes collateral responsibility for therecent spate of financial crises to a basic flaw of the architecture of the international financialsystem, free markets for foreign exchange. A valid positional distinction between reserve/ hardand soft currencies, based on reputation, accounts for the systematic substitution of the formercurrencies for a country’s soft currency in liquid asset holdings. The result of this “asymmetricreputation” in an environment of free currency markets is the systematic devaluation of softcurrencies. Moreover, bubbles, devaluations and financial crises, far from being self-correctingmonetary phenomena, can lead to sharp contractions in the economy through the misallocation ofresources in competitive devaluation trade, as opposed to comparative advantage trade. In a casethat is parallel to asymmetric information and incomplete credit markets, the appropriate policyintervention in asymmetric-reputation driven incomplete currency markets is maintaining mildlyrepressed exchange rates. The operational definition of “mild” is imposing restrictions oncurrency substitution, whether it is home-grown or it is the result of foreign financial capitaltaking short positions on the local currency. JEL Classification: F31, F41, G15