Why Would a Country Fix Its Exchange Rate? Borrowing Somebody Else's Credibility

Fixing an exchange rate means the central bank undertakes to buy or sell its own currency at a stated rate whenever anyone wants to trade at it, which requires holding reserves of the anchor currency to sell when demand for the local currency falls. Maintaining the rate constrains everything else, since interest rates must be set at whatever level keeps capital from flowing out, which means they follow the anchor country's policy rather than domestic conditions. That is the central trade, and it is frequently described as a trilemma, in that a country can have a fixed exchange rate, free movement of capital and independent monetary policy in any two combinations but not all three at once.

Regimes range across a spectrum rather than falling into two categories:

• •Hard pegs, including adopting another currency outright or a currency board with full reserve backing
• •Conventional pegs at a stated rate, defended by intervention
• •Crawling pegs, adjusted gradually according to a rule
• •Bands, allowing movement within a stated range around a central rate
• •Managed floats, where the rate moves and the authorities intervene without announcing a target
• •Free floats, where the rate is set by the market and intervention is rare

The benefits are real and are largest for particular kinds of economy. A fixed rate removes exchange risk for trade and investment, which matters enormously to small open economies whose trade is a large share of output. It imports the anchor country's inflation record, which is valuable for a government whose own record is poor and whose promises to control inflation are therefore not believed, so the peg substitutes a visible commitment for an unconvincing one. It simplifies planning for firms and households. And it removes the temptation to inflate away debts, which is precisely the constraint some governments want to impose on themselves. The cost is that domestic conditions cannot be addressed with interest rates, so a recession must be met with fiscal measures or endured.

Adopting a shared currency outright takes the arrangement to its limit and clarifies what pegs are trying to achieve. Members give up monetary independence permanently rather than conditionally, which removes the speculative attack entirely since there is no rate to defend and no separate currency to sell. The cost is that a member in recession while others expand cannot adjust, and the classic analysis holds that a currency area works when labour moves freely between members, when wages and prices adjust, when fiscal transfers cushion regional shocks and when the members' economies move together. The European experience after 2010 tested those conditions directly and found several of them weak, which is why the crisis took the form it did and why subsequent reform focused on fiscal arrangements rather than on monetary ones.

A peg survives as long as the market believes it will, which makes the failures abrupt. When traders judge that the rate is unsustainable, they sell the currency, the central bank must buy to defend it, reserves fall, and the visible fall in reserves confirms the judgement, which accelerates the selling. Raising interest rates to defend the rate deepens whatever domestic difficulty already exists, and that political cost is what speculators are betting the government will not bear. Several prominent failures followed exactly this pattern, including the departure of sterling from a European exchange rate arrangement in 1992 and the Asian currency crises of 1997. A peg that is abandoned generally goes in a single step rather than gradually, and the resulting devaluation is severe.

Holding a rate requires buying and selling the currency on demand and forces interest rates to follow the anchor country, which is the trade the arrangement makes. Small open economies and governments with poor inflation records gain the most. Defence fails when the political cost of high rates is judged unbearable, and the abandonment is abrupt rather than gradual.