The continuing economic and financial challenges facing members of the euro area, combined with more recent pressures on some emerging market and developing countries, raise a familiar question. What is the best monetary regime for countries facing such stresses? The answer is that no monetary regime is best for all countries, at all times, in all circumstances, including times of stress. The more rigid the monetary regime a country chooses—for example, involving a hard peg or (in the extreme) participation in a monetary area—the greater the importance of finding the right macroeconomic policy tools to achieve economic and financial stability. But a full toolbox does not guarantee policy success.
Consider the countries in the euro area. During the peak period of the global financial crisis in 2008 and 2009, the national authorities did not have to worry about pressures on their exchange rates, as they did during the 1992–93 crises in the semi-fixed Exchange Rate Mechanism of the European Monetary System. A decade and half earlier, a number of countries were forced to devalue their currencies. They and their partners recovered, but the economic chaos lasted several years.
In 2008 and 2009, the euro declined by 15 percent against the US dollar, but the euro depreciated for the entire area, rather than having the German currency rise while the Italian currency fell, and the European Central Bank (ECB) eased monetary conditions dramatically to cushion the impact of the global financial crisis on the euro area economy as a whole. On a real effective basis, against 61 other currencies adjusted for differences in inflation rates as reported by the Bank for International Settlements, the euro fluctuated in a narrow range of less than 5 percent from mid-2007 to late in 2009. The countries of the euro area were well served by their choice of monetary arrangements.
More recently, however, some individual euro area countries arguably have been less well served by their participation in the euro area. From late 2009 until late 2012, when several euro area countries were in crisis, the euro again declined by 15 percent against the dollar and by a similar amount on a real effective basis over the same period. But the euro’s depreciation—coupled with only a moderately expansionary monetary policy by the ECB—failed to restore growth to the European countries in crisis or to correct their loss of competitiveness in the last 10 years.
Fiscal policy and price and wage flexibility did not adequately compensate for the lack of exchange rate or monetary policy tools. Perhaps some of these countries should never have joined the euro area, but bygones are bygones. Had they not done so, they would have lacked the advantage the euro conveyed during the global financial crisis. Perhaps they should have withdrawn from the euro area after 2009, but the economic and financial costs of withdrawal would have been substantial for them and their partners.
The emerging market and developing countries in the spotlight today have their own monetary policies. In principle, they do have the scope to allow their exchange rates to adjust to changes in global economic and financial conditions. Recently, the exchange rates of several countries—Brazil, India, Turkey, South Africa, and others—have come under unwelcome downward pressure. Their central banks have resisted tighter monetary policies and used their foreign exchange reserves out of concern about slowing economic growth.
Exchange rate flexibility and national control over monetary policy have proved to be insufficient to deliver optimal economic results. The reason is that at least some of these emerging and developing economies had overheated, developed large current account deficits, recorded rising rates of inflation, and become addicted to short-term capital inflows, which contributed to currency mismatches. Perhaps they are better off than if they had hard exchange rate pegs or were members of a monetary area. But even with greater scope to use exchange rate and monetary policy tools, they have not escaped stress.
The lesson of these two tales is that no monetary regime is best for all countries or in all circumstances, but that whatever a country’s regime, the available tools must be employed carefully before crises strike.