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Bordo, Michael D.

Article Exchange rate regimes, globalization, financial crises, and monetary policy

NBER Reporter Online

Provided in Cooperation with: National Bureau of Economic Research (NBER), Cambridge, Mass.

Suggested Citation: Bordo, Michael D. (2006) : Exchange rate regimes, globalization, financial crises, and monetary policy, NBER Reporter Online, National Bureau of Economic Research (NBER), Cambridge, MA, Iss. Winter 2006/07, pp. 10-13

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Exchange Rate Regimes, Globalization, Financial Crises, and Monetary Policy

Michael D. Bordo*

My research in the past decade has con- Today while advanced countries can market that mitigated these effects involved centrated largely on four related themes successfully float, emergers who are less significant start-up costs, while the impor- that I discuss in this article: Exchange Rate financially mature and must borrow abroad tance of scale suggests that network exter- Regimes, Globalization, Financial Crises, in advanced country currencies are afraid to nalities and liquidity were pivotal in the and Monetary Policy. float, for the same reason as their nineteenth emergence of overseas markets in domestic century forbearers were. To obtain access to currency debt.5 Exchange Rate Regimes foreign capital, they may need a hard peg to The limiting case of a fixed exchange the core country currencies. In my paper with rate regime is a monetary union. My study As discussed in the Fall 999 NBER Marc Flandreau the key distinction between of the history of monetary unions (MUs) Reporter, much of my earlier work focused core and periphery countries, both then with Lars Jonung 6—based on the exam- on the gold standard and related mone- and now, is financial maturity, evidenced in ples of the United States, Germany, and tary regimes. A series of papers with Finn the ability to issue international securities Italy — suggests that the success of MUs Kydland, Ronald MacDonald, and Hugh denominated in domestic currency3 (or the of the past has been intimately linked with Rockoff emphasized the importance of absence of “original sin”, a phrase coined by both fiscal and political unification. The credible commitment mechanisms in the Eichengreen and Haussman (999)4). implementation of EMU was largely driven design of monetary regimes, focusing on the However, a case study by Chris Meissner, by the political will of elites and its ultimate gold standard. My recent work extends this Angela Redish, and myself of the debt history success may also depend upon the political approach. of several former colonies of Great Britain will of the citizenship. The choice of exchange rate regimes, (the United States, Canada, Australia, New between fixed and floating exchange rates, Zealand, and South Africa), who had largely Globalization evolved considerably in the past hundred overcome the problem of original sin by the years.2 Before 94, advanced countries third quarter of the twentieth century, finds Globalization—the integration of adhered to gold while periphery countries that sound fiscal institutions, high credibility goods, labor, and capital markets — has been either emulated the advanced countries or of the monetary regimes, and good financial one of the dominant issues in the past sev- floated. Some peripheral countries were development are not sufficient to completely eral decades. The present era of globaliza- especially vulnerable to financial crises and break free from original sin. Conversely, tion was preceded by an earlier era in the late debt default, in large part because of their poor performance in these policy realms is nineteenth century — from 870 to World extensive external debt obligations denomi- not, for the most part, a necessary condition War I. Globalization in historical perspec- nated in core country currencies. This left for Original Sin. The factor we emphasize tive was the subject of a recent NBER con- them with the difficult choice of floating for the common progress toward borrowing ference volume, edited with Alan Taylor but restricting external borrowing or devot- in domestic currencies across the five coun- and Jeffrey Williamson. The articles in the ing considerable resources to maintaining an tries is the presence of shocks, such as wars, book covered many aspects of the globaliza- extra hard peg. massive economic disruption, and the emer- tion experience, including the integration gence of global markets. The differences in of markets, growth convergence, inequal- *Bordo is a Research Associate in the NBER’s evolution between the United States and ity, financial development, the transmission Programs on Monetary Economics and the the Dominions we attribute to differences in of shocks, and the political economy of the Development of the American Economy. size, the role of a key currency, which charac- backlash in the interwar period that ended He is also a Professor of Economics at terized the United States and not the others, the first era of globalization. Rutgers University. During 200–7, he and to membership in the British Empire. My research with Barry Eichengreen is the Pitt Professor of Economic History The importance of major shocks suggests and Douglas Irwin7 focused on a compari- at Cambridge University and a Fellow at that the establishment of a domestic bond son of the record of financial and commer- Kings College Cambridge.

