Tight Money in a Post-Crisis Defense of the Exchange Rate: What Have We Learned?
| Author | Peter J. Montiel |
| Profession | Peter J. Montiel is Fred C. Greene Professor of Political Economy at Williams College. |
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The policy advice given by the imf during the 1997 Asian financial crisis has generated much controversy. Several aspects of the imf's policy advice have been called into question, but a main focus has been its advocacy of tight monetary policy in countries experiencing recessions and banking crises. This policy prescription seems to run counter both to the standard countercyclical role that monetary policy plays during recessions in industrial countries and to the traditional role of the central bank as lender of last resort in a confidence-driven banking crisis.
The imf originally advocated a tight-money policy stance to prevent exchange rate depreciation from being "passed through" excessively to domestic prices and to limit the "overshooting" of exchange rate depreciation, thereby mitigating the adverse effects of depreciation on the net worth of domestic financial institutions and firms (see Lane and others 1999). Because many firms and banks in the crisis countries had severe currency mismatches on their balance sheets, the imf feared that an excessive depreciation of the currency would exacerbate the danger to their solvency, thereby potentially magnifying the economic dislocations and output losses associated with the crisis.
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Critics of this policy prescription assail it on two grounds. First, they claim that even if tight money had been successful in sustaining the value of the currency above what it would have been with a looser monetary policy, the high domestic real interest rates implied by this policy would themselves have probably brought about the adverse real effects the policy sought to avoid. Thus even if it had achieved its goal with respect to the exchange rate, the policy would have been suboptimal (see Krugman 1999).
Second, critics question whether tight monetary policy can ever be successful in defending the value of a currency in crisis circumstances. They argue that because high interest rates imperil the solvency of firms and banks, they reduce the likelihood that domestic agents would be able to service their external debts. Because of their adverse effects on credit risk, high domestic interest rates actually reduce the attractiveness of acquiring claims on the domestic economy and consequently may actually result in a depreciation of the currency.
To see the empirical appeal of this view, consider the monthly time-series data for interest rates and exchange rates for the Republic of Korea and Thailand during 1997'98 (figure 1).1Both countries are acknowledged by the imf to have attempted a tight-money defense of the exchange rate in the wake of the Asian crisis. The data suggest why the second criticism may be difficult to dismiss. Interest rates and exchange rates appear to have been positively correlated in Thailand during the second half of 1997 and after the spring of 1998, whereas in the Republic of Korea the positive association seems to have held over almost the entire two-year period around the time of the crisis.
The proposition that tight money can be counterproductive in sustaining the value of the domestic currency under (at least some) crisis conditions directly contradicts one of the most generally accepted tenets of international macroeconomics. For this reason, this contrarian view of events in Asia has spawned a vigorous controversy, and a substantial amount of empirical research has been devoted in recent years to testing this proposition. This article seeks to take stock of what has been learned about this issue as the result of this attention. It focuses on whether the recent systematic empirical research supports the proposition that monetary tightening after the outbreak of the Asian-or any other-currency crisis indeed resulted in currency depreciation.2 Given the novelty of the "contrarian" view, the article begins by setting out and evaluating the analytical arguments for this view.
The analytical context in which the controversy over post-crisis monetary policy has arisen is that of a small open economy that maintains a flexible exchange rate.3 The issue under debate has to do with the immediate asset-market response of the exchange rate to a change in the stance of monetary policy in such an economy. In other words, it concerns the response of the exchange rate over a relatively short time horizon. A substantial body of open-economy macroeconomic modeling has been devoted to this issue over the 30 years or so since the collapse of the Bretton Woods system.
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Figure 1.
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Conventional models of exchange rate determination are based on an asset-market approach to explaining exchange rate movements-that is, they are derived from a combination of a stable money demand function and alternative versions of an interest-parity condition linking the expected returns on financial assets denominated in domestic and foreign currencies. Such models unambiguously suggest that tighter money strengthens the exchange rate, perhaps even more in the short run than in the long run. To suggest that this association may not hold in the post-crisis context, therefore, one needs to move significantly beyond the standard models. This section reviews the analytical basis for the contrarian view before the evidence is examined in the sections that follow.
The simplest basis for the contrarian view does not question the relevance of the traditional interest parity conditions that appear in standard models or the analytical link between the domestic interest rate and a floating exchange rate suggested by these models. Instead, it notes that very high domestic interest rates would be required to raise borrowing costs sufficiently to offset the gains arising from near-certain expectations of even a relatively small depreciation of the exchange rate over a short time horizon. Because interest rates at such levels would have destructive effects on the real economy, interest rate defenses are typically mounted with lower interest rates than would be required to achieve this effect.
How could such an apparently inadequate defense be expected to be successful' The expected future exchange rate is simply the probability-weighted average of a range of potential future exchange rate outcomes. Such a defense can be successful if it reduces the probability weight placed by the market on a sharp depreciation of the exchange rate in the near future, thus resulting in an appreciation of the expected future exchange rate relative to what would have happened without the defense. This revision of probabilities could materialize if mounting an interest rate defense signals information to the market about the authorities' resolve not to allow the sharp exchange rate movement that the market expects given the state of the economy. By demonstrating that they are willing to impose high costs on the domestic economy if necessary to make it more expensive to speculate against the currency, the authorities may seek to convey their high level of resolve in defending a particular value of the currency.
This signaling channel for tight-money currency defenses has been emphasized by Drazen (2001). As he points out, however, the effectiveness of a tight-money defense depends critically on what markets actually learn from the signal the authorities send when they mount such a defense. The information the authorities hope to convey concerns their future policy intentions.4 But the message the authorities try to send and the one that the market receives may not always be the same. The Page 4 government's avowed intentions may simply not be credible. For example, if the domestic economy is weak and the government's political position is precarious, the authorities' announced willingness to inflict pain on the domestic economy to punish speculators may be interpreted by the market as no more than a bluff. This is more likely the more sensitive the domestic economy is to high interest rates (see Bensaid and Jeanne 1997), as, for example, when leverage is very high and net worth very low among domestic firms and financial institutions. The credibility of a tight-money policy may thus be weakest precisely under post-crisis conditions, when the fragile condition of the domestic economy magnifies the damage that would be done by high interest rates.
In other circumstances, the signal may actually backfire. Assume, for example, that some subset of the fundamentals that drive the value of the currency is unobservable to the market (but not to the government) and the market believes that the government is more likely to adopt an interest rate defense when these fundamentals are weak. Under these circumstances, mounting a defense may send exactly the opposite signal from that intended by the authorities, thus increasing speculative pressures against the currency (see Drazen 1999).5
The upshot is that the link between interest rates and the exchange rate is not structural but depends on how markets interpret the signal conveyed by the interest rate defense. This in turn depends on the vulnerability of the domestic economy to high interest rates, the strength of the government's political position, the extent to which the stance of monetary policy reveals information about the economy's fundamentals, and other factors. The implication of the signaling story is that the effectiveness of an interest rate defense depends on the...
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