Fiscal conservatism, exchange rate flexibility, and the next generation of debt crises.

• Author: Rogoff, Kenneth

Despite all the invective hurled at international financial markets by critics of the "Washington Consensus," the fact is that strong healthy financial markets are essential for middle-income countries that aspire to the ranks of advanced countries. Deeper financial markets mean a better "allocation of risk, but they can also make economies more vulnerable to crises. The question is not simply how to avoid crises entirely, but how to handle the ones that do inevitably occur. When it comes to avoiding international debt crises, the single best precaution any middle-income country can take is to keep down its debt/GDP ratios, especially public debt, and especially public external debt. The second most important step is to adopt a sufficiently flexible exchange rate regime. Whereas relatively fixed exchange rates systems work well for poor developing countries that are insulated from international capital markets, they are a lightening rod for disaster for upper-middle-income and advanced countries, except perhaps for economies headed toward a currency union.

Lessons from the Recent Debt Crises

There is little question that overly rigid exchange rate regimes played a central role in virtually every major international debt crisis over the past decade. Mexico (1994), Thailand and Asia (1997-98), Russia (1998), Brazil (1999), and Argentina (2001) all fell into debt crises under the weight of unsustainable fixed exchange rate regimes. As Obstfeld and I wrote in our 1995 paper "The Mirage of Fixed Exchange Rates," countries with open capital markets are very seldom able to maintain fixed rates for more than half a dozen years without experiencing a major crisis.

Many economists (e.g., Jagdish Bhagwati, Dani Rodrik, and Joseph Stiglitz) lay the blame for the 1990s debt crises on premature capital market liberalization, and there is an important element of truth to this. But it would be far more accurate to say that the real problem in the 1990s was that Asian economies liberalized their capital markets without simultaneously making their exchange rates more flexible. Had they done both simultaneously, most if not all of the crisis-stricken countries would still have experienced a crisis, but the problems would likely have been smaller and easier to manage. One can point to many reasons why New Zealand and Australia did not collapse in the same way as other Asian economies, including better financial market regulation. But during the European Monetary System crisis of the early 1990s, Sweden had reasonably strong and well regulated financial markets, but this did not protect it from catastrophe when speculators challenged its exchange rate peg. I have little doubt that Australia and New Zealand would have met the same fate but for their very flexible exchange rates.

Vulnerability to Future Crises

Will the world be less vulnerable to crises over the next decade than it was over the preceding decade? There is good news and bad news. The good news is that outside Asia, and excluding central European countries that are hoping to join the euro system, few countries today have rigid exchange rates. Brazil can certainly thank its flexible exchange system for helping it to survive its 2002 crisis, together, of course, with prudent domestic macroeconomic management and $30 billion in back-loaded IMF loans.

But there are also several reasons for...