10 NBER Reporter Winter 2006/7 cial globalization in the two eras of global- policies. One possible determinant of cri- 973–98, with countries in the same region ization.8 The empirical evidence we survey ses in emerging countries is the presence of not receiving assistance, suggests that the suggests that, while in some respects the original sin. real performance of the former group was financial integration of the pre-94 era My work with Chris Meissner finds, in possibly worse than the latter. Similar results remains unsurpassed, in other respects both eras of globalization, an increased prob- are obtained after adjusting for self-selection today’s financial markets are even more ability that emerging countries with original bias and counterfactual policies7. closely integrated than those in the past. sin experienced debt, currency, and bank- The difference today is that new informa- ing crises. Furthermore, crises were more Monetary Policy tion-generating-and-processing technolo- likely to be a problem for middle-income gies have reduced the market-segmenting emerging countries that were less financially Economic history has long provided effects of asymmetric information. In con- developed. In the first era of globalization, a useful laboratory for the practitioners of sequence, the range of financial claims that countries like Italy, Portugal, Argentina and monetary policy. My research in the area has are traded internationally has broadened. Brazil were more crisis-prone than Australia, focused on deflation and monetary policy While in the past entities (governments, Canada, Denmark, and Sweden. and asset prices. railroads, and mining companies) with tan- Another part of this research program Deflation in historical perspective gible and therefore relatively transparent focuses on the transmission of financial cri- assets were predominant, now international ses. Antu P. Murshid and I (2000)2 pres- The return in the 990s to an environ- investors transact freely in a much broader ent evidence from weekly data on sovereign ment of low inflation has raised the spec- range of securities. bond prices and interest rates for episodes of ter in the United States of deflation and the We also find that the commercial inte- financial turbulence from 880 to 997. We collapse of prices such as occurred in the gration before World War I was more lim- find little evidence for contagion, defined 930s. My work with Angela Redish focuses ited. Given that integration today is even as an incidence in bilateral cross-market on the deflationary experience of 870–96 more pervasive than a hundred years ago, it correlations, adjusted for heteroscedastic- during the pre-94 classical gold standard is surprising that trade tensions and finan- ity. However, we do find evidence sugges- period. That episode has resonance for today cial instability have not been worse in recent tive of transmission via fundamentals-based because the gold standard regime, anchored years. Institutional innovations that have trade channels. A related paper (Bordo and by a credible commitment to maintaining taken place in the past century, such as the Murshid, 2002)3, using principal compo- long-run price stability, conveys similarities evolution of sound monetary and fiscal poli- nents analysis on monthly spreads on long- to today’s central bank commitment to low cies, the establishment of the Bretton Woods term bond yields, finds that financial market inflation, and in both eras globalization was Institutions, GATT and the WTO, may be shocks were more globalized before 94 present with major technology shocks. We part of the explanation. than they are now.4 use a structural VAR methodology to dis- Financial crises represent an extreme tinguish between good deflation, reflecting Financial Crises and Financial form of financial instability. Michael Dueker, productivity-driven increases in aggregate Instability David C. Wheelock, and I (2000, 2002)5 supply, and bad deflation, driven by col- construct indexes of financial stability for lapses in aggregate demand. Our findings The recent era of globalization has been the United States and the United Kingdom for the United Kingdom and Germany are characterized by a large number of finan- for 790–997. We find that aggregate price that deflation was primarily of the good vari- cial crises, both currency and banking cri- level and inflation shocks contributed to ety; for the United States, these results gen- ses, especially in the emerging markets.9 My financial instability in the 790-933 and erally prevail with the exception of a bank- research with Barry Eichengreen and others 986-97 periods. ing-panic-induced demand-driven deflation considers whether this is a new phenom- Finally, my research has examined the episode in the mid-890s.8 Andrew Filardo enon. Using a database for 2 countries role of policy in preventing, managing, and and I (2004)9 generalized this finding to a from 880–997, we compiled evidence on resolving crises. Anna J. Schwartz and I panel of over twenty countries for the past the incidence, duration, and costs of vari- (998) examine the historical record over two centuries. With the exception of the ous types of crises across four exchange rate the past two centuries on international res- interwar period we find that deflation was regimes.0 Like the evidence on financial cues. We contrast the experiences before generally benign. integration, ours came with a strong feeling 973 of rescues of monetary authorities of Monetary Policy and Asset Prices of déjà vu. The incidence and duration of advanced countries that were temporarily currency crises have increased since earlier short of liquidity with the experience in The link between monetary policy and eras of globalization, while those of bank- the 990s of bailouts of insolvent emerg- asset price movements has been of peren- ing crises are similar. The output losses of cri- ing countries. In a later paper, we assess the nial interest to policymakers. Should the ses are quite similar across eras of globaliza- impact of IMF loans on the macro perfor- monetary authorities intervene to offset an tion except for twin crises, which have been mance of the recipients.6 A simple with- asset boom before it turns into a bubble that worse. Moreover, we find that crises seem without comparison of countries receiving bursts, with severe consequences for the real to reflect both economic structure and bad IMF assistance during crises in the period economy? Olivier Jeanne and I (2002)20

