Jeffrey Frankel came to Washington to enlist IMF economists in his search for the “missing middle”—the wide center ground that fills the spectrum between the extremes of fixed and floating exchange rates. In a lively presentation at an IMF Institute seminar on August 7, Frankel reviewed current issues in research and policy on exchange rate regimes but chiefly focused on a conundrum. Why is it that while it is the post-Asian crisis fashion for economists and policymakers to advocate deserting intermediate exchange rate regimes, roughly half of all countries still inhabit this middle ground?
In an effort to unravel the mystery of the missing middle, the Harpel Chair professor of Harvard University’s School of Government explored whether exchange rate regimes matter for the real economy, weighed the respective advantages of fixed versus floating rates, and examined new criteria for optimum currency areas. Ultimately, Frankel argued, the real culprit is not intermediate exchange rate regimes but the notion that any single currency regime is right for all countries at all times.
Exchange rate goals
Drawing on the Princeton University Graham Lecture that he presented in April this year, Frankel noted that in the late 1990s, a view evolved that only a rigidly fixed exchange rate or a clean float would solve the problems that come with modern globalized financial markets. This hypothesis, Frankel observed, seems to be held as a corollary of the “impossible trinity,” which posits that a country can pick only two goals from the tripartite menu of exchange rate stability, monetary independence, and financial market integration.
Frankel provided a new angle on the trinity, noting that, as international financial market integration becomes more of a given, countries’ options seem to boil down to a single choice: exchange rate stability or monetary independence. But while a country cannot have complete exchange rate stability and complete monetary policy independence, it could—through a managed float—have some of both.
Frankel did not overlook the motivations that might prompt a country to abandon the “soft middle ground of flexible rates.” Monetary union and pure floating are the two regimes invulnerable to speculative attack, and complicated intermediate regimes may be insufficiently transparent to global investors. Most of the intermediate regimes that have been tried have failed—“of ten spectacularly so,” he conceded. Though formally pegged to the dollar when their crises hit, Mexico, Thailand, Indonesia, Korea, Russia, and Brazil were all following a variety of middle regimes.
Nonetheless, Frankel pointed out, neither pure floating (which is subject to large swings in exchange rates and speculative bubbles) nor currency unions (which can be broken by political upheavals) are the policymaker’s nirvana. Indeed, one of the most interesting questions Frankel put on the table was, “Would any exchange rate regime have prevented the recent crises in emerging markets?”
Frankel offered both theoretical and empirical arguments against the current conventional wisdom that countries should retreat from intermediate regimes because they are intrinsically unsustainable. Such a view, he said, tends to overlook one of the economist’s stocks in trade: that life involves trade-offs and, thus, corner solutions are of ten not optimal. Countries pick fixed exchange rates because they reduce transactions costs and exchange rate risks that might discourage trade and investment. They also fix their exchange rates to provide a credible nominal anchor for monetary policy. A floating exchange rate allows a country to pursue an independent monetary policy that accommodates negative real shocks without constricting demand.
Countries have to weigh the advantages of more exchange rate stability against those of more flexibility, and picking the optimal degree of flexibility would of ten seem to yield an inferior solution. Moreover, Frankel pointed out that the fixed versus floating debate is a vastly oversimplified dichotomy. There is a continuum of flexibility, so that you must travel from currency union to currency board just to arrive at a fixed exchange rate regime, and then must continue through pegs (adjustable, crawling, basket, and target zones) before reaching the free float. Based on the IMF classification of 185 economies in late 1999, 51 were independent floaters, 45 had abandoned national currencies, and 89 (48 percent of the total) had intermediate regimes.
The recent work of Guillermo Calvo and Carmen Reinhart of the University of Maryland is also germane, Frankel said. It is difficult to distinguish floaters from exchange rate targeters when you look at exchange rate stability and foreign reserve changes. Floaters should have less of both than the targeters, but this is not the empirical finding.
Optimum currency areas
Frankel used his research with Andrew Rose of the University of California at Berkeley on optimum currency areas to provide an elegant example of his proposition that the optimal exchange rate regime varies across countries and over time. Frankel and Rose found that among countries in currency unions, income correlation depends positively on trade integration. This suggests that a parameter assumed to be external to the choice of an optimum currency area—income correlation among potential members—is inherent to that choice and can change over time. Empirical results suggest that when a country adopts the currency of a neighboring state, the monetary union gradually promotes trade between the neighboring countries, which in turn has a positive effect on the correlation of their incomes. Thus, a currency union, by promoting trade among members, raises countries’ cyclical correlation so that they may come to better satisfy the optimum currency area criteria ex post than they did ex ante; in other words, countries can “grow into” being good candidates for an optimum currency area.
In his view, Frankel concluded, there are good arguments to be made against the current conventional wisdom that would have countries limiting their exchange rate choices to the extreme ends of the exchange rate spectrum—that is, either firmly fixed or freely floating.