NBER Reporter Winter 2006/7  present some stylized facts on boom-bust Historical Perspective, M. D. Bordo, A. torical experience on banking crises. dynamics in stock and property prices in Taylor, and J. Williamson, eds., Chicago: 0 M. D. Bordo and B. Eichengreen, “Crises twenty OECD countries in the past thirty University of Chicago Press (2003); and M. Now and Then: What Lessons from the years, as well as for the United States for the D. Bordo, “Market Discipline and Financial Last Era of Financial Globalization”, NBER past 50 years. We find that asset booms Crisis Policy: An Historical Perspective”, Working Paper No. 71, January 2002; turning into busts are infrequent events, but Research in Financial Services: Private and M. D. Bordo, B. Eichengreen, D.Klingebiel, when they happen they are sometimes asso- Public Policy, Vol. 1, (200), pp 15–2. and S.Martinez-Peria, “Is the Crisis ciated with considerable economic distress. 4 B. Eichengreen and R. Haussman, Problem Growing More Severe?” Economic We develop a theoretical framework that “Exchange Rates and Financial Fragility”, Policy, (2001); and M. D. Bordo and B. outlines the circumstances under which a NBER Working Paper No. 71, November Eichengreen, “Is Our Current International central bank may consider following a pre- 1999. Economic Environment Unusually Crisis emptive policy to prevent the consequences 5 M. Flandreau and N. Sussman, Prone?”, in International Financial System: of a bust. “Old Sins: Exchange Rate Clauses and Conference Proceedings, (1999), D. Wheelock and I (2004)2 examine the European Foreign Lending in the 19th Gruen and L. Gower, eds., Reserve Bank of economic environment in which past U.S. Century”, in Other People’s Money: Debt Australia, Sydney. stock market booms occurred as a first step Denomination and Financial Instability  Earlier evidence on the transmission of toward understanding how these booms in Emerging Markets Economies, B. banking crises is in M. D. Bordo, “ Some come about and whether monetary pol- Eichengreen and R. Hausmann, eds., Historical Evidence 170–1933 on the icy should be used to defuse them. In gen- Chicago and London: University of Chicago Impact and Transmission of Financial Crises”, eral, we find that booms in the past century Press (2005). NBER Working Paper No. 10, September and a half occurred in periods of rapid real 6 M. D. Bordo and L. Jonung, “ The 19; and M. D. Bordo, B. Mizrach, growth and productivity advance, suggest- Future of EMU: What Does the History of and A. J. Schwartz, “Real Versus Pseudo ing that booms are driven at least partly by Monetary Unions Tell Us?” NBER Working International Systemic Risk: Some Lessons fundamentals. We find no consistent rela- Paper No. 735, September 1999. Also From History”, Review of Pacific Basin tionship between inflation and stock mar- see M. D. Bordo, “The United States as a Financial Markets and Policies, (199). ket booms, though; booms have typically Monetary Union and the Euro: A Historical 2 M. D. Bordo and A. P. Murshid, “Are occurred when money and credit growth Perspective”, Cato Journal, Vol. 2, No. 1–2, Financial Crises Becoming Increasingly More were above average. Spring/ Summer 200, pp.13–70. Contagious? What is the Historical Evidence 7 M. D. Bordo, B. Eichengreen, and J. on Contagion?”, NBER Working Paper No.  M. D. Bordo and F. Kydland, “The Kim, “Was There Really an Earlier Period 7900, September 2000. Gold Standard as a Rule: An Essay in of International Financial Integration 3 M. D. Bordo and A. P. Murshid, Exploration”, Explorations in Economic Comparable to Today?”, NBER Working “Globalization and Changing Patterns in History (1995); M. D. Bordo and H. Paper No. 73, September 199; and M. the International Transmission of Shocks in Rockoff, “The Gold Standard as a `Good D. Bordo, B. Eichengreen, and D. Irwin, “Is Financial Markets”, NBER Working Paper Housekeeping Seal of Approval’”, Journal of Globalization Today Really Different than No. 9019, June 2002. Economic History (199); and M.D.Bordo Globalization a Hundred Years Ago?”, in 4 This differs from Paulo Mauro, Nathan and R. MacDonald, “Violations of the Brookings Trade Policy Forum, S. Collins Sussman, and Yishay Yafeh, “Emerging ‘Rules of the Game’ and the Credibility of and R. Lawrence, eds, Brookings Institution, Market Spreads: Then Versus Now”, the Classical Gold Standard, 10–190”, Washington, D.C. (1999). Quarterly Journal of Economics 7, NBER Working Paper No. 115, July 1997. 8 Also see M. Obstfeld and A. Taylor, (2002), pp.95–733, which may be attribut- 2 J. A. Frankel, “Experience of and Lessons Global Capital Markets: Integration, Crisis, ed to the use of different country samples. Our from Exchange Rate Regime in Emerging and Growth, Cambridge University Press, sample contains both advanced and emerg- Economies”, NBER Working Paper No. (200). ing countries while theirs was based solely 10032, October 2003. Also M. D. Bordo and 9 In “Why Clashes Between Internal and on emerging countries. In “Have National H. James, “One World Money, Then and External Stability Goals End in Currency Business Cycles Become More Synchronized?”, Now”, NBER Working Paper No. 1219, Crises, 1797–199”, NBER Working Paper NBER Working Paper No. 10130, December May 200, posits that in today’s world of No. 5710, June 1997, Michael D. Bordo and 2003, Bordo and Thomas Helbling also find globalization and large shifts in relative Anna J. Schwartz present a narrative of the evidence that global shocks are the key deter- prices, the Einsteinian or relative conception history of currency crises from 1797–199, minant of the synchronization of business of money implicit in floating exchange rates is which reflects a clash between internal and cycle movements observed across exchange rate more suitable than the Newtonian view that external stability goals. In “Some Historical regimes from 10 to the present. underlies the case for fixed exchange rates. Evidence 170-1933 on the Impact and 5 M. D. Bordo, M. Dueker, and D. C. 3 M. D. Bordo and M. Flandreau, International Transmission of Financial Wheelock, “Aggregate Price Shocks and “Core Periphery, Exchange Rate Regimes, Crises”, NBER Working Paper No. 10, Financial Instability: An Historical Analysis”, and Globalization”, in Globalization in September 19, Bordo examines some his- NBER Working Paper No. 752, April

12 NBER Reporter Winter 2006/7 2000, and “Aggregate Price Shocks and October 200, Michael D. Bordo, Ashoka and A. Redish, “Good versus Bad Deflation: Financial Stability: The United Kingdom Mody, and Nienke Oomes find evidence that Lessons from the Gold Standard Era”, NBER 179–1999”, NBER Working Paper No. following the adoption of an IMF program, Working Paper No. 10329, February 200. 53, November 2001. both macroeconomic aggregates and capital 9 M. D. Bordo and A. Filardo, “Deflation 6 In “The International Monetary Fund: flows improve, although they may initially and Monetary Policy in a Historical Its Present Role in Historical Perspective”, deteriorate somewhat. Consistent with theo- Perspective: Remembering the Past or Being NBER Working Paper No. 772, June 2000, retical predictions and earlier empirical find- Condemned to Repeat It?”, NBER Working Michael D. Bordo and Harold James describe ings, they also find that IMF programs are Paper No. 1033, October 200. the evolution of the IMF from its origins as most successful in improving capital flows to 20 M. D. Bordo and O. Jeanne, “Boom- the guardian of the Bretton Woods adjustable countries with bad, but not very bad, fun- Busts in Asset Prices, Economic Instability, peg exchange rate system and financier of tem- damentals. In such countries, IMF programs and Monetary Policy”, NBER Working Paper porary current account deficits for advanced are also associated with improvements in the No. 9, May 2002. countries to its present primary roles as devel- fundamental themselves. 2 M. D. Bordo and D. C. Wheelock, opment financier and crisis manager for the 8 M. D. Bordo and A. Redish, “Is Deflation “Monetary Policy and Asset Prices: A Look emerging world. Depressing? Evidence from the Classical Gold Back at Past U.S. Stock Market Booms”, 7 In “Keeping Capital Flowing: The Role of Standard”, NBER Working Paper No. 9520, NBER Working Paper No. 1070, August the IMF”, NBER Working Paper No. 103, March 2003; and M. D. Bordo, J. L. Lane, 200.

The Microeconomic Evidence on Contagion, Capital Controls, and Capital Flows

Kristin J. Forbes*

On December 9, 2006, Thailand exchange rates, stock indices, investment, and the definition has evolved over time.4 The implemented restrictive capital controls on growth. This “microeconomic approach” to last decade has clearly shown that crises that foreign investment and the Thai stock index answering questions in international finance originate in relatively small economies (such fell by over 5 percent before trading was has the benefit of using the wealth of infor- as Thailand) can quickly affect markets of halted. Investors quickly began to draw com- mation incorporated in firm behavior — in- very different sizes and structures located parisons to the summer of 997, asking if formation that is lost in the aggregation pro- around the world, including markets that events in Thailand would spark contagion cess used to create macroeconomic statistics. appear unrelated to the country where the and be the first in a series of crises around the Heterogeneity across firms can be an impor- crisis originated. globe. My research over the past few years tant tool in identifying the impact of vari- Early analyses of contagion tested for has attempted to provide the framework ous macroeconomic events. This strategy of increased comovement between countries and analysis to understand these types of using disaggregated and firm-level data in after a crisis (in variables such as their stock events — covering topics from financial con- international economics recently has become returns, bond spreads, exchange rates, or tagion and global linkages to capital controls popular in the international trade literature capital inflows). One complication with this and capital flows. as well as in international finance.2 approach, however, is that the correlation Many researchers — including other coefficients underlying this analysis depend NBER affiliates — have made important Contagion, Currency Crises, on market volatility and can be biased. My contributions to these topics. Much of my and the Cross-Country work with Roberto Rigobon shows how this own research has tried to take a different Transmission of Shocks bias can significantly affect estimates of con- approach by using firm-level data to under- tagion.5 We develop a correction for this bias stand the macroeconomic movements in A series of financial crises—Mexico, and show that most recent crises were trans- Asia, Russia, Argentina — motivated an mitted to other countries through linkages * Forbes is a Research Associate in the academic literature on “contagion” and the that exist in all states of the world — and not NBER’s Program on International Finance 3 and an Associate Professor of Economics at international transmission of crises. The through special transmission channels that MIT’s Sloan School of Management. Her term contagion is generally used to refer to only occur during crises. Other authors have profile appears later in this issue. the spread of negative shocks — although since used different identifying assumptions